In 1983, I founded Grameen Bank to provide small loans that people, especially poor women, could use to bring themselves out of poverty. At that time, I never imagined that one day microcredit would give rise to its own breed of loan sharks.

Commercial microcredit has given microfinance a bad name and suffered for it. Following on a political backlash against MFIs in India, shares in SKS Microfinance have plunged to less than half of their peak in Sept-Oct 2010. The industry has seen collection rates fall to 20%, from the enviable 99% it enjoyed previously. The state of Andhra Pradesh, where much of the lending is concentrated, has passed a new law substantially restricting the activities of MFIs and the national government and central bank are likely to come up with new nationwide regulation as well.

To believe industry pundits much of this has to do with political convenience. Asking the poor not to pay their debts is a populist measure to score easy political points. MFI proponents have also indicated that the industry itself needs to be better at elaborating on the benefits it provides.

Is commercial microcredit an illustration of mission drift?

Yet it cannot be so simple. If MFIs do provide an irreplaceable service to the poor why are those same people happy to see MFIs go out of business? Perhaps the backlash is simply a reaction to what we know is wrong with microcredit, and to how far it has drifted from its roots:

Commercialization has been a terrible wrong turn for microfinance, and it indicates a worrying “mission drift” in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity.

We have known for some time that microcredit may not be a panacea for poverty. Neither the impacts nor mechanics of poverty alleviation through microcredit are obvious. Microcredit, as a business, is immensely successful. Microcredit, as a tool for socio-economic development has been of questionable effectiveness.

Rather than address this obvious disconnect MFIs in India have been busy growing big. And some have been busy cashing in. Little thought has been given to fixing what does not work or explaining what we do not understand.

What is clear is that the industry, which emerged with the express purpose to help lift people out of poverty, has simply neglected the most basic of infrastructure requirements such as a credit bureau. If the backlash has been politically convenient for bureaucrats and politicians, the lack of any emphasis on development has been economically convenient for the industry.

What happens in microcredit will happen in any social business

No doubt the industry will be forced to address these shortcomings and may move closer to the social roots from which it had drifted. However, this backlash exposes a fundamental contradiction most social businesses face.

A growing view in western thinking has been that for-profit business models can serve as a complement or alternative to philanthropy and public spending. Failing public schools can be replaced by (or have been replaced by) cheap private ones; ineffective health systems can be replaced by private clinics; lack of electricity, water, and other basic necessities can all be addressed by private providers.

This view, that difficult social issues can be addressed by businesses “at the bottom of the pyramid” has been propogated by many and has led to a rush of professionals from investment banking and management consulting to the sector. The logic is that since public money is insufficient to tackle these issues, profitable approaches will encourage the trillions of private wealth to enter this field. JP Morgan even went so far as to call impact investing an “emerging asset class.”

Yet, this entire movement can trace its roots back to microcredit. And if microcredit hasn’t proven to be particularly successful at balancing social impact with business returns, can impact investing do better?

We expect that social businesses (to use the term loosely) provide social impact as a direct corollary to the business objectives. Thus, microcredit helps people out of poverty through provision of loans. Yet, the two impacts are rarely in alignment – more loans to an individual does not translate into a faster climb out of poverty, just to indebtedness. Private education may be better than public education and help empower a generation. But a private provider, once entrenched, would be encouraged to maximize profits to the point acceptable to customers – yet, it is hard to imagine how higher fees could possibly benefit the poor. The same can be said for healthcare providers. They, like private schools, would be encouraged to provide the lowest level of service acceptable to customers, so long as it beats that of the public school.

If we are to ensure this does not happen in the broader universe of social business and impact investing we must first be intellectually honest about one thing.

Social businesses are essentially businesses. Private capital may help them grow but it brings with it a strong tendency to turn social businesses from being social to being businesses.

For investors, this means if we wish an organization to remain true to its social objectives we can ask it to operate as a charity. Alternately, we can require it to meet its social objectives either through regulation or incentives. But to expect that social businesses will, without being coerced, somehow not drift from their social objectives towards their business imperatives is naive.

For businesses themselves, it means they must acknowledge this dichotomy and be clear about where they position themselves. Being seen as social comes with a responsibility to live up to that promise, or risk a subsequent backlash when the disconnect between promise and reality is exposed.

In order to help get some kind of bearing on the impact of microfinance, we present here a short literature review on how microfinance affects the lives of the poor. The selected papers are organized into three categories: the broader context, the impact of microcredit, and the impact of microsavings (surprisingly, there seems to have been more work done on savings than credit).

The broader context

Effects of Financial Access on Savings by Low-Income People
Fernando Aportelo, Bank of Mexico
December 1999

This paper assesses the impact of increasing financial access on low-income people savings. Effects on households’ saving rates and on different informal savings instruments are considered. The paper uses an exogenous expansion of a Mexican savings institute, targeted to low-income people, as a natural experiment and the 1992 and 1994 National Surveys of Income and Expenditures. Results show that the expansion increased the average saving rate of affected households by more than 3 to almost 5 percentage points. The effect was even higher for the poorest households in the sample: their saving rate increased by more than 7 percentage points in some cases. Furthermore, the expansion, in general, had no effect on high income households. In the case of informal savings instruments, evidence of crowding out of these instruments caused by the expansion is limited. Results do not rule out the possibility that a considerable fraction of the increase in households’ savings could have come from new savings.

Do Rural Banks Matter? Evidence From The Indian Social Banking Experiment
Robin Burguess & Rohini Pande; LSE, Yale University
August 2003

Lack of access to finance is often cited as a key reason why poor people remain poor. This paper uses data on the Indian rural branch expansion program to provide empirial evidence on this issue. Between 1977 and 1990, the Indian Central Bank mandated that a commercial bank can open a branch in a location with one or more bank branches only if it opens four in locations with no bank branches. We show that between 1977 and 1990 this rule caused banks to open relatively more rural branches in Indian states with lower initial financial development. The reverse is true outside this period. We exploit this fact to identify the impact of opening a rural bank on poverty and output. Our estimates suggest that the Indian rural branch expansion program significantly lowered rural poverty, and increased non-agricultural output.

The Economic Lives of the Poor
Abhijit V. Banerjee and Esther Duflo; Abdul Latif Jameel Poverty Action Lab, MIT
October 2006

This paper uses survey data from 13 countries to document the economic lives of the poor (those living on less than $2 dollar per day per capita at purchasing power parity ) or the extremely poor (those living on less than $1 dollar per day). We describe their patterns of consumption and income generation as well as their access to markets and publicly provided infrastructure. The paper concludes with a discussion of some apparent anomalous choices.

The Impact of Microcredit

Expanding Microenterprise Credit Access: Using Randomized Supply Decisions to Estimate the Impacts in Manila
Dean Karlan, Jonathan Zinman;
Yale University, Darthmouth College, IPA, Financial Access Initiative, MIT Jameel Poverty Action Lab
July 2009

Microcredit seeks to promote business growth and improve well-being by expanding access to credit. We use a field experiment and follow-up survey to measure impacts of a credit expansion for microentrepreneurs in Manila. The effects are diffuse, heterogeneous, and surprising. Although there is some evidence that profits increase, the  mechanism seems to be that businesses shrink by shedding unproductive workers. Overall, borrowing households substitute away from labor (in both family and outside businesses), and into education. We also find substitution away from formal insurance, along with increases in access to informal risksharing mechanisms. Our treatment effects are stronger for groups that are not typically targeted by microlenders: male and higher-income entrepreneurs. In all, our results suggest that microcredit works broadly through risk management and investment at the household level, rather than directly through the targeted businesses.

The miracle of microfinance? Evidence from a randomized evaluation
Abhijit Banerjee, Esther Duflo, Rachel Glennerster, Cynthia Kinnan; MIT Jameel Poverty Action Lab, Indian Centre for Micro Finance, Spandana
October 2009
Hyderabad, India

The researchers from the Abdul Latif Jameel Poverty Action Lab (J-PAL) at MIT and the Indian Centre for Micro Finance worked with Spandana to randomize the roll-out of its microcredit operations in Hyderabad, India’s fifth-largest city. Spandana chose 104 areas of the city to expand into eventually, rejecting some districts as having too many construction workers, who come and go and might take Spandana’s money with them. In 2006–-07 Spandana started lending in a randomly chosen 52 of the 104. Researchers followed up by surveying more than 6,000 households between August 2007 and April 2008, restricting their visits to families that seemed more likely to borrow: ones that had lived in the area at least three years and had at least one working-age woman. The surveyors made sure not to visit an area until Spandana had been there at least a year. They surveyed in “treatment” areas (ones where Spandana worked) and control ones (where it did not yet).

The impact of microsavings

The Impacts of Savings
Dean Karlan
Financial Access Initiative
January 2008

A summary of literature on the impact of microinsurance up to January 2008.

Female Empowerment: Impact of a Commitment Savings Product in the Philippines
Nava Ashraf, Dean Karlan, Wesley Yin; HBS and Jameel Poverty Action Lab, Yale, University of Chicago
March 2008

Female “empowerment” has increasingly become a policy goal, both as an end to itself and as a means to achieving other development goals. Microfinance in particular has often been argued, but not without controversy, to be a tool for empowering women. Here, using a randomized controlled trial, we examine whether access to and marketing of an individually-held commitment savings product leads to an increase in female decision-making power within the household. We find positive impacts, particularly for women who have below median decision-making power in the baseline, and we find this leads to a shift towards female-oriented durables goods purchased in the household.

Savings Constraints and Microenterprise Development: Evidence from a Field Experiment in Kenya
Pascaline Dupas and Jonathan Robinson; UCLA, UCSC, NBER
March 2009

We conducted a field experiment to test whether savings constraints prevent the self-employed from increasing the size of their businesses. We opened interest-free savings accounts in a village bank in rural Kenya for a randomly selected sample of poor daily income earners. Despite the fact that the bank charged substantial withdrawal fees, take-up and usage was high among women and the savings accounts had substantial, positive impacts on their productive investment levels and expenditures. These results imply that a substantial fraction of daily income earners face important savings constraints and have a demand for formal saving devices (even for those that offer negative de facto interest rates).

Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines
Nava Ashraf, Dean Karlan, Wesley Yin
July 2005

We designed a commitment savings product for a Philippine bank and implemented it using a randomized control methodology. The savings product was intended for individuals who want to commit now to restrict access to their savings, and who were sophisticated enough to engage in such a mechanism. We conducted a baseline survey on 1777 existing or former clients of a bank. One month later, we offered the commitment product to a randomly chosen subset of 710 clients; 202 (28.4 percent) accepted the offer and opened the account. In the baseline survey, we asked hypothetical time discounting questions. Women who exhibited a lower discount rate for future relative to current tradeoffs, and hence potentially have a preference for commitment, were indeed significantly more likely to open the commitment savings account. After twelve months, average savings balances increased by 81 percentage points for those clients assigned to the treatment group relative to those assigned to the control group. We conclude that the savings response represents a lasting change in savings, and not merely a short-term response to a new product.

On the other hand, NYTimes microfinance evangelist Nicholas Kristof recently called for a “savings revolution”. To back up that call to arms, Rodman points to a great study on the impact of microsavings. That study, by Dupas and Robinson from rural Kenya, is an exciting read for it shows that despite negative rates of return on savings accounts, rural women both love savings accounts and seem to benefit from them:

We find that, about 6 months after having gained access to the account, the daily private expenditures of women sampled for the account were, on average, 37 to 44% higher than those of women in the comparison group. Their average daily food expenditures were 14-29% higher.

Why do savings accounts work so well? The study points out this may be because women without accounts “may be tempted to spend any cash that they hold” and because “it may be difficult to refuse requests for money.” In other words, savings accounts bring discipline to consumption patterns.

There is an interesting parallel with microcredit here. Recent studies of microfinance show that microcredit tends to smooth out consumption – allowing people to purchase consumer goods (TVs, refrigerators) that they would not be able to pay for up front. No doubt, microsavings can help individuals do the same – consumer more. However, there is a huge difference in the dynamics of how that consumption happens. In the case of microsavings, individuals are spending past income. In the case of microcredit, individuals are spending future income – money they neither have nor can risk loosing.

This also leads us to another benefit of microsavings – it acts as insurance in times of illnes. This is another “suggestive finding” of the Dupas and Robinson study:

We find that individuals are not fully protected from income risk. In particular, our logbooks show that, over the period of study, women in the control group were forced to draw down their working capital in response to health shocks. Women sampled for the savings account, however, were less likely to reduce their business investment levels when dealing with a health shock and were better able to smooth their labor supply over illness. In particular, women in the treatment group were more likely to be able to afford medical expenses for more serious illness episodes.

Finally, there is reason to believe that microsavings might be better business as well. For one, it requires no startup capital – which is provided by the clients themselves. Second, the cost of providing credit should actually be higher that for provision of savings – because accepting savings does not require doing a credit check. And finally, operational costs should also be similar or lower.

That logic brings us full circle. Microsavings do much the same for the poor as microcredit (i.e. smooth consumption and investment). And they do so at a lower cost. So why not replace microcredit with microsavings – which seems to be microcredit at a lower cost and with insurance built in.

For more, read Financial Inclusion in India and Do Rural Banks Matter.

The studies are not new but their coverage on the NYT is certainly refreshing. And looking at them together reveals a few interesting points.

First, it is clear that the accepted usage of the term “microfinance” has expanded substantially. First Macro Bank should not even be compared to Spandana for its target clientele is extremely different – existing entrepreneurs with above average national income. That FMB qualifies as a “microlender” seems to suggest merely that microfinance is now behaving as any business – going after the most profitable clients.

Second, it is clear that the impact of microfinance is a lot more fuzzy than development enthusiasts had us believe:

The effect on businesses is not dramatic but some clearly benefit. In the Philippines, male-owned businesses increase profits, although female-owned businesses do not. In India, borrowers who already own a business buy assets for their business. One borrower out of eight starts a business they would not have started otherwise. Others buy durables for their homes

However, there is no evidence that microcredit has any effect on health, education, or women’s empowerment, at least right now, eighteen months after they got the loans. On the other hand, there is also no evidence that people are behaving irresponsibly. Indeed in India we have evidence of people giving up some of the little daily pleasures of life (like tea, snacks, betel leaves and tobacco), to pay for bigger things that they could not previously afford (carts for their business, televisions for their homes).

So, microfinance has no clear impact on socio-economic indicators. And that is ok according to the authors.

Many seem to think that this is not enough. However, as we see it, microcredit seems to have delivered exactly what a successful new financial product is supposed deliver—allowing people to make large purchases that they would not have been able to otherwise. The fact that some people expected much more from it (and perhaps they are right, may be it will just take longer), is perhaps inevitable given how eager the world is to find that one magic bullet that would finally “solve” poverty. But to actually blame microcredit for not promoting the immunization of children is no different from blaming immunization campaigns for not generating new businesses.

In other words, the failure of microfinance to deliver a miraculous cure for poverty is a failure of its early proponents, not of the method itself. As a report pointed out in 2006, microfinance should be viewed as just another business. That perspective is very necessary if we are to get some realism into the debate on what works in microfinance and what does not.

Microfinance has succeeded in developing a relatively low-cost delivery model that can reach millions of underserved clients. That is its success. Its failure is that it has for too long believed in its own rhetoric of poverty alleviation. Now that we know that is not true, it is time to move beyond an obsession with providing credit, to other financial products such as savings and insurance that are likely to be much more effective at insulating the poor from life’s volatility.

The result: Today in India, some poor neighborhoods are being “carpet-bombed” with loans, says Rajalaxmi Kamath, a researcher at the Indian Institute of Management Bangalore who studies the issue. In India, microloans outstanding grew 72% in the year ended March 31, 2008, totaling $1.24 billion, according to Sa-Dhan, an industry association in New Delhi.

This development should hardly be surprising as commentators have long warned of the perils of too much credit chasing too few good candidates. That, and poor governance, were identified last by the MF Banana Skins 2008 report as key challenges for the future of the industry.

There is a parallel here with the sub-prime crises which had its origins in these same twin problems – too much credit and moral hazard on the part of those doing the lending (see this post for more). Yet, despite these problems, microfinance continues to grow.

According to the Monitor Institute microloan volume grew from USD 4 billion in 2001 to USD 25 billion in 2006. And new microfinance investment vehicles (MIVs) are going beyond debt financing to take equity stakes as well (e.g. the DWM Microfinance Equity Fund I closed this summer with USD 82 million from four institutional investors), illustrating a growing confidence in this sector.

An interesting observation is that loan volume growth seems to be outpacing actual investment growth by a large margin. While loan volumes were USD 25 billion in 2006, a CGAP brief estimates assets in MIVs in Europe and the US at only USD 6.5 billion. The remaining money must be coming from savings, public equity (e.g. Compartamos), philanthropic grants, IOs, and other public institutions. Nevertheless, MFIs must still be heavily leveraged to have such large loan books.

A second observation is that while private MIVs have the most incentive to ensure quality of microloans they also have the most incentive to charge higher interest rates. This is particularly so now that microfinance advocates have advertised themselves as a new and uncorrelated asset class resilient to the economic recession.

This makes microfinance doubly vulnerable compared to housing finance before the sub-prime crises. While the latter was only vulnerable to defaults from below, microfinance is also vulnerable to ethical pressures. Having sold itself as a “social investment,” microfinance cannot be seen to create indebtedness. Should that happen the flood of money in this sector will likely dry up quickly, putting pressure on the MFIs and in turn on the borrowers.

It is time that social investors and microfinance proponents scaled back their optimism – both on the impact of microfinance and on its investment potential. Microfinance cannot be immune to the basic rule of finance that risk and return are correlated. Moreover, such high expectations provide incentives to actually undermine both the social impact and potential returns of microfinance. An expectation of growth incentivizes providing loans even to those that cannot use them for anything other than consumption. And an expectation of higher or more consistent returns provides incentives for higher rates, which in turn can lead to indebtedness.

Microfinance investors may be doing damage to their own investments in this manner, by compromising the sustainability of the model. It is time for some realism, because regardless of whether microfinance is good or not endless growth cannot be without consequences – as the subprime crises showed.

The authors conclude in their randomized trial of 52 (of 104) slums in India:

We show that the intervention increased total MFI borrowing, and study the e¤ects on new business starts, investment, and consumption. Households with an existing business at the time of the program invest in durable goods, and their profits increase. Households with high propensity to become business owners see a decrease in nondurable consumption, consistent with the need to pay a fixed cost to enter entrepreneurship. Households with low propensity to become business owners see nondurable spending increase. We find no impact on measures of health, education, or women’s decision-making.

There are several interesting results to be gleaned for this summary, but just as many questions.

Testing the Enterprise Hypothesis

The first interesting result is that microfinance seems to encourage, or at least enable, commercial enterprise. According to the survey the presence of microfinance helps to “create and expand businesses” amongst a subset of current or “likely” entrepreneurs. However, amongst the rest of the population, it tends to increase non-durable consumption.

The last part of this result is not surprising as anecdotal evidence has long suggested that microfinance works also to smooth consumption. What is surprising, however, is the high density of entrepreneurs in the target communities. A full 31% of households run a very small business – compared to the OECD average of 12%. This may seem counter-intuitive. Then again, the opportunity cost of poor households becoming entrepreneurs is extremely low, which may explain this result.

Testing the Development Impact

The survey also tests the impact on development indicators and finds no impact whatsover on health or education. While the MF as a tool for development argument has long ago been dropped by most serious MF proponents, this undermines it further. That said, as the authors note, it may be too early to conclude that microfinance does not enhance social outcomes. Rather, “after a longer time, when the investment impacts have translated into higher total expenditure for more households, it is possible that impacts on education, health, or womens’ empowerment would emerge.”

Open Questions

Unfortunately, the study seems to leave open several questions – and the report is missing several critical pieces of information.

First, it seems 69% of households in the baseline have outstanding loans at an average rate of 3.85% per month. What is the average loan amount and rate charged after the Spandana intervention and do loan rates come down? A key criticism of MFIs has been that loan rates seem to remain stubbornly high – is that true?

Second, what is the percentage of population that are likely entrepreneurs. In other words does microfinance, on balance, lead to greater enterprise or greater non-durable consumption?

Finally, and most important, the study says nothing about the failure rate of businesses. In the baseline, 30% of households have a business. Just how many of these still exist at a later point in time? Similarly, how many of the entrepreneurs that borrow, succeed?

This point is particularly relevant if you consider that existing businesses seem to register an increase in business profits of up to INR 5,000 – a 600% maximum rate of return in some cases. Such returns cannot be had without substantial risk, a monopoly, or some other market imperfection. So, where is the catch?

Conclusion

This survey is worth reading simply because it is the first real study on the impact of microfinance. It is interesting in that the results are intuitive – credit in the BoP world seems to work similar to how it works in the developed world. Responsible and entrepeneurial individuals use it to start businesses or save for the future. But many others use it to live beyond their means and may end up in a debt trap.

That said, the survey is also interesting in what it does not reveal about microfinance. While the inconclusive evidence on human development indicators can simply be a matter of time, it is a tangential issue. At the core of microfinance today, is its value proposition as a business incubator. There are as many questions on microfinance as a business itself that must be answered.

MI would have us believe that the problem with securitization was only its implementation, and therefore, can be fixed. But there is a more fundamental problem with securitization – as applied to subprime or microfinance loans – that is not one merely of implementation, and thus cannot be fixed by regulation and transparency.

As pointed out by this World Bank paper, securitization creates a moral hazard that “adversely affects the screening incentives of lenders.” In the MFI world this means that if MFIs do not own the risk of a loan, they are less likely to screen potential creditors properly. The result is likely to be an increase in default rates.

This is not all, though. If the subprime crises was caused partly by moral hazard, the impact of that hazard was magnified by the availability of cheap and plentiful credit. Banks vastly increased credit availability to subprime creditors simply because money was cheap and easy to be had. This reduced any remaining incentive on the part of lenders to conduct proper due diligence.

Microfinance was, till recently, in a similar situation – overfunded but with few good organizations to lend through (see the 2008 MF Banana Skins report). Given the availability of cash, it is unclear why securitization – as a means of increasing capital for MFIs – is even necessary. Any good MFI should have no trouble raising cash. And any bad MFI should not get cash – even through securitization.

Finally, the idea of securitization for MFIs also ignores another article in MI that talks of the Dangers of Leverage. The author argues that many MFIs are blind to the risk of credit default.

Further analysis from the Risk Roundtable in Mumbai supplies an eerie parallel to the early stages of the downfall of banks and investment banks. The risk survey leading up to the Roundtable found that most respondents, including MFIs, investors and lenders, felt that liquidity risk is the major risk, not risk of credit losses.

Microfinance, as a sector, has done well – continuing to provide moderately positive returns even in the current environment (see graph). This has led its proponents to claim that microfinance is a separate asset class uncorrelated to bonds, equities, and even alternative assets such as real estate, commodities, and hedge funds.

Symbiotics Microfinance Index (USD)

Yet, the dynamics of risk and return can not be any different in microfinance. Given that MFIs do not consider credit risk extremely high and have amply money for lending, their incentives for proper screening are already low. Securitization would take away any remaining incentives, and seems to be a solution looking for a problem, rather than the other way around, that could prove dangerous for this still unproven sector.

Update: After some research, I’ve realized that securitization of microfinance is not so new after all. The MIT Journal Innovations discussed it in 2007 (Is Securitization Right for Microfinance). Go back even further, and BusinessWeek had a feature on it in September 2004 (Tiny Loans, High Finance). And according to this discussion at Chicago’s GSB, the idea has been around “since the mid-1990s.”

The problems Karnani cites are well known, and were pointed out years ago by Thomas Dichter, among others. People take microfinance’s poverty alleviating characteristics as fact – so much so that nobody has really studied the phenomenon. Those that have, says Karnani, find the impact on poverty is not as unambiguous – and he quotes several studies:

One of the most comprehensive studies reaches a surprising conclusion: Microloans are more beneficial to borrowers living above the poverty line than to borrowers living below the poverty line. This is because clients with more income are willing to take the risks, such as investing in new technologies, that will most likely increase income flows. Poor borrowers, on the other hand, tend to take out conservative loans that protect their subsistence, and rarely invest in new technology, fixed capital, or the hiring of labor.

Microloans sometimes even reduce cash flow to the poorest of the poor, observes Vijay Mahajan, the chief executive of Basix, an Indian rural finance institution. He concludes that microcredit “seems to do more harm than good to the poorest.”

The failure of microfinance to bring people out of poverty should not be surprising, except to those deafened by its hoopla. People below the poverty line simply “do not have the skills, vision, creativity, and persistence to be entrepreneurial. Even in developed countries with high levels of education and access to financial services, about 90 percent of the labor force is employees, not entrepreneurs.” Indeed, Thomas Dichter made a similar point, pointing out:

The microcredit paradox is that the poorest people can do little productive with the credit, and the ones who can do the most with it are those who don’t really need microcredit, but larger amounts with different (often longer) credit terms.

Karnani’s Solution: Jobs, not Microcredit

Karnani – as you may remember – previously challenged C.K.Prahalad and his “Bottom of the Pyramid” theory (see also NextBillion). He, of couse, has his own solution – creating jobs through encouraging labor intensive industrial production. The PDF of his article is worth reading, for it shows how poverty declined rapidly in China, but not India and Africa – largely due to such growth.

Yet my analysis of the macroeconomic data suggests that although microcredit yields some noneconomic benefits, it does not significantly alleviate poverty. Indeed, in some instances microcredit makes life at the bottom of the pyramid worse. Contrary to the hype about microcredit, the best way to eradicate poverty is to create jobs and to increase worker productivity.

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

A Good Idea Gone Worse: Markets Trump the State

Karnani makes a lot of sense. Microfinance may have some non-economic benefits but it has been hijacked by “development experts” and “grassroots NGOs” to expand their legitimacy, and become something it never was intended to be. He is equally critical of Prahalad, who in his opinion “glosses over the real issue” – the failure of government and public service - by urging companies to provide consumer goods when what they need are the fundamentals:

Why do poor people accept that they cannot expect running water? Even if they do accept this bleak view, why should we? Instead, we should emphasize the failure of government and attempt to correct it. Giving a voice to the poor is a central aspect of the development process.

That is the key here – the development process. In that sense, the hoopla around microfinance and markets is doubly egregious – for it encourages a blind belief that markets will solve the world’s poverty issues by themselves. They will not. Indeed, by promoting microfinance, and micro entrepreneurs, the hoopla might make things worse, by encouraging economic activity well below economies of scale.

For too long, the world has naively believed that microfinance alleviates poverty. A nobel peace prize and several hundres of millions in private capital have been dedicated to the cause. Yet, the cause is ephemereal. The reality of microcredit is less attractive than the promise, and “even The Economist is beginning to realize it”. Time the well informed development expert, philanthropist, and policy maker focused on something real.

There are two similarities between the poor in the US and the poor in the rest of the world. First, they don’t make much money. Second, everyone wants to lend to them. This article gives plenty of food for thought, for why that may not be such a good thing – not as a business, but as a way out of poverty.

A Question of Choice

Some support credit based on the faith that the market knows best. Credit – even expensive credit – allows the market to function, and is better than no credit at all simply because it increases choice. Much the same argument is made by C.K.Prahalad, in support of the Base of the Pyramid theory – which extols corporations to see the billions of poor as consumers:

Nobody, poor or rich, is compelled to pay a high price for a used car, a credit card, or anything else…”The only feasible way to run a capitalist society is to allow companies to maximize their profits,” says Tyler Cowen, an economist at George Mason University in Fairfax, Va. “That will sometimes include allowing them to sell things to people that will sometimes make them worse off.”

Even if one were to accept the superiority of free-markets (not a given), this argument has a flaw. The theory fails because low-income consumers – and the poor in developing countries – do not live in perfect markets. Rather, they live in markets that are imperfect and subject to asymmetric information. The result is exploitation, and a choice that can be often illusory, and sometimes dangerous:

A public housing administrator who reviews tenants’ tax returns pointed out to Thomas that Jackson Hewitt had pared $453, or 10.4%, in tax-prep fees and interest from Thomas’ anticipated refund. Only then did she discover that various services for low-income consumers prepare taxes for free and promise returns in as little as a week. “Why should I pay somebody else, some big company, when I could go to the free service?” she asks. The lack of sophistication of borrowers like Thomas helps ensure that the Money Now loan and similar offerings remain big sellers.

Cheap Credit
Another argument for microcredit is that it is cheaper than the alternative – a moneylender. In America, there is no equivalent, so low-income credit is indeed the only alternative. But is it really cheap?

Not quite. If anything, credit has become more expensive:

Federal Reserve data show that in relative terms, that debt is getting more expensive. In 1989 households earning $30,000 or less a year paid an average annual interest rate on auto loans that was 16.8% higher than what households earning more than $90,000 a year paid. By 2004 the discrepancy had soared to 56.1%. Roughly the same thing happened with mortgage loans: a leap from a 6.4% gap to one of 25.5%. “It’s not only that the poor are paying more; the poor are paying a lot more,” says Sheila C. Bair, chairman of the Federal Deposit Insurance Corp

The microcredit market is still new, but one sees a similar trend there. As access to credit has expanded, institutions have grown and tapped commercial capital. That capital seeks market and risk-adjusted returns. Those returns can only come at the cost of more expensive credit – and poorly informed consumers.

The Myth of Enterprise & the End of Poverty

Finally, the diehard also believe that microcredit helps start new sustainable businesses. By some miracle, the developing world’s poor are an army of entrepreneurs, seeking capital to start sustainable and profitable businesses, that will pull millions of microcredit customers out of poverty. Yet, evidence suggests microcredit does not go to start enteprises, but to smooth consumption. And that is a road that is just as likely to lead to indebtedness, as to riches:

She graduated in 1992, owing $45,000 on student loans. That debt became her main financial burden, she says. The 9.5% interest rate isn’t particularly steep, but she tended to view the payments as less pressing than putting food on the table or paying rent. Late fees piled up. Today she owes $159,991, up from $117,000 only 18 months ago. When dunning notices arrive, she tosses them in the stove.

There is no reason to believe that the poor in America are any less entrepreneurial than their developing world bretheren. So if credit – cheap or not – has not saved the former from poverty, is there reason to believe it will save the latter, who have substantially fewer skills and opportunities?

Calling a Spade a Spade: A Good Business

Low-income consumers in the U.S. are an interesting case study for microfinance proponents worldwide. Because credit by itself doesn’t seem to be helping them. “Instead of becoming an opportunity for upward social and economic mobility, it becomes a debt trap for many trying to move up,” according to Nouriel Roubini, an economics professor at New York University’s Stern School of Business.

There is a lot of money involved here. According to Stephens Inc, such “alternative financial services” totals more than $250 billion a year. Still, let stop pretending that credit will save the world and its poor. It hasn’t yet in a country where it has been plentiful for a long time. This is a business, and microcredit an industry. Like all businesses, it will help some and make others worse off. Let us figure out what to do with the latter.

Understanding how microfinance affects clients is not straightforward because there are several possible explanations for why, say, a borrower is doing well compared to her non-borrowing peers. The credit might be helping–or perhaps the borrower was already comparatively prosperous and would have fared as well even without the loan. These new papers elucidate cause and effect by performing controlled experiments, in which a few parameters are randomly varied and the effects measured.

Controlled Experiments?

The idea of ‘experiments’ sounds good. It gives scientific legitimacy to what are essentially social phenomena marked by multiple variables, complex correlations, and extraneous – often invisible – factors. I need to look at these reports to see just how ‘controlled’ they are.

Another organization that has been taking a similar approach to impact assessment is Innovations for Poverty Action (IPA). Genevieve has joined IPA and will lead a couple of evaluations in the Philippines, including one on group vs. individual lending that sounds awfully close to what the CGD has published.

I have two propositions for Genevieve that could lead to some interesting evaluation projects.

Experiment One: Social Impact – Profit vs. Development Benefits

First, there is an inherent tradeoff between microfinance as a business and as a development tool. Microfinance will largely benefit one of two stakeholders – commercial enterprises and their shareholders, or poor borrowers. As Muhammad Yunus recently made me realize the two are mutually exclusive.

So, how may one test this assertion? Evaluating the interest rates offered by MFI’s and asking the following questions may offer a few clues:

• How do MFI rates compare with what a money lender was offering?
• How do they compare to those of Grameen Bank – which says it can offer lower interest rates by being ‘non-loss, non-dividend’.
• Is there a trend towards higher interest rates, the higher the commercial pressure on an organization? Do banks offer higher rates than independent MFIs, than grassroots NGOs?
• Did an MFI’s interest rates go up after it partnered with a bank?
• Have aggregate interest rates gone up over time, as the need to prove development benefits has gone down?

This is an important test, because if true it allows us to categorize MFIs into two groups and then test for development impact across them. It may also show that most MFIs today embrace the rhetoric of a ‘market based development solution’, ignoring the fact that development benefits accrue only when the solution is priced somewhat below the market rate (set by the money lender). In other words, the major benefit of these providers is to expand the market by bringing in external funds, not any development impact, per se.

Experiment Two: Generating Enterprise – Equity vs. Debt

My second assertion is that microfinance is inherently flawed as a tool to create ‘sustainable enterprise’. Studies show that microfinance ends up funding consumption of individuals. This may well be commendable in itself. However, if our goal is to create enterprise for long-term economic growth how can microfinance be more effective?

The problem is that the incentives of MFIs are not oriented towards generating sustainable enterprise. They are oriented simply towards repayment of loans. The latter is not an indication of success of the former. One way to generate private enterprise through ‘the market’ may then be to use equity, not debt, to fund micro and small entrepreneurs.

So, here’s another test. Do organizations which take equity stakes in micro and small enterprises (MSE) have a better incubation success rate than microfinance providers?