By Making It on 4 August, 2010
In what is a regular feature, distinguished contributors consider one of the controversial issues of the day. With all the media hype surrounding new online lending platforms, such as Kiva.org, the time is right to ask if microfinance really is an effective poverty reduction tool.
Anis Chowdhury is Professor of Economics at the University of Western Sydney, Australia. Currently, he is working as a Senior Economic Affairs Officer at the United Nations Department of Economic and Social Affairs (UN-DESA).
Professor Mohammad Yunus, the originator of the concept of microfinance, believes that 5% of Grameen Bank’s clients exit poverty each year. However, there are few credible estimates of the extent to which microcredit actually reduces poverty.
Ideally one can ascertain the impact of microfinance if the counterfactual – what would have happened to a person who borrowed from a microlender if he/she had not done so – can be easily tested. Many early studies compared borrowers with non-borrowers. But if borrowers are more entrepreneurial than those who do not borrow, such comparisons are likely to grossly overstate the effect of microcredit. Two recent studies attempted to overcome this problem by using randomized sample selection methods. Neither study found that microcredit reduced poverty. One of these studies found no impact on measures of health, education, or women’s decision-making among the slum dwellers in the city of Hyderabad, India. The other study found that the provision of microfinance in Manila, the Philippines, had no discernible effects on the probability of being below the poverty line nor did it find any significant impact on the quality of food that people ate.
The findings of the most cited set of studies, based on empirical evidence drawn from comparative experiences in seven developing countries (published in 1996), are also provocative: poor households do not benefit from microfinance; it is only non-poor borrowers who can do well with microfinance and enjoy sizable positive impacts. A vast majority of those with starting incomes below the poverty line actually ended up with less incremental income after getting microloans, as compared to a control group which did not get such loans.
No miracle cure
These findings imply that credit is only one factor in the generation of income or output. There are other complementary factors, crucial for making credit more productive. Among them, the most important is the recipient’s entrepreneurial skills. Most poor people do not have the basic education or experience to understand and manage even low level business activities. They are mostly risk-averse, often fearful of losing whatever little they have, and are struggling to survive. Most prominent promoters of microfinance, including Professor Yunus and Sam Daley-Harris, director of the Microcredit Summit Campaign, recognize that microcredit is not a miracle cure; for it to succeed other complementary factors are needed.
Some microfinance institutions (MFIs) and non-governmental organizations seem to have understood this need, and are offering training to build management and entrepreneurial skills. However, the focus has been generally on supply-side factors which complement one another to make microinvestment productive. Very little attention has been paid to the demand side. In the absence of an expanding domestic market, microenterprises will most likely replicate a barter economy. In extreme cases of a stagnant market, the availability of credit in order to facilitate transactions can leave the parties even worse off, as they have to repay loans with interest, while seeing no growth in revenues or income. Therefore, it is not surprising that a World Bank-sponsored study (published in 2005) involving 1,800 households in Bangladesh, found only very marginal improvements for borrowers of microcredit. For example, the incomes of women who received microcredit increased by only 8 taka for each 100 borrowed. As one commentator noted, a US$250 one-year loan would raise a borrower’s annual income by US$12.50, or about three cents a day!
This modest income gain happened in the context of rapidly expanding garments production in Bangladesh. It would have been an interesting counter-factual to see what would have happened in the absence of the fast expanding garments industry. Consideration of demand-side factors highlights the importance of pro-growth macroeconomic, trade, and industry policies.
In response to the modest findings in terms of monetary measures of poverty, advocates of microfinance cite impressive social progress, such as reduced infant and maternal mortality in Bangladesh. But can such achievements be attributed to microfinance? Sri Lanka was a star performer in social progress long before the microfinance movement started. In recent times, Andhra Pradesh in India has also performed much better than the rest of India in terms of social indicators of development. Microfinance does not seem to have played a big role there either.
The interest rates charged by microfinance institutions have drawn vigorous criticism. There are claims of interest rates ranging from 30 to 100% on an annualized basis. Some defend the high rates on grounds of sustainability; anything less will not attract profit-seeking bankers into this market. However, this argument weakens the claim that microfinance is more cost effective compared to commercial banking loans.
Where the interest rate is at the lower end, it is often due to implicit subsidies. This, then, raises the issue of the social opportunity cost of subsidies; could this money be better utilized elsewhere, such as for public health, education, or supporting agriculture and rural industries? Some defend the MFIs’ interest rates by arguing that they are still less onerous than the alternatives offered by moneylenders. Others argue that the returns on capital are indeed high in microenterprises, and that therefore the levying of high interest rates is justifiable. In respect of the latter, it is not clear how these studies impute the cost of ‘own labour’ – the time and labour spent by the owner of the microenterprise. In an economy characterized by surplus labour, one can impute a zero shadow price for own labour. In that case, the entire surplus over and above the cost of capital can be regarded as profit or returns on capital. This could be the most plausible explanation for finding high returns from microenterprise loans.
Ideally, own labour should be priced at a “decent” or legislated minimum wage to enhance poverty reduction. Employment (self or otherwise) at a wage below a decent rate only adds to the pool of “working poor”, who perhaps are even more vulnerable to shocks, due to the debt burden of microcredit. This could be another explanation for the so-called graduation problem of microenterprises, or why so many loans need to be rescheduled or refinanced, as reported by the Wall Street Journal.
Expansion of microfinance
If the poverty reduction impact of microfinance is so doubtful, how can one explain the movement’s phenomenal expansion? The authors of an extensive survey of the literature and interviews with the movement’s leading players claim that the success of microfinance is due to innovative business practices involving product design and management, and enabling environments. Similarly, extensive case studies of MFIs in Bangladesh and the Philippines found that the real explanation for their success lay in careful attention to managerial and strategic ‘fundamentals’. These include keeping transaction costs low, and matching loan payment schedules to borrowers’ income and savings potential.
A political economy explanation for the growth of the microfinance movement is that microfinance campaigners successfully projected the image of the movement, such as empowerment of women, which resonates well with the donor community. The birth of the movement roughly coincided with the rise of neo-liberal ideas in the late 1970s and early 1980s. Thus, the notion that microfinance programmes are primarily engaged in the promotion of small-scale enterprises appealed to major donors. While donors were wary of subsidized credit through state-owned specialized financial institutions, they were quite happy to subsidize microfinance institutions, as they appeared to promote a market economy, and more importantly, they helped to diminish the role of the government.
In liquidity-constrained societies, there is always demand for credit. So, when donor-supported MFIs push the supply of credit, there is no shortage of takers. As a result, microfinance expanded exponentially. However, if the market itself does not expand rapidly, this can only create debt burden or underutilization of credit, and a downward pressure on the returns on investment.
Even the vocal critics admit that microfinance can help the poor smooth consumption over periods of cyclical downturns or unexpected crises. If this consumption smoothing means parents can send their children to school, or buy essential medications, and maintain nutritional intakes of their children, then microfinance is likely to have positive long-term impacts on productivity.
The high interest rates that are charged remain an important concern, and most MFIs have been found lacking in lending to the ultra poor. Nonetheless, it seems that microfinance has significantly dented the informal credit markets by undermining debt-bondage and usury in some agrarian societies. Thus, microfinance is having a modernizing impact.
More importantly, by “democratizing” the credit market, the microfinance movement has also constrained the MFIs’ own behaviour. For example, when some MFI officials went to collect repayments immediately following the devastating cyclone Sidr in Bangladesh in 2007, this was widely reported in the national newspapers. As a result, the MFIs acted quickly to suspend loan recovery and to offer softer loan conditions.
In other words, the rapid expansion of microfinance has empowered not just women, but all small borrowers. Note should also be taken of the learning-by-doing effect. Even when own labour in microenterprises is given a zero shadow price, the people who are involved do benefit. They learn some basic principles of business, and with luck, and perhaps some help, may be able to become more viable and even expand. This is akin to apprenticeship where the apprentice gets a low wage, but in exchange gets training in a trade. So, with their support and training programmes, many MFIs are making some useful contributions. Microfinance gives the unemployed and the poor some opportunities, hope, and self-esteem.
Finally, being successful business ventures, microfinance institutions themselves have also created a large number of well-paid jobs, which should have considerable multiplier effects.
Many of these positive effects cannot be measured in monetary terms, and hence will remain largely unacknowledged in the literature focused on the traditional income or expenditure measures of poverty.
The danger of the hype about microfinance – and the focus on microenterprises – is that the needs of small businesses in the informal sector may not get due attention. The owner-operators of these small businesses have already proven their entrepreneurial acumen, but they face numerous constraints, ranging from inability to access the formal credit market, to difficulties with marketing their products. These enterprises should be supported with easy access to credit and other financial services, such as insurance. Their problems have been exacerbated by neo-liberal financial sector reforms which have sought to promote profit-seeking financial institutions by eliminating state-run, specialized financial institutions that catered for the needs of small and medium-sized enterprises (SMEs) and the agricultural sector. It is now realized that these reforms had their own limitations, and that SMEs and the agricultural sector, especially food production, need state support. Management and operational lessons learnt from successful MFIs can provide valuable inputs into the design of specialized financial institutions for SMEs and the agricultural sector.
The above is an edited and abridged version of UN-DESA working paper #89