Microfinance debate – Ethical Corp

Debate: Microcredit – Is microfinance helping to reduce poverty?

No, says Aneel Karnani of Michigan’s Ross Business School

Yes, says Filipe Santos of international business school Insead

Round one
Microcredit does not work

Dear Filipe,

Microcredit is the newest silver bullet for alleviating poverty.

Enthusiasm for microcredit has attracted untold billions of dollars from governments, commercial banks, wealthy philanthropists and other donors. Worldwide, 3,552 microcredit institutions provided loans to 155 million clients, according to the State of Microcredit Summit Campaign Report 2009.

In spite of the resources devoted to microcredit, it does not significantly alleviate poverty, although it does yield some non-economic benefits. Indeed, in some instances microcredit organisations exploit the poor, making their plight even worse. Contrary to the hype, the best way to eradicate poverty is to create jobs and increase worker productivity.

Despite the hoopla surrounding microcredit, there has been relative little empirical research on its impact on poverty reduction. In March the World Bank published Moving out of Poverty. An “important insight” from this study is that “the tiny loans usually provided under microcredit schemes do not seem to lift large numbers of people out of poverty”.

According to the Grameen Bank website, microcredit is “offered for creating self-employment for income-generating activities and for housing for the poor, as opposed to consumption”. The poor are expected to invest the microloans to start up or develop a microbusiness and thus climb out of poverty.

But the problem is that “many loans ostensibly taken for microenterprises are used for other purposes” according to a new research study Portfolios of the Poor, based on detailed financial diaries of Grameen clients and other poor people. Most microcredit clients use the money to finance consumption or for consumption-smoothing. This provides a useful service to the poor, but microcredit used for consumption will not increase the income of the poor or alleviate poverty.

The second major problem with microcredit is the businesses it is intended to fund. A client of microcredit is an entrepreneur in the literal sense: she raises the capital, manages the business and takes home the profits. But the current use of the word “entrepreneur” requires more than the literal definition. An entrepreneur is a person of vision, creativity and persistence who converts a new idea into a successful business.

Some clients of microcredit are certainly true entrepreneurs, and have created thriving businesses – these are the subjects of heart-warming stories. But the vast majority of microcredit clients are caught in subsistence activities. They usually have no specialised skills, and so must compete with all the other self-employed poor people in entry-level trades. Most have no paid staff, own few assets and operate on too small a scale to achieve efficiencies, and so make very meagre earnings. Most microenterprises are very small and many fail – contrary to the UN’s hype that microentrepreneurs will grow thriving businesses that lead to flourishing economies.

This should not be too surprising. Most people do not have the skills and drive to be true entrepreneurs. Even in developed countries with high levels of education and infrastructure, about 90% of the labour force is made up of employees rather than entrepreneurs. Most clients of microcredit are not entrepreneurs by choice and would gladly take a decent job if possible. We should not romanticise the poor as entrepreneurs.

As an example, rather than giving microloans of $200 each to 500 women so that each can buy a sewing machine and set up a microenterprise manufacturing garments, it is much better to lend $100,000 to an entrepreneur with managerial capabilities and business acumen and help her to set up a garment manufacturing business employing 500 people.

Now the business can exploit economies of scale, deploy specialised assets, and use modern business processes to generate value for both its owners and employees. The International Labour Organisation states: “Nothing is more fundamental to poverty reduction than employment.” Creating opportunities for steady employment at reasonable wages is the best way to take people out of poverty.

Yours,
Aneel

An innovative answer to poverty

Dear Aneel,

I will not claim that microcredit is the silver bullet to the world’s poverty problem. And I agree with you that the impact of microfinance in poverty alleviation is often romanticised instead of being scientifically shown.

What I will claim is that microcredit is an innovative approach for providing financial services in a sustainable way to 3 billion poor people worldwide who have been shut out from functioning financial markets. These people are often forced to rely on unregulated local money-lenders who charge exorbitant interest rates and frame their loans in a way that increases the dependence of the borrowers instead of empowering them. This, in turn, deepens the poverty in which people find themselves.

The fact that a few money-lenders may now be disguising themselves as microfinance institutions to better exploit the poor is not an argument against microfinance’s effectiveness, but rather a reason for increased transparency and safeguards on how microfinance operates.

Microcredit is, in essence, a business model innovation that was so successful that it span a new global industry with a loan volume in the range of $30bn, 150 million customers and growth rates of more than 30% a year.

As with any good disruptive innovation, microcredit shattered conventional wisdom – the belief that poor people were not creditworthy, that non-collateralised loans were too risky, and that large loan sizes were necessary to cover high costs.

Because of these views, billions of poor people had been shut out of access to finance. Microcredit – with its low-cost delivery model, focus on simplicity and impact, intelligent use of social pressure mechanisms to improve repayment, and non-profit mission – proved that credit could be extended to poor borrowers on economically fair terms.

Microfinance as an industry is still work in progress. Many microfinance institutions (MFIs) continue to rely on donors and are not sustainable. Yet the successful models are becoming clear. Grameen Bank – considered a “large-scale successful model” in the World Bank report that you cite – shows that MFIs can become sustainable by drawing on local savings and converting them into loans, operating as a bank for the poor. Microfinance must consolidate and converge on proven models and practices that show sustainability, scale and impact, while continuing to lower operating costs and innovate.

You argue that microborrowers often use their loans for consumption or emergencies as opposed to investment in microbusinesses that generate income. In many cases this may be true. But why should we constrain the choices of poor people? Even consumption loans can have important economic impacts.

A randomised study in South Africa, published in 2007, by Dean Karlan from Yale University and Jonathan Zinman from Dartmouth College, shows that expanding access to consumer credit for populations not perceived as creditworthy actually increases employment, reduces hunger and reduces poverty for the borrowers, at the same time that it is profitable for the lender.

The fundamental economic insight holds true: increased access to products and services creates new opportunities for consumers, which in turn increases economic welfare. The role of microfinance is to start this economic process for 3 billion people that have been so far excluded from access to basic financial services.

You argue that microfinance considers everyone an entrepreneur when, in reality, most people are just gaining self-employment through subsistence activities. The first problem with this argument is that it treats policy decisions as stark choices when often they can be complementary – wouldn’t it be better to have both factories and microentrepreneurs? Of course you would argue that resources are scarce and focusing on one area will take away effort from the other. Yet, MFIs such as Grameen Bank operate in a sustainable way, recycling savings to loans in local communities instead of consuming global resources.

Second, of course it would be nice to have a factory that has a strong economic impact. Yet the important question is: why is a factory not there? If there was an economic opportunity to set up a factory surely a dynamic entrepreneur would get a bank loan, probably backed by the government, and set up such a factory.

The truth is that in developing countries with a lack of basic economic and legal infrastructure (clear property rights, rule of law, transportation, market access, stable exchange rates) large scale economic activities cannot take place since uncertainty is too high. In these situations, bottom-up, community-driven, microentrepreneurial activities are a more effective and resilient mechanism to generate widespread economic impact.

This is exactly the type of economic development process that microcredit is meant to unleash. Microfinance has an important role to play in the fight against global poverty.

Yours,
Filipe

Round two
Undermining SMEs

Dear Filipe,

You and I agree that “even consumption loans can have important economic impacts”. The poor not only have low income, but also face unpredictable fluctuations in that income. Microcredit is a useful service that helps the poor survive by smoothing consumption. But this is a dramatic break with the original Grameen Bank innovation.

Grameen Bank states its central objective has been to “reverse the age-old vicious circle of ‘low income, low saving and low investment’, into a virtuous circle of ‘low income, injection of credit, investment, more income, more savings, more investment, more income’”.

Similarly, the United Nations on its website declares: “Currently microentrepreneurs use loans as small as $100 to grow thriving businesses.” The microcredit innovation correctly views the poor as producers, not as consumers, and focuses on ways to increase (not just smoothen) their income. But the problem is that microcredit does not achieve this objective; microenterprises do not help the poor to rise out of poverty.

You argue for “policy coexistence” – the pursuit of both microcredit and development of larger enterprises. The problem is that microcredit actually undermines long-term economic development and poverty reduction. Small and medium enterprises (SMEs) are the best source for growing formal employment, and yet it is precisely this sector that is under-developed in the low-income countries.

According to research published in 2003 by George Washington University academic Meghana Ayyagari, the informal sector accounts for 47% of GDP in low-income countries, compared to its 30% share in middle-income countries, and 13% in high-income countries. In low-income countries, SMEs account for just 15.6% of GDP, compared to a share of 39% in middle-income and 51.5% in high-income countries.

Microcredit leads to high growth and saturation of the informal sector and hinders the development of SMEs – for three reasons.

First, financial resources are limited, whether local savings or foreign investment, and microcredit is absorbing an ever larger share of the financial resource base.

Second, governments in these fragile countries have only so much political capital and administrative capacity. It is critical that governments prioritise development approaches that have a higher payoff.

Third, microcredit leads to an over-supply of inefficient microenterprises and a hypercompetitive informal sector, which reduces profitability and undermines the development of more efficient SMEs in the same locality. UN-Habitat, the UN agency for human settlements, found that 63% of the employed population in Dhaka, the capital of Bangladesh, was in the informal sector, a significant rise over the past 30 years.

Microcredit, at best, does not help to reduce poverty, and probably makes the situation worse by hindering more effective approaches to poverty reduction.

Yours,
Aneel

Unlocking resources

Dear Aneel,

Microcredit allows poor people to finance their microenterprises. Granted, most of these will remain very small. However, some may grow into small or medium-sized business, as happens in more developed countries. In fact, the overwhelming majority of entrepreneurs in developed countries are also microentrepreneurs starting with little capital and mostly employing themselves and family.

Yet, the favourable economic and social context in these countries allows some microenterprises to grow into larger organisations that create employment. Establishing a favourable economic and social context is the central role of governments. Focusing solely on promoting large-scale economic activities in extremely poor and fragile societies is bound to fail.

The weakness of SMEs in low-income countries has more do to with the lack of economic infrastructure – which imposes high costs and entry barriers to doing business formally – than with a competitive microenterprise sector.

The key issue with financial resources is not that they are limited but that they are unusable for productive activities since they are often tied to illiquid assets or savings because of a lack of access to banking services.

Unlocking this capital for use in productive activities is the most important function of any banking system, whether in developed or developing countries. So, instead of absorbing a larger share of the financial resource base, microfinance based on a savings-lending model has actually the potential to unlock financial resources for productive use.

An advantage of microcredit is that it does not need to rely on government services or subsidies to the same extent that some large-scale economic investments do. In addition, since the financing and investment decisions are taken by numerous organisations in a decentralised way, they are much less prone to the cancer of corruption and cronyism that often plague developing countries, hindering economic development.

Yet, you are correct in pointing out that a subsidised microenterprise sector can hinder the development of more efficient SMEs. That is why microfinance needs safeguards and improvements.

These could include: creating mechanisms to avoid supporting unsustainable microenterprises with ever-increasing loans; recycling local savings into credit as opposed to becoming dependent on international donors; using the distribution network set up by MFIs to deliver other services such as telecommunications and business training; ensuring transparency and accountability; and promoting impact assessment.

These are some of the things we should be focusing on to increase the impact of microfinance in poverty reduction worldwide. Instead of arguing that microcredit does not work we should ask: how can microcredit be improved to work better?

Yours,
Filipe

Aneel Karnani is associate professor of strategy and chair of strategy at the Ross School of Business, at the University of Michigan. akarnani@umich.edu

Filipe Santos is assistant professor of entrepreneurship at Insead, and director of the Insead Social Entrepreneurship Programme. filipe.santos@insead.edu

Arguments for and against microfinance

For

  • Proves that the poor are creditworthy and small loans can pay for lenders.
  • Increases access to financial services, with knock-on benefits to economy.
  • Small-scale, bottom-up enterprise can succeed in places where risks to big business deter investment.

Against

  • Borrowers use loans for subsistence, not true enterprise creation.
  • Loans used for consumption, not investment.
  • Scaling up microenterprises is hard: instead of lending $200 each to 500 entrepreneurs, why not lend $100,000 to one entrepreneur to start a business for 500 people?

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