Lessons from Microfinance

Microfinance is increasingly accquiring a sacrosanct status in our anti-poverty programs. Whole poverty eradication programs are being tailored around the concept of micro-loans. It is seen as the biggest idea in poverty eradication for a long time, and is seen as the "Holy Grail" to wiping out poverty from the face of earth. Developing country governments believe that microloans will unleash billions of small entrepreneurs, whose small businesses will put an end to poverty. Spurred on by all this euphoria, the United Nations declared 2005 the “International Year of Microcredit” and in 2006 the Nobel Peace Prize was awarded to the doyen of micro-credit Mohammed Yunus.

Micro loans are generally smaller amounts and given at higher interest rates. Their repayment periods are also shorter. They are different from normal formal institutional credit, in so far as they are given without insisting on any collateral. In the context of India, most of the microfinance loans are given to Self Help Groups (SHGs), as the peer pressure of a group has been found to ensure regular repayment. These SHGs typically consist of 10-12 members, mostly women. Apart from ensuring access to credit, microcredit borrowers gain valuable experience in working within a formal institution, learning what to expect from lenders and fellow borrowers, and what is expected of themselves. This experience will be a help should they ever graduate to commercial credit or have other dealings with the formal financial world.

Surprisingly for such an important policy choice, and that too on a complex and multi-dimensional issue like poverty eradication, there has been limited empirical analysis of the impact of the micro finance movement. Google searches could not locate even a single rigorous and detailed study of the impact of micro finance activities on poverty eradication in pioneering states in India like Andhra Pradesh and Kerala.

The impact of micro finance loans need to be analyzed in the light of the experience of the past decade, and policies formulated based on this. What long term impact has microfinance had on SHGs who have been involved with thrift and microfinance activities for a long time? How have the incomes of SHGs increased after first, second, third, and further linkages with microfinance loans? What are the major uses to which microfinance loans have been put to? Have micro finance loans been instrumental in lifting families into a higher trajectory of livelihood or economic growth? Have these loans been instrumental in spawning small businesses in villages? What have been the economic multiplier of these micro loans? Is it the solution to poverty in the developing world, or something more modest— a way to empower the poor, particularly poor women, with some control over their lives and their assets? Finally, what role does micro credit have in our poverty eradication master plan?

James Suroweicki writes that micro finance loans are mostly used to “smooth consumption”—tiding a borrower over in times of crisis, or used for non-business expenses, such as a child’s education. It’s less common to find them used to fund major business expansions or to hire new employees. This is partially because such loans are usually very small and and generally come with very high interest rates, but also because the vast majority of microbusinesses have only one paid employee: the owner. He invokes the economist Jonathan Morduch who says that microfinance “rarely generates new jobs for others”, and argues that microfinance is therefore unsuitable to sustaining and creating entrepreneurship, which is vital to making a serious dent on poverty.

He claims that poor countries need not more microbusinesses, but "more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation." He writes about the problems facing these medium sized companies, "In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need. It’s easy for really big companies in poor countries to tap the markets for funding, and now, because of microfinance, it’s possible for really small enterprises to get money, too. But the companies in between find it hard. It’s a phenomenon that has been dubbed the “missing middle.”"

The problem in the developing countries is a dearth not just of lenders but also of people willing to buy an ownership stake in companies, like the angel investors and venture capitalists that American entrepreneurs often rely on. Bank loans are not adequate and flexible enough for these middle companies to survive. As Suroweicki says, "Supplying the missing middle will require backers who want to invest in companies rather than just lend to them. "

But there have been encouraging developments as the microfinance movement continues to evolve. With microfinance loans increasingly taking the centre stage of poverty eradication efforts, banks and post offices have entered micro-finance lending in a big way. They lend micro loans to SHGs at slightly less than the regular bank rates. In fact, all the scheduled banks (the nationalized banks) in India have been given annual targets to provide micro loans to groups as part of their priority sector lending. States like Andhra Pradesh have gone one step further and give interest subsidy to SHGs that have been regular in repayment for a minimum period of six months. According to the present rules, SHGs can get upto Rs 1,50,000 for their first linkage with the bank, upto Rs 3,00,000 for their second linkage, and upto Rs 5,00,000 for their third linkage. (Rs 40 = $1)

Attracted by the large interest rates, many private Microfinance Institutions (MFIs) too have entered the sector. They lend at between 20-40% rates, which offers them significant profit opportunities. Unfortunately, the absence of proper regulation has left the door open for the emergence of a number of unhealthy lending and recovery practices, which have brought considerable bad name to the sector. The Government have in turn responded with regulatory proposals, some of which threatens to strangle private participation in the sector. These include capping micro-finance interest rates at lower rates, which would distort incentives and inhibit the market.

Tyler Cowen and Karol Boudreaux, while acknowledging the undoubted benefits of micro-credit, puts its impact in perspective thus, "microcredit may help some people, perhaps earning $2 a day, to earn something like $2.50 a day. That may not sound dramatic, but when you are earning $2 a day it is a big step forward... The improvements may not show up as an explicit return on investment, but the benefits are very real. If a poor family is able to keep a child in school, send someone to a clinic, or build up more secure savings, its well- being improves, if only marginally."

It is undeniable that microfinance has had a deep impact on poverty alleviation, in terms of institutionalizing access to formal credit markets and helping people escape the clutches of exploitative money lenders. It has helped "smooth over" consumption and provided timely and adequate money for poor families to meet their important and immediate needs like health and education, besides providing a significant part of the working capital requirement for many self-employed families. Micro finance has therefore clearly helped in making incremental advances in the fight against poverty.

Apart from its immediate benefits, it has also brought millions of women into the orbit of the formal credit delivery mechanism. Its most lasting impact has arguably been in the massive force of social empowerment it has unleashed among the women members of the SHGs. As a poverty alleviation strategy, it has been a remarkable and undoubted success. But as a poverty eradication strategy - the jury is still out.