Microfinance: Panacea for all economic ills?

Written By Shamanthy Ganesha

From ancient slums and impoverished villages in the developing world to the tired inner cities and frayed suburbs of America’s economic fringes, these and millions of other women are all part of a revolution. Some might call it a capitalist revolution . . . As little as $25 or $50 in the developing world, perhaps$500 or $5000 in the United States, these microloans make huge differences in people’s lives . . . Many Third World bankers are finding that lending to the poor is not just a good thing to do but is also profitable.
(Brill 1999)

Over the past few decades, the popularity of microfinance as a poverty alleviation tool has increased vastly. The UN declared 2005 as the year for Microcredit while Dr. Mohammed Yunus, well known as ‘The Father of Micro Finance’ won the Nobel Prize for Peace in 2006 for his work. Microfinance industries in many countries such as India, Bangladesh and Indonesia have been growing exponentially. There has been a giant wave of interest amongst people from many quarters, including economists and policy makers. In broad terms, microfinance is the provision of microcredit, microsaving and microinsurance services to people who are usually otherwise excluded from formal financial markets. While there is much reason to be highly optimistic about the potential of microfinance, I adopt a more sceptical view of it. I spent this summer working as intern at a well known microfinance think tank in Chennai, India. My work their involved constant interaction with both urban and rural microfinance clients. In this article, I detail how the information that I gained from informal interviews with these microfinance clients made me question some typical assumptions that are made about microfinance and its functioning.

It is a well known fact that the world’s poor generally do not have access to formal sources of credit. There is an essential asymmetric information problem between the providers of formal credit and the poor. The costs of monitoring how the poor use their debts by far outweigh the benefits that they accrue to formal credit providers. They have low propensities to save given that they are highly liquidity constrained. Moreover, under usual circumstances the poor own little or no assets at all. Thus the effectiveness of using collateral as a form of screening device is severely limited. The group lending mechanism which is often hailed as the greatest innovation of microfinance is said to get around this moral hazard problem by allowing the borrowers themselves distinguish between ‘safe’ and ‘risky’ individuals. Given that each individual is jointly responsible for the entire group’s loans, economic reasoning tells us that individuals who have relatively high coefficients of risk aversion will form groups with other risk averse individuals while the individuals with relatively low risk coefficients are screened out. Also, once the individuals receive their loans, they have an incentive to monitor each other’s activities if they are to make regular repayments and be eligible to borrow in the future. The task of monitoring the use of borrowed funds is effectively transferred from the lenders to the borrowers themselves.

Firstly, it does not seem to be the case that group formation takes part on the basis of risk type. Quite a few of the women with whom I spoke told be that they had not known all, if any of their group members before they joined the Joint Liability Group (JLG) or Self Help Group (SHG). The common practice is for one of the women to initiate the group (the group leader). This group leader then invites other women to be part of the group. Most often than not, this group leader invites women who live in close proximity to her, maybe in the same street. To me, it seems more likely that women segregate themselves by geographical proximity, caste and religion than by their relative risk types. Also, even once the loans are received it is unlikely for the women to be actively engaging themselves in monitoring each other’s business activities. Very few of the women I spoke to had any information regarding the type, costs and profits of the businesses of other women in their groups. One reason for this could be that monitoring is not costless for the women. Given that nearly all these women have to manage their time between their duties towards their families and nurturing their own businesses, very little time and energy is left for monitoring their peers’ activities. It is only when one of the women repeatedly fails to make repayments that the other members will make a visit to her house to inquire about what is happening. In my opinion, it seemed that there was less social cohesion among group members than is commonly assumed in the literature.

Moreover, it is common to assume that microfinance organisations have low interest rates and require no collateral and that it follows that they should be preferred to the mean usurious moneylenders who charge exorbitant interest rates. There are several misconceptions in the above statement. Firstly, the real rates of interest (as opposed to the quoted nominal rates) that the MFIs offer may not be very much lower in comparison to the professional moneylenders’ interest rates. Secondly, it is not always true that MFIs do not ask for collateral. In some cases the MFI asks prospective borrowers to make an advance deposit equivalent to some percentage of the loans that they are to receive before releasing funds. Thirdly, the moneylender is not always the mean and usurious man he is made out to be in the traditional literature. More often than not, the local moneylender will be a family friend of the borrowers. The women to whom I spoke to would never refer to them as moneylenders but usually as ‘acquaintances of the family’. In fact, it could be that in some particular cases the moneylenders are actually preferred to MFIs. One reason for this could be that the money lenders do not stipulate strict repayment schedules. Given that they have an informational advantage over the MFIs and other formal providers of credit and live in close proximity to their clients, they are unlikely to stipulate a strict repayment schedule. The borrowers pay back their loans as and when they make enough money to do so. Further, it seems quite a common practice for women to borrow from money lenders while they are borrowing from micro finance institutions. As mentioned above, some MFIs have deposit requirements. The women go to the moneylenders to obtain funds to make the deposit. The initial microfinance loans tend to be small and may not be sufficient to start up an enterprise from scratch. At times of emergencies such as illness in the family or a daughter’s wedding the women which require one-off expenditures that will not provide any direct revenue, the poor have little choice but to reach out to the local moneylenders.

Another reason why people believe that microfinance is an invincible tool is the high repayment rates that are reported by various MFIs. It is common for most MFIs to quote a repayment rate of 95% and above. Does it mean that the women’s income generation activities are producing very high returns? Many of the clients with whom I interacted did not use their loans solely for their enterprises. A good part of the loan may actually be used for consumption purposes. Moreover, some of the women were engaged only sporadically in their respective enterprises (Some of their services and produce were demanded only seasonally). Also it is more likely for the women’s enterprises to be a supplementary source of income for the household. Thus the enterprises don’t always have very high returns. It is slightly puzzling to me therefore as to how the women manage to make regular repayments. An important question to ask here is whether the repayments are made voluntarily. I was told by some of the women that peer pressure induced them to go to the moneylenders, thus they become indebted involuntarily to the money lenders. Also, anecdotal evidence suggests that some MFIs may use strict enforcement schemes on groups that fail to make repayments that are not very different to the methods used by professional money lenders.

These are a few reasons as to why I believe that the results of microfinance that are commonly reported should be looked at more critically. This does not mean that I think that microfinance is not a good thing and is an absolute failure. What I do believe is that microfinance is not as perfect as it is made to sound. The way forward would be to acknowledge it’s shortcomings and devise appropriate ways to overcome them.