The Microfinance Silver Bullet

A silver bullet is an action that cuts through complexity, providing an immediate solution to a long-standing problem. Is microfinance that bullet to the issue of global poverty?

Shereein Saraf

Shereein Saraf

May 28, 2021 / 8:00 AM IST

Microfinance Silver Bullet

A silver bullet is an action that cuts through complexity, providing an immediate solution to a long-standing problem. Is microfinance that bullet to the issue of global poverty?

The complex nature of developing economies, embedded in their urban-rural dynamics, diverse cultures, dialects, people, behaviors, and actions, makes it a test case for innovative economics and policy measures. In a poverty-stricken world, credit is a gateway to global prosperity and empowerment. However, is access to credit alone enough?

One peculiarity observed in developing economies is the skewed firm size distribution. A majority proportion of businesses are small-scale operations and, in most cases, confined to the boundaries of a rural household. Many rural women entrepreneurs start businesses catering to the local economy like tailoring clothes, preparing food items such as pickles, and selling fruits and vegetables in semi-urban areas, involving low-cost goods. These self-employed micro-entrepreneurs could potentially use microfinance loans to renew capital requirements – thread and cloth for sewing, ingredients for food, or bags for customers to take groceries home. The self-employed and microentrepreneurs in South Asia and Sub-Saharan Africa account for about 80% of the workforce. In Sub-Saharan Africa, about 42% of rural households operate a small-scale business. 

A majority of the rural households of India are involved in agricultural and agri-related businesses. The lack of credit holds back many entrepreneurs from expanding their business models. Bangladesh, on the other hand, is famous for its textile industries. However, it is not because of its entrepreneurial outlook, but cheap labor for trade with developed countries. These are sweatshops, not businesses. Even if they draw a microfinance loan, it might not aid them to escape the poverty trap – which, in effect, is a labor trap. 

Another feature of developing economies is the high-interest charging moneylenders. A typical person on a regular day will prefer going to a moneylender to obtain a loan over going to the nearest bank branch (that is not so near), filling out the complicated paperwork, proving his collateral to be valid, and then probably getting a loan. It is easier for him to knock on the doors of a moneylender with whom he shares a history of previous loans and, thus, has maintained this long-term relationship. Though this relationship is parasitic, it is access to loans with few questions asked. 

With this vision, Nobel Laureate Muhammad Yunus settled for a middle-ground between informal moneylenders and formal-sector institutions, such as banks. The idea was to provide small loans with flexible repayment schedules and relatively lower interest rates, when compared to traditional moneylenders, to poor communities. 

Contrary to the above description of Bangladesh’s textile industry, it was the country where this idea originated in the 1970s. Since then, Microfinance Institutions (MFIs) such as Grameen Bank and Bangladesh Rural Advancement Committee (BRAC) have expanded the access to credit, savings, and insurance to rural populations and have aided productive employment and poverty reduction. The current microfinance landscape, however, faces severe challenges. Lack of financial literacy, misrepresentation of data due to the informal nature of loans, and inadequate infrastructure are some of these problems. 

Microfinance also promised empowerment of women, especially among rural entrepreneurs and Self-Help Groups (SHGs). It has led to some positive results, such as consumption smoothening and investments towards the education and healthcare of children. It has not led to significant impacts such as business expansion, financial autonomy, and bargaining power of the women members of the household. 

A 2015 paper by Banerjee, Karlan, and Zinman juxtaposed evidence from six randomized evaluations on microcredit expansion in Bosnia, Ethiopia, India, Mexico, Morocco, and Mongolia. Access to microfinance was not enough to crowd out other informal sources of credit as the evidence does not point towards any strong substitution effect. The nuances of financial behaviors – spending, borrowing, income streams to sustain businesses – are yet to unfold. 

Another experiment showed that early loan repayments often discourage risk-prone investments, limiting the growth of microenterprises. Although microfinance has achieved high repayment rates, its impact on household poverty alleviation is little. 

Microfinance targets households with a credit constraint. This characteristic of microfinance invokes the microeconomic and financial principle of moral hazard. Borrowers can take on loans and spend them on consumption needs – durables, food, or beverages – and never repay the loan back. This scheme works well when many microfinance providers are present around. A default with one organization will not restrict the borrower from taking out a loan from another microlender. As microfinance organizations are informal sources of credit, they do not impact the borrower’s account or a much more sophisticated credit score.

Default is not uncommon in experiments in India, where the sample has access to a network of microfinance institutions. As a result, research experiments introducing microfinance to new borrowers (than the knowledgeable and networked borrowers) reaped notable positive results across African and Asian countries. 

Microfinance has become a political fix for deep-rooted poverty issues. 

Structural adjustment programs thrust upon the developing economies in the 1970s and 1980s left the lower and middle-income populations vulnerable. Globalization and trade have led to poverty, creating some winners and many losers. Microcredit is an oversimplified approach to solve a complex problem. It has no longer remained charitable as it was at its inception. Banco Compartanos, a for-profit microlender in Mexico, is known for its steep interest rates.

Microfinance, which claimed to be the silver bullet to poverty and deprivation, is a half-done solution to the poverty problem. It has been tested in various shapes and forms and has a scope for further development. The tool of microfinance can be effective for policy advocates and social organizations but only with a suite of other solutions and not alone. These could be business training to microentrepreneurs, financial literacy, shifting social norms, and gender biases, especially within rural households.