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Microfinance and Global Development

Can tiny business loans change the world?

by Mark DeYoung

In 2006, microcredit took center stage when Dr. Muhammad Yunus won the Nobel Peace Prize for his work in establishing the Grameen Bank, a massive microfinance institution in Bangladesh. Microcredit is a banking and development concept that originated in the 1970s and involves the distribution of “micro” loans to the world’s more impoverished citizens. Typically no more than $200, these loans are meant to fund small business activities, but can also be used to buy everyday consumer items. Touted as one of the most innovative development instruments of our time, microcredit is cited for making a dramatic impact on poverty reduction, contributing to improvements in women’s rights, and fostering growth in small enterprise. While many statistics and case studies support these assertions, many experts are wary of the real-world of micro lending.

Many microfinance institutions claim an exceptionally high repayment rate on the part of their borrowers (Grameen Bank clients have repaid at a near 99% rate). One strong possibility for this success is that micro borrowers are often repaying loans by taking on additional debt with licensed or unlicensed moneylenders (our equivalent of Payday and Cash Advance lenders). According to the Wall Street Journal, as the Indian microfinance community took off in the 1990s, so did traditional money lending. From 1995 to 2006, the number of traditional moneylenders grew by 56 percent. Though harder to document, numbers of unlicensed lenders are believed to have made similar gains. The pressure to repay microcredit loans is often so great that borrowers resort to street lenders. As a result, microcredit may contribute to an increased debt burden for the most impoverished. It also may indicate a financial system that seems healthy on the surface but could be headed towards a needed adjustment or crash (similar to what happened with American sub-prime mortgages and all the financial instruments attached to those mortgages).

Strategic management expert Dr. Aneel Karnani, writing for the Stanford Social Innovation Review, believes that microcredit is built around a far too romantic idea of the individual as entrepreneur. “Most people do not have the skills, vision, creativity, and persistence to be entrepreneurial,” he argues. “Even in developed countries with high levels of education and access to financial services, about 90 percent of the labor force is employees, not entrepreneurs.” Although some microcredit borrowers have created visionary businesses, most are caught up in subsistence activities. Borrowers “usually have no specialized skills, and so must compete with all the other self-employed poor people in entry-level trades,” Karnani added. In India, for example, the size of businesses is one-tenth the size of comparable firms in other emerging economies, creating poor productivity growth. Placing continued emphasis on microcredit will only contribute to this problem.

Other experts question the role of microcredit in economic development based on historical precedence and recent national success stories.
According to Thomas Dichter (a consultant to international agencies such as the World Bank, USAID and the UN Development Program), “the development of the advanced industrial countries did not depend on the average middle class or poor person having access to credit. The relatively recent rise of the middle class depended upon economic growth – the expansion of the economy – which created jobs which led to buying power.” Rather than creating growth, microcredit is often used by the poor to survive periods of crisis.

“Again, there is no question that such a use of credit helps the poor,” continued Dichter.  “But this is not what the majority of microcredit enthusiasts claim it can do - function as capital aimed at increasing the returns to a business activity.”  

Recent trends seem to support this assertion. Countries like China, Vietnam and South Korea have seen dramatic growth and reduction in poverty despite little microfinance activity, while countries such as Indonesia, Bolivia and Bangladesh have been much less successful despite a great influx of microcredit.

“Countries that have lifted people out of poverty have not done it through microfinance,” agreed business strategy expert Dr. Karnani. “It’s been through the development of larger enterprises which create jobs.”

A big part of the problem when analyzing microcredit as a development tool is that there are still few official studies. According to The Economist, “the few studies that have been done suggest that small loans are beneficial, but not dramatically so.”

It is true that the microfinance industry is making unique innovations in the banking industry and spurring some positive development. However, it is too soon to judge the role these small financial instruments will play in development over time, and based on what some experts suggest, if there are not proper reforms, microcredit could very well do more harm than good.

Pope Benedict XVI, while generally quite positive in his views on microcredit, touched on the need for analyzing the process and guarding against exploitation.

Writing in Caritas in Veritate, he argued, “the experience of micro-finance, which has its roots in the thinking and activity of the civil humanists…should be strengthened and fine-tuned…The weakest members of society should be helped to defend themselves against usury, just as poor peoples should be helped to derive real benefit from micro-credit, in order to discourage the exploitation that is possible in these two areas.”

In the mean time, the hype over microcredit continues. Former UN Deputy Secretary-General Mark Malloch Brown stated that “by directly empowering poor people, [microcredit] has become one of the key driving mechanisms towards meeting the Millennium Development Goals.”

Perhaps a more balanced view is needed for the moment.

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(The views expressed in this column are those of the author and do not necessarily reflect the positions of Headline Bistro or the Knights of Columbus.)