Has microfinance changed the world?

The idea of lending self-sustaining interest-based loans to poor people to help them overcome their deprivation seems like a clever and convenient strategy to address global deprivation, as it aims to provide poor people profit-making (interest-based) loans on the assumption that the availability of this credit can help overcome poverty. Yet, despite the enthusiasm for microloans, the emergent results are not very encouraging.

Till about 40 years ago, many of the world’s poorest did not really have access to formalised credit facilities due to a lack of collateralisable assets. Lending to the poor didn’t make much sense for banks due to the small size of the loan, which implied that the bank’s administrative costs would be higher than the amount of interest they could earn on such meagre loan amounts. Therefore, poor people generally relied on loans from friends or relatives, or from small-time neighborhood money-lenders, who would often charge them exorbitant interest rates.

Muhammad Yunus, an economics professor in Bangladesh, who went on to create the Grameen Bank, came up with innovative ways to lend to the poor. Microfinance models vary, but they are based on similar principles. They basically try to reduce the cost of processing a loan and minimise the risk of default by lending to small groups of people, who can apply peer pressure to ensure that each borrower pays back their share. Estimates show there are nearly 140 million poor clients who have been lent well over $100 billion. Besides providing loans to poorer entrepreneurs to invest in their businesses, micro-lenders now offer a diverse portfolio of financial services, ranging from credit for purchasing solar panels to crop insurance schemes.

Yet, delivering credit to the doorstep of poorer clients is expensive due to which microfinance entities need to charge higher interest rates than conventional lenders. The irony of high interest rates has been justified using the rationale that poor people in need would have to pay even higher interest rates if they had no recourse but to rely on informal lenders.

Initially, many advocates of microfinance seemed convinced that the poor, especially impoverished women, could transform their own lives using micro-credit. Lending to women was especially favoured as the means to produce a wide range of indirect virtuous outcomes ranging from improving nutritional rates for girls, addressing gender disparities in education, and enhancing socio-cultural and political participation of women.

Enthusiasm for the promise of microfinance solving many complex development problems by merely lending self-financing loans to the poor led to Yunus being awarded the Nobel Peace Prize in 2006.

A series of research studies, led by prominent economists at Yale and MIT, tried to use rigorous field experiments to test the effectiveness of microloans. These studies compared a randomly selected group of people who had been offered microloans to similar groups without such loans in countries like India, Mexico, Mongolia and the Philippines. The findings of this research showed how average microloan borrowers did not end up with significantly increased income relative to the control groups. Perhaps this is because poor people often do not use microloans in ways predicted by microfinance pundits. Instead of investing in small businesses, or buying inputs for their crops, many use microloans to meet household needs or pay for other necessary expenses such as weddings. The use of microfinance is also criticised for increasing the burden of women, who may be able to get a microloan, but gain additional work on top of all the unpaid labour they do. Micro-credit is also blamed for eroding social capital within poor communities due to the group lending mechanism.

The idea of making poor people pay interest and avail access to credit in order to overcome deprivation may seem like a convenient solution to donor agencies and microfinance lenders. Yet, the actual impact of such a strategy on addressing the underlying causes of poverty are not as remarkable as was hoped.

Published in The Express Tribune, December 20^th, 2019.

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