January 23, 2011
Microfinance
Overselling of Microfinance-Becker
Some enthusiasts for microfinance have sold it as an important component of the solution to poverty in developing countries. It often does help lower poverty, especially of poor women, but it cannot ever make more than a small contribution to overcoming poverty. As I said on October 29th 2006 when we posted on microfinance, "Economic growth requires secure property rights, encouragement of private enterprise, openness to international trade, stimulation of education, limited and sensible regulations, and reasonably honest government. Microfinance makes only a small direct contribution to any of those variables". Others may subtract some of the variables I mention, and add different ones, but no serious development economist would suggest that microfinance would have a major role in the economic development of poor economies.
Nor did microfinance invent small-scale loans to poor farmers and others. Local moneylenders in India and elsewhere have been doing that for centuries. However, the Grameen Bank founded in 1983 by Muhammad Yunus discovered several rather new ways to lend to the poor. This bank loaned primarily to poor women, usually Moslem women. Local moneylenders generally ignored Moslem women, either out of prejudice against women managing their own (small) businesses, or for other reasons.
The Grameen Bank also encouraged the formation of credit groups of a few women, about five members typically, that guaranteed repayment of the loans made to each woman in the group. Members of a group pressured other members to repay since they all might suffer if any member defaulted. With these guarantees, a group did not have to put up any collateral for the loans made to its members, a big advantage to poor women.
Although microfinance has had only a small impact on overall poverty in any country or region, studies suggest it has helped the Moslem women who received small loans. Families in which Moslem women have received microfinance improved the education of their children, especially the education of daughters, spent more on medicines, and accumulated more gold, which is usually the primary asset of Moslem women in Asia.
Yunus and many others have criticized the participation of for-profit lenders in microfinance. Yet in fact, for-profit lenders have always participated, although on much smaller individual scales than the companies Posner mentions (Compartamos and SKS Microfinance) that have hundreds of millions of dollars of capital. For-profit lenders have charged "high" interest rates, but they have usually been flexible in allowing borrowers to take longer to repay if they were experiencing temporary financial difficulties. One would expect these lenders to adapt some of the lending innovations pioneered by the Grameen Bank and other microfinance lenders if the innovations improved repayments or helped in other ways to raise profits.
Although examples have been given of excessively high interest rates and other questionable terms changed by some for-profit micro lenders, it is not apparent that such behavior has been common. Poor farmers are accustomed to the borrowing process because they need to borrow in order to finance their outlays on seed and other farm inputs that occur months before they harvest rice or other crops to sell. Unscrupulous lenders could not easily fool these borrowers.
Even with well-informed borrowers, commercial interest rates will be high to borrowers with poor collateral, and to borrowers whose incomes fluctuate greatly due to the weather and other factors. Government-imposed ceilings on interest rates and other lending restrictions are likely to prevent such borrowers from gaining access to funds, unless governments or NGOs provide subsidized lending. This is why ceilings on interest rates and most other lending restrictions recently introduced or proposed will end up doing more harm than good.
After the financial crisis began, similar claims about exploitation of ignorant consumers were levied against providers of credit cards and mortgages. These claims motivated the consumer "protection" and other parts of The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in July 2010. Yet little evidence suggests that borrowers were widely fooled by small print on borrowing contracts, by how interest rates were calculated, or by other claims about consumer exploitation (see my post on July 11, 2010). The consumer protection provisions of this Act will do little good, and will raise borrowing costs to the consumers who can least afford it.
Governments in countries with substantial microfinance should be mainly concerned about increasing the degree of competition among micro lenders in more remote rural areas. For monopolies do charge excessively high interest rates, and require borrowers to satisfy other onerous terms. Non-profits and other lenders should be encouraged to operate in localities where risk-adjusted interest rates are high, and anti-monopoly agencies should investigate possible collusion among lenders in these localities. Such policies would be more effective than trying to discourage for-profit lenders from making microloans.
The Crisis in Microfinance—Posner
On October 29, 2006, shortly after the award of the Nobel Peace Prize to Muhammad Yunus and his Grameen Bank of Bangladesh, Becker and I blogged about microfinance, which Yunus and his bank had pioneered. The term "microfinance" (or "microlending") refers to the making of tiny loans to small farmers, shopkeepers, artisans, and other minute commercial enterprises in underdeveloped countries such as India and Bangladesh at high interest rates—sometimes as high as 20 percent a day. In my blog posting, I called microfinance a worthy experiment, superior to philanthropy because the high interest rates that the microfinanciers charge should induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. But I sounded a skeptical note. I said that the "success [of microfinance] has yet to be demonstrated despite glowing appraisals by Kofi Annan and others. It may simply be the latest development fad…The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit." I noted that the Grameen Bank had a surprisingly low default rate and pointed out that it "does not have written loan agreements and does not sue defaulters or invoke other legal remedies against them. The natural inference to draw is that the bank is extremely selective in its choice of persons to whom it is willing to lend, and such selectivity, if imitated by other microfinanciers, must greatly limit the scope and impact of microfinance." I concluded by "suggest[ing], albeit tentatively, that there may be a good deal less to microfinance than its boosters claim."
Microfinance has continued to expand since 2006. The number of microloans made in India rose from 10 million in March 2007 to 26.7 million in March 2010. By the end of 2009 total microloans stood at $70 billion, half of them in India and Bangladesh. But a series of suicides by microborrowers in the fall of 2010 in the Indian state of Andhra Pradesh, the site of more than 25 percent of Indian microlending, led to charges that the microlenders, which are commercial rather than eleemosynary enterprises (though, as we'll see, the Grameen Bank seems to straddle the two types of enteprise), were charging exorbitant interest rates and coercing people into taking out loans they could not afford to repay. Politicians urged borrowers not to repay their microloans; and repayment rates, previously as high as 98 percent, plummeted to 10 to 20 percent. The government of Andhra Pradesh has imposed strict limitations on microlending, and the Reserve Bank of India (India's central bank) has proposed that similar controls be established throughout India—controls including a ceiling on interest rates and loan amounts and limiting eligibility to borrowers having an income above a specified level. In December 2010 the prime minister of Bangladesh declared that microlenders were "sucking blood from the poor in the name of poverty alleviation" and ordered an investigation of Grameen Bank. Similar reactions to microlending have taken place in Nicaragua, another country that had embraced microlending with enthusiasm.
And then just a week ago, in a short article in the New York Times entitled "Sacrificing Microcredit for Megaprofits," www.nytimes.com/2011/01/15/opinion/15yunus.html?_r=2&scp=2&sq=microfinance&st=cse,Yunus himself wrote: "when I began working…on what would eventually be called 'microcredit,' one of my goals was to eliminate the presence of loan sharks who grow rich by preying on the poor. In 1983, I founded Grameen Bank to provide small loans that people, especially poor women, could use to bring themselves out of poverty. At that time, I never imagined that one day microcredit would give rise to its own breed of loan sharks. But it has." He writes that the problem "began around 2005, when many lenders started looking for ways to make a profit on the loans by shifting from their status as nonprofit organizations to commercial enterprises. In 2007, Compartamos, a Mexican bank, became Latin America's first microcredit bank to go public. And this past August [2010], SKS Microfinance, the largest bank of its kind in India, raised $358 million in an initial public offering."
It seems rather an odd point for Yunus to make, because the Grameen Bank is itself a stock corporation, not a nonprofit. See www.grameen-info.org/index.php?option=com_content&task=view&id=179&Itemid=145. Yunus says in the Times article that all the bank's profits are returned to the borrowers in the form of dividends, but if so I don't understand how the bank attracts equity capital. He contends that his is the best model for microlending, explaining that "commercialization has been a terrible wrong turn for microfinance, and it indicates a worrying 'mission drift' in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity… Instead of creating wholesale funds dedicated to lending money to microfinance institutions, as Bangladesh has done, these commercial organizations raise larger sums in volatile international financial markets, and then transmit financial risks to the poor…Some advocates of commercialization say it's the only way to attract the money that's needed to expand the availability of microcredit and to 'liberate' the system from dependence on foundations and other charitable donors. But it is possible to harness investment in microcredit—* and even make a profit*—without working through either charities or global financial markets." The phrase I've italicized is strange, because Yunus claims that his bank does not make a profit, but instead distributes any surplus of income over expenses to the borrowers, and urges that as the model for the microfinance industry.
The recent uproar in microlending puts one in mind of our own controversies over payday lending, title lending (borrowing at high interest rates with one's car as security), credit-card lending, and subprime mortgage lending—all examples of loans at very high interest rates, made largely to unsophisticated consumers. There is an inconclusive literature on the net social benefits of these forms of credit (sometimes lumped together in the term "fringe banking"). The basic difference between our fringe banking and microfinance is that fringe banking is primarily consumer rather than commercial lending, but the small farmers and shopkeepers who take out microloans probably are even less sophisticated on average than the American customers for fringe banking. Moreover, although what critics of fringe banking call "predatory lending" is not highly regulated in the United States and as a result fraud and other exploitive conduct may well abound, regulatory protections are undoubtedly far weaker in countries like India and Bangladesh.
Yunus's mysterious nonprofit-profit model of microfinance cannot attract substantial capital, but commercialized microfinance seems increasingly unlikely to have substantial social benefits—and this with or without regulatory controls designed to protect unsophisticated borrowers. Without the controls, there will undoubtedly be a good deal of fraud, and improvident borrowing without fraud. With the controls, the amount of lending will be curtailed. But with or without controls, the amount of lending will be limited by the very high default rates that can be anticipated unless there is very careful screening of would-be borrowers. Interest rates will remain very high and will strangle many of the businesses that rely on microfinance. Microfinance may turn out to be a niche service, with little overall impact.