24 March 2008

Microfinance: Microcredit Isn't Perfect and It Isn't Enough to End Poverty

"Making loans and fighting poverty are normally two of the least glamorous pursuits around, but put the two together and you have an economic innovation that has become not just popular but downright chic," writes James Surowiecki, on the Financial Page of last week's New Yorker. "What Microloans Miss," is another in a recent spate of articles decrying the hype around microcredit (see my earlier post on another such article from the Stanford Social Innovation Review last summer).

Microcredit is neither perfect nor a panacea. That's a given, but to claim that the vogue around is more hype than real progress seems a tad overdone.

"This vogue has translated into a flood of real dollars," writes Surowiecki, "institutional and individual investments in microfinance more than doubled between 2004 and 2006, to $4.4 billion, and the total volume of loans made has risen to $25 billion, according to Deutsche Bank. Unfortunately, it has also translated into a flood of hype. There’s no doubt that microfinance does a tremendous amount of good, yet there are also real limits to what it can accomplish. Microloans make poor borrowers better off. But, on their own, they often don’t do much to make poor countries richer."

True enough. What microloans accomplish best may be a way to provide a safety net for poor people in countries where access to credit and financing is limited. Muhammad Yunus, the "godfather of microfinance," saw the innovation as a way to help poor people escape the usury of moneylenders.

"But can microcredit achieve the massive changes its proponents claim?" ask Karol Boudreaux and Tyler Cowen in "The Micromagic of Microcredit," their recent essay in The Wilson Quarterly. "Is it the solution to poverty in the developing world, or something more ­modest -- ­a way to empower the poor, particularly poor women, with some control over their lives and their ­assets?"

Boudreaux and Cowen make some good points, many based upon their own experiences in Africa and Asia, and their essay is worth reading in full.

"Most microcredit banks charge interest rates of 50 to 100 percent on an annualized basis (loans, typically, must be paid off within weeks or months)," write Boudreaux and Cowen. That's not as scandalous as it ­sounds -- local moneylenders demand much higher rates. The puzzle is a matter of basic economics: How can people in new businesses growing at perhaps 20 percent annually afford to pay interest at rates as high as 100 ­percent?

"The answer is that, for the most part, they can’t. By and large, the loans serve more modest ­ends—­laudable, but not world changing."

The authors report that "in the Tanzanian capital of Dar es Salaam, Joel Mwakitalu, who runs the Small Enterprise Foundation, a local microlender, told us that 60 percent of his loans are used to send kids to school; 40 percent are for investments. A study of microcredit in Indonesia found that 30 percent of the borrowed money was spent on some form of ­consumption."

In the end, the authors surmise, "the cash allows a poor entrepreneur to maintain her business without having to sacrifice the life or education of her child. In that sense, the money is for the business, but most of all it is for the child. Such ­life­saving uses for the funds are obviously desirable, but it is also a sad reality that many microcredit loans help borrowers to survive or tread water more than they help them get ahead."

Microcredit provides access to financing to which traditional "informal sector" people do not have access. Banks typically will not loan to the informal sector. Microcredit may even help poor people save more rather than get out of debt, by increasing their asset base -- a family with a cow that provides milk, natural fertilizer and biofuel or helps plow the fields is better off than a family without a cow.

Boudreaux and Cowen explain that "microcredit is making people's lives better around the world. But for the most part, it is not pulling them out of poverty. It is hard to find entrepreneurs who start with these tiny loans and graduate to run commercial empires.

"The more modest truth is that microcredit may help some people, perhaps earning $2 a day, to earn something like $2.50 a day. That may not sound dramatic, but when you are earning $2 a day it is a big step forward. And progress is not the natural state of humankind; microcredit is important even when it does nothing more than stave off ­decline."

Even Yunus, whose latest book is about a new innovation he calls "social business" doesn't claim microcredit is enough to eliminate poverty.

What Surowiecki argues for is greater investment in small- to medium-sized businesses (SMEs). He, like Aneel Karnani, who wrote the SSIR piece to which I referred above, argues that "businesses that can generate jobs for others are the best hope of any country trying to put a serious dent in its poverty rate. Sustained economic growth requires companies that can make big investments -- building a factory, say --and that can exploit the economies of scale that make workers more productive and, ultimately, richer."

Some others seem to agree, as Surowiecki points out, that "what poor countries need most, then, is not more microbusinesses. They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation."

SMEs represent the "missing middle" that "require backers who want to invest in companies rather than just lend to them."

Recently this missing middle got a high-powered group of such backers: Google.org, the Soros Economic Development Fund, and the Omidyar Network have launched a new US$17 million Small to Medium Enterprise Investment Company in India "to create job opportunities and spur greater economic participation for a larger segment of the population."

And this is a good thing. For as Jake de Grazia, formerly of PlaNet Finance China, writes on his blog, A More Perfect Market, "all communities are going to need more than just microfinance. Maybe the ideal more is the nurturing of SMEs and the creation of jobs."

"The real issue," as Boudreaux and Cowen conclude in their essay, "is that we so often underestimate the severity and inertia of global poverty. Natalie Portman may not be right when she says that an end to poverty is 'just a mouse click away,' but she's right to be supportive of a tool that helps soften some of poverty’s worst blows for many millions of desperate ­people."

The question, really, is not whether microcredit is enough, but rather how can we provide the full range of financial services to the poor to which most of us have access?