5/9/11 - the myth of microfinance

In today's excerpt - "microfinance" (or microcredit)—which is the lending of very small amounts of money to entrepreneurs in poverty-stricken countries around the world—has been increasingly lauded as a key to the advancement of these countries. In 2005, the popularity of microfinance reached fever pitch as it was designated the International Year of Microcredit by the United Nations, with endorsements from royalty, like Queen Rania of Jordan, and celebrities, like the actresses Natalie Portman and Aishwarya Pai. The ascendancy of microfinance reached its peak in 2006, when the Nobel Peace Prize was awarded jointly to Professor Muhammad Yunus, the Bangladeshi "inventor" of microcredit, and his Grameen Bank. The problem? Unless heavily subsidized, microfinance doesn't provide much beyond a temporary, illusory benefit:

"The entrepreneurs in the informal [poor] sector, it is argued, are struggling not because they lack the necessary vision and skills but because they cannot get the money to realize their visions. The regular banks discriminate against them, while the local moneylenders charge prohibitive rates of interest. If they are given a small amount of credit (known as a 'microcredit') at a reasonable interest rate to set up a food stall, buy a mobile phone to rent out, or get some chickens to sell their eggs, they will be able to pull themselves out of poverty. With these small enterprises making up the bulk of the developing country's economy, their successes would translate into overall economic development.

"The invention of microcredit is commonly attributed to Muhammad Yunus, the economics professor who has been the public face of the microcredit industry since he set up the pioneering Grameen Bank in his native Bangladesh in 1983, although there were similar attempts before. Despite lending to poor people, especially poor women, who were traditionally considered to be high-risk cases, the Grameen Bank boasted a very high repayment ratio (95 per cent or more), showing that the poor are highly bankable. By the early 1990s, the success of the Grameen Bank, and of some similar banks in countries such as Bolivia, was noticed, and the idea of microcredit—or more broadly microfinance, which includes savings and insurance, and not just credit–spread fast.

"The recipe sounds perfect. Microcredit allows the poor to get out of poverty through their own efforts, by providing them with the financial means to realize their entrepreneurial potential. In the process, they gain independence and self-respect, as they are no longer relying on handouts from the government and foreign aid agencies for their survival. Poor women are particularly empowered by microcredit, as it gives them the ability to earn an income and thus improve their bargaining positions vis-a-vis their male partners. Not having to subsidize the poor, the government feels less pressure on its budget. The wealth created in the process, naturally, makes the overall economy, and not just the informal sector entrepreneurs, richer. Given all this, it is not a surprise that Professor Yunus believes that, with the help of microfinance, we can create 'a poverty-free world [where the] only place you can see poverty is in the museum'. ...

"Unfortunately, the hype about microfinance is, well, just that—hype. There are growing criticisms of microfinance, even by some of its early 'priests'. For example, in a recent paper with David Roodman, Jonathan Morduch, a long-time advocate of microfinance, confesses that '[s]trikingly, 30 years into the microfinance movement we have little solid evidence that it improves the lives of clients in measurable ways'. The problems are too numerous even to list here; anyone who is interested can read the fascinating recent book by Milford Bateman, Why Doesn't Microfinance Work? But those most relevant to our discussion are as follows.

"The microfinance industry has always boasted that its operations remain profitable without government subsidies or contributions from international donors, except perhaps in the initial teething phase. Some have used this as evidence that the poor are as good at playing the market as anyone else, if you will just let them. However, it turns out that, without subsidies from governments or international donors, microfinance institutions have to charge, and have been charging, near-usurious rates. It has been revealed that the Grameen Bank could initially charge reasonable interest rates only because of the (hushed-up) subsidies it was getting from the Bangladeshi government and international donors. If they are not subsidized, microfinance institutions have to charge interest rates of typically 40-50 per cent for their loans, with rates as high as 80-100 per cent in countries such as Mexico. When, in the late 1990s, it came under pressure to give up the subsidies, the Grameen Bank had to relaunch itself (in 2001) and start charging interest rates of 49-50 per cent.

"With interest rates running up to 100 per cent, few businesses can make the necessary profits to repay the loans, so most of the loans made by microfinance institutions (in some cases as high as 90 per cent) have been used for the purpose of 'consumption smoothing'—people taking out loans to pay for their daughter's wedding or to make up for a temporary fall in income due to the illness of a working family member. In other words, the vast bulk of microcredit is not used to fuel entrepreneurship by the poor, the alleged goal of the exercise, but to finance consumption."


Ha-Joon Chang


23 Things They Don't Tell You About Capitalism


Bloomsbury, New York


Copyright 2010 by Ha-Joon Chang


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