Microfinance: Back to the Drawing Board - Pacific Standard

Microfinance: Back to the Drawing Board

Despite the hype surrounding microfinance as an answer to solving world poverty, new research shows it isn't the savior economists envisioned.
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Yohane Mdeme owns a food market in Tanzania. Though poor and with little to no collateral, he applied for a loan of $850 through Kiva.org to expand his small business. Twenty years ago in such a place and for such a client, Mdeme would never obtain the capital to increase his business. No bank would have given out such a small loan, much less to a person without collateral.

Yet Mdeme is well on his way to receiving his requested amount in full.

This process, called microfinance, has been put on a pedestal by development economists thanks to its high repayment rates and ability to provide capital and growth where it used to be nonexistent. But recent research links its success with national economic growth, suggesting it only succeeds in economies that are already beginning to bloom.

In other words, microfinance is less of a medicine for the sickest patients and more of a therapy for patients already on the mend.

Despite some localized successes, most treatments for addressing world poverty seem to end in near failure, leaving potential donors, whether governments, NGOs or individuals, dismayed at the futility.

In recent years, development economists started to believe that microfinance was the lever giving the impoverished the means to raise themselves out of poverty and for their communities to grow toward economic prosperity, without creating dependence while teaching the rudiments of credit. Microfinance can help a farmer borrow enough to increase his number of livestock so he can increase his overall profit, or it can help the local weaver buy a new loom from which she can produce higher-quality products. Typically, the loans are made to groups, so one person's loan is contingent on another person's repayment, which ratchets up the social pressure. Microfinance is also more often extended to women, who exhibit higher repayment rates. Using these two strategies and others, repayment rates have been remarkably high among many microfinance banks.

Its growth and prospects reflect that optimism: Microfinance has recruited more than 100 million customers worldwide and 10,000 microfinance institutions; Bangladeshi banker Muhammad Yunus received the Nobel Peace Prize in 2006 for his microfinance efforts; the United Nations declared 2005 "The Year of Microcredit," and three years later, Forbes could write about "Microfinance Fever."

However, recent research suggests this path to development has been inflated beyond its true potential, in part because much of its success is based on anecdote — think of Yohane Mdeme's story as the beginning and end of analysis — and not number crunching.

In one new study that looked at data, Michigan State University economics professor Christian Ahlin, Jocelyn Lin of New York University and Michael Maio of the University of Minnesota studied the relationship between the success of microfinance banks and the larger national economies in which they operate. Their work, which appears in The Journal of Development Economics, doesn't burst microfinance's "bubble," but it ought to make expectations more grounded and realistic.

The group believed that while the internal operations and institution-specific methodologies of microfinance institutions (MFIs) have been studied extensively, "much less studied are whether and how an MFI's success depends on the macroeconomics and institutional structure and outcomes of the country where it is located."

The researchers give the example of widely imitated MFI Bank Rakyat Indonesia, which gives out microcredit loans to small farmers. The bank's most notable success was experienced from 1980 to 1997 — when Indonesia averaged 5 percent real gross domestic product growth. Was microfinance in this case riding the coattails of the larger macroeconomic expansion and economic boom, or was Bank Rakyat Indonesia successful in its own right because of its own practices and the merits of microfinance and thus worth imitating?

While it may seem obvious that an MFI will succeed in a growing economy, Ahlin, Lin and Maio say this perspective is shortsighted. It is plausible that microfinance requires a stalled or inept economy — why else is it necessary?

As Ahlin suggests, microfinance may need a "vibrant informal economy, a situation that tends to grow rarer as an economy and its institutions develop." If growth occurs and the informal work force is diminished, there is no longer an urgent need for microfinance. In addition, "a deceleration of growth may also raise demand for products made by micro-enterprises as consumers substitute away from imports or high-quality goods." So while microfinance may require an overall rising tide, it may need some low spots to thrive, the poverty-busting equivalent of Wall Street's buying on dips.

Lastly, growing wage-earning opportunities, which comes with growth, guarantees a steady income that lures potential entrepreneurs away from microfinance since entrepreneurship usually entails risk and variability in income.

On the other hand, a growing economy may increase the demand for microcredit as individuals are more willing to take risks in a reliably growing economy.

The study compares the success of 373 microfinance institutions with the growth of its host country. MFIs were evaluated based on the ratio of revenue to costs and loan portfolio growth; the host economy is measured by traditional yardsticks such as growth in per capita gross domestic product, manufacturing's share in GDP, inflation, income inequality and private credit as a fraction of GDP, among other factors. That allowed researchers to "handicap" an institution's performance based on the underlying economic conditions.

The team demonstrates a strong relationship between macroeconomic expansion and microcredit success; macroeconomic growth and MFI profit margins correlate almost one-for-one in percentage points. And when the economy is hurting, microfinance fails along with it.

The group also asks, "Is [microfinance] rivalrous ... with a development path based on industrialization, manufacturing, and foreign trade and investment?" At least in the long run and in some economic climates, the signs imply yes. The group explains how microfinance competes with the manufacturing sector and the formal work force and thus microfinance is inhibiting true industrialization in countries that might to be ready for it. The worker is lured away from a formal, paid position so he can remain in the informal sector. (Of course, many might suggest this might not be a bad thing.)

The team also highlights that while wage-paid positions reduce microfinance participation, it also complements a limited base of micro-entrepreneurs by increasing aggregate demand for goods and increasing loan sizes. With all that in mind, we are forced to reassess the appropriate economic climate for microfinance.

The authors advocate that the widespread microfinance strategy should not be implemented in manufacturing-dominated economies competing with wage incomes though limited and concentrated microfinance would be quite effective.

For example, Tijuana, Mexico is not a prime candidate for a large microfinance sector as it has no rural sector, relies on a manufacturing economy based in products ranging from shoes to car parts and is heavy with foreign direct investment. Rather, large scale microfinance should be implemented in rural societies where there are higher measured repayment rates, service-based economies and economies with less formal labor, both of which produce higher measured participation rates.

Microfinance has its time and place and assists in economic development, but there is no one solution to galvanize an economy that is in shambles. It is going to take a combination of strategies that account for differing social, environmental and political settings. Only by finding locally suitable solutions arrived at on a case by case basis where requirements will certainly vary can shared basic human needs be universally satisfied.

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