Joseph Cotterill isn't convinced by microfinance

Developed world businesses are busy rediscovering the nineteenth-century virtues of what used to be called philanthropy, and they are busier still encasing them in the twenty-first-century jargon of “corporate social responsibility.” These Western banks and corporations are in their turn becoming increasingly outflanked by emerging market multinationals, who are even keener to cultivate their own conscientious reputations on world markets. Surely both developments, however, pale in comparison to the vast, if flawed, microfinance revolution.

Microfinance is the practice of giving out tiny loans to people who are too poor to raise cash through large banks, in the hope of encouraging them to break the poverty cycle. It is no longer a new idea. One of its earliest practitioners,  economist Muhammad Yunus, received the Nobel Peace Prize two years ago for his work in the area.
Mr Yunus’ first furtive experiments began in 1976. Institutions offering microcredit loans now operate in over seventy countries. Some are now huge enterprises with thousands of employees, as with the Latin American conglomerate Pro Mujer, or Indonesia’s Bank Rakayat. In Bangladesh, the spiritual home of microfinance and the base of the Grameen Bank, Mr Yunus’ first venture in creative financing for the poor, one in five people have used a microcredit loan at some point. About six million people in the tiny but populous South Asian state have been lifted out of poverty by microfinance. This all certainly sounds like dominance of the Global South. However, it also implies the microfinance revolution is coming perilously close to a state of diminishing returns.

After all, too much remains to be achieved. It’s important not to overrate the extent of the microfinance empire. For example, Post office banks all over the developing world remain untouched by the revolution. Since post offices are by far the largest depositories of rural savings in any developing country – and in one or two developed ones too, as Japan’s lucrative postal monopoly demonstrates – this is a big deal. The savings stashed away in India’s post offices – estimated at $55bn in 2005 – rival the holdings of the country’s state bank.

This is disappointing, because the inner workings of microfinance lending seem promising. Not only do microfinance programmes function on highly exclusionary criteria, they also throw an interesting sidelight on to the role of social capital in microeconomic interactions. Loans are only given out to the poorest, and even then only to groups of five people looking to start a business: small enough to prevent free riding, large enough to generate crushing peer pressure on individuals who can’t or won’t pay their share. (The group as a whole has to make up the shortfall). Since women are generally susceptible to social pressure, they are the best credit risks. Ninety-five per cent of the Grameen Bank’s borrowers are female.
However, whatever else microfinance is doing, it is not really creating a new generation of what Mr Yunus calls “informal businesses” across the developing world, and which he often sets out as the ultimate goal of his microfinance work. Economists Tyler Cowen and Karl Boudreaux report, for instance, that thirty per cent of the microcredit doled out so far in Indonesia has gone straight into consumption, not investment for business ventures.

 Data from similar projects in Tanzania also suggests that investment is outweighed by spending on goods such as school fees. Of course, the latter can be seen as investment in its own right. The fact remains, however, that most microfinance borrowers are too clever for even nimble outfits like microfinance NGOs, and that they are more interested in using short-term credit to fulfil immediate needs rather than plan for the future. Of course, this is still a very good thing for improving the lives of the world’s poorest people. Nevertheless, it is apt for Cowen and Boudreaux to conclude that “many microcredit loans help borrowers to survive or tread water more than they help them to get ahead.”

Nor is this quite the whole story of the perverse incentives to be found at the heart of microfinance economics. In truth, microfinance’s modern success is based on a very simple and very old principle. Cowen and Boudreaux also argue that if you are a poor person living in a poor country with few reliable institutions, it has never been a good idea to put your savings into a monetary format. Microcredits have provided an easy means for peasants across Asia and Africa to push their savings over the tipping point from meagre cash holdings to proper sunk capital. This includes milk cows.
Indeed, a 2003 Grameen Bank report revealed that these were the single most popular item purchased with the bank’s loans, and it is not difficult to see the positive externalities involved. Unlike cash under the bed, cows do not disintegrate in a typhoon or flood. On the contrary, if disaster strikes, they can be quickly killed and eaten or sold off as meat. Nor can friends or relatives wheedle repeated small amounts of cow from borrowers who are not paying attention. Cows also differ from paper notes in making a fuss if they are being stolen.

So far, so sensible. However, peasants’ preference to “invest” in cows rather than actually put money away has serious implications for the limits of microfinance. Borrowers are turning to small loans as a vote of no confidence in the wider legal structures of their societies. Without the rule of law, there is little point  in embracing monetisation.

This is best seen in microfinance’s successful fight against many of the baleful lending practices associated with traditional societies. To Western eyes, the annual interest rates attached to the typical microfinance loan seem penurious – ranging from fifty to a hundred per cent. This needs to be compared, however, to the two or four hundred per cent rates charged by the shifty middlemen and small-time usurers who haunt the villages of the sub-continent and shanty towns in Africa and Latin America. Traditional lending is also by and large illegal. Debts are often collected violently and at supremely short notice, sending borrowers back into the cycle of poverty.

   
For Cowen and Boudreaux, microcredit’s great advantage over traditional lending practices is its introduction of larger organisational scales and regularised interest rates. From there, peasants are inducted into the rudiments of the “formal financial world,” and a few entrepreneurs might be inspired to brave the world of commercial loans. They therefore conclude that “the future of microcredit lies in the commercial sector, not in unsustainable aid programmes.” Surely, however, this step will not be taken until commercial contracts are legally enforceable in a fair judicial system. At least aid programmes obey international standards and pay for themselves out of the loans’ interest rates. 

If microfinance is here to stay in developing countries like Bangladesh and Bolivia, then it should be taken as a danger sign that governments are stalling in their promises to reform state-building and consolidate civil society. Microfinance is at best an economic sticking plaster for the deeper problems of poverty. It is decidedly not the dawn of a new era of “social business.”