Economics 101

Can Microfinance Really Help the Poor?

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In the years following World War II, foreign aid was the dominant strategy for stimulating economic growth in impoverished countries. Over time, however, the use of aid has been called into question and attacked as wasteful, if not corrupt.

Within the past decade microfinance became the new panacea for eliminating poverty, but recently it too has undergone increasing scrutiny, with Lesley Sherratt’s Can Microfinance Work? being only one of the most recent examples.

Christians have embraced microfinance as a solution to poverty that helps the poor help themselves, but we must ensure that our efforts are really helping people rather than simply making us feel good. As Elise Daniel asks,

If our social justice strategies aren’t the most effective or efficient, are we really exercising biblical prudence and stewardship? Are we protecting human dignity and fulfilling the Christian call to help “the least of these?”

In light of recent critiques, we must ask: can microfinance really help the poor?

I believe it can, but some caveats are in order. Microfinance encompasses multiple discrete activities, chief among them microcredit. Microcredit—the practice of making small loans to poor people who invest them in equally small business enterprises, hoping to recoup the loan—is what is usually involved when “microfinance” is mentioned.

While microcredit has improved the lives of some poor people, there are many for whom it has made no discernible difference. Worse, microcredit has often harmed those it was meant to help, so we must examine the ascribed causes of harm and determine how to respond to them. We should also consider other components of microfinance that may be more effective at helping the poorest of the poor than microcredit, such as microsavings.

Out of Poverty?

For several years microfinance institutions (MFIs) have claimed that microcredit can lift people out of poverty, and they have moving success stories to prove it. Indeed, the idea of microfinance as the miracle cure to poverty has been fueled by such anecdotes.

However, individual stories cannot tell us the overall effect of microcredit on poverty, and most formal studies of microfinance to date have reportedly become suspect.

In Can Microfinance Work? Sherratt writes, “The vast majority [of studies on microfinance] have been beset with methodological flaws”:

In a recent systematic review of publications on the impact of microfinance, Duvendack and coauthors surveyed 2,643 publications, but found only 58 worth studying in depth, observing, “Our report shows that almost all impact evaluations of microfinance suffer from weak methodologies and inadequate data…thus the reliability of impact estimates are…adversely affected.”

Specific methodological problems have included the lack of a “control group of similarly placed nonborrowers” and “sample selection bias.” Only recently have more reliable studies—random control trials (RCTs), which are often used in medical experiments—been done. Not many RCTs have been conducted so far, but the largest one found that

Where there was an existing business, loans were used to expand it: where there was not a pre-existing business, loans were used to increase nondurable consumption (food or, possibly, paying down more expensive debt). Overall, on the substantial evidence it gathered then, the study found no clear impact of the provision of microcredit on poverty.

The authors of this study also surveyed five other RCTs and reached the same conclusion:

Where there was an existing business, the loan was used to put more money into it, and business activity increased. But after two years there was little or no effect on total household income, on average consumption, on health or education, or indeed on female empowerment where this was measured.

These loans were not misused, insofar as they were invested in businesses. It is just that many people are apparently not lifted out of poverty by such investments, with most benefits going to the richest poor:

Nearly all of the gains from microcredit [accrue] to successes among the top 5%, possibly fewer.

Brian Fikkert and Russell Mask echo these findings in From Dependence to Dignity, a book on microfinance from a Christian perspective:

A number of recent studies have found that microloans are not launching most poor microentrepreneurs on a rapid upward trajectory out of poverty.

While they point out that the positive effects of microfinance could be “long-term, perhaps even multigenerational,” they also acknowledge, “The vast majority of poor households are unlikely to experience dramatic increases in their incomes through starting their own microenterprises.”

Fikkert and Mask observe that the poor who tend to desire business loans are those who are just above and below the poverty line. In conjunction with Sherratt’s contention that microcredit mostly helps the richest poor and that “the losers from it are generally the poorest of borrowers,” this may suggest that extending microcredit primarily to the “rich” poor will do the most good and the least harm.

If true, this course of action should be seriously considered, for the potential harms that can arise from microcredit are significant.

Microcredit’s Unintended Consequences

According to Sherratt, two major harmful consequences of extending microcredit are onerous interest rates and abusive loan collection practices stemming from the enforcement of joint liability in lending groups.

Data compiled from the Microfinance Information Exchange and MicroFinance Transparency show that average interest rates on small loans charged by MFIs in Southeast Asia, Latin America, and Africa are “multiples of the formal rates [charged by commercial banks], not just an additional margin on top of them.” To give just one example, as of December 2013 the commercial bank rate in India was 10.3 percent, whereas the average MFI small loan rate was 29.5 percent as of April 2014. The gap between the commercial bank rate and average MFI small loan rate is even larger in several countries (Pakistan: 11.5 percent vs. 36.8 percent; Bolivia: 11.4 percent vs. 34.5 percent; and Zambia: 10.4 percent vs. 152 percent).

Sherratt acknowledges that MFIs generally do not charge high interest rates because they are greedy or unscrupulous, but because it is the cost of doing business:

In some cases, the profit motive will be part of what is driving high interest rates, and in some cases it may be excessive salary and administration costs: but in many cases, it will also be true that the high interest rates that are charged do simply reflect the very high relative cost of making small loans [emphasis in original].

Fikkert and Mask agree that MFIs’ high interest rates are necessary for financial sustainability, but Sherratt goes further by maintaining that regardless of whether MFIs’ motives are benign or malign, charging high interest rates to those who can least afford it is exploitative:

It is not incoherent to think that, for much of the industry, the only rates at which microfinance can be offered (at least sustainably) are in fact exploitative.

On this issue, Fikkert and Mask note that the Bible “does not forbid interest on loans for investment purposes.” At the same time, they say, “It is advisable for microfinance ministries to have funds available to make no-interest loans or gifts to people in destitute circumstances.”

It can be inferred that they believe the best practice is to only charge interest on loans to those who can truly afford it, the richest poor. This moral consideration fits well with Sherratt’s practical argument that microcredit is of greatest benefit to the “rich” poor.

While the authors seem to harmonize here, they disagree on the fundamental matter of joint liability in lending groups, with Fikkert and Mask upholding it as essential to the practice of microcredit and Sherratt decrying it as conducive to further bad consequences.

The Question of Joint Liability

Joint liability (also known as group liability) means that lending group members are mutually responsible for each other’s loan repayments. If someone misses his or her payment, another person in the group must make good on it so that all members in the group can receive their next loan.

Fikkert and Mask argue that joint liability is an essential component of microcredit because it creates what they call social collateral on loans. Most poor borrowers don’t have much in the way of physical collateral, so joint liability—specifically the withholding of further loans until all repayments have been made—incentivizes group members to hold one another accountable for missing payments.

Sherratt, however, charges that joint liability inspires perverse incentives. If future loans will not be forthcoming until all repayments have been made, this can lead to group members taking extreme measures to exact compensation from defaulting members. In one study of microfinance in Bangladesh, the author

Observed routine credit related strife among members and their families. This ranged from scolding, removing a woman’s gold nose-ring (a symbol of marital status, symbolically divorcing/widowing her), and taking a woman’s family’s food supply, leaving them with none….In the worst cases…members “would sell off the defaulting member’s house. This is known as house-breaking.”

To clarify, this refers to literally breaking apart a person’s house and selling the pieces. Sherratt contends that liability does not fall on the perpetrators alone:

When the MFI has insisted upon the use of group liability and knows from experience that as a result practices such as housebreaking occur, it cannot claim to be innocent of them when they do.

What can be done to prevent such abuses? Against the prevailing wisdom, Sherratt suggests that joint liability is not indispensable to microcredit. The common fear is that without it more borrowers will default, but she counters, “This has not been evidenced, because historically, relatively few have tried extending microfinance on an individual lending model basis.” Sherratt also cites a recent study showing that

When women are offered individual tailor-made loans, repayment is enhanced, compared to group-lending methods.

The debate over joint liability is still ongoing, but we cannot disregard the real harms it may inflict upon those it was meant to help. This, combined with the burden of necessarily high interest rates, should prompt us to look for other ways of helping the poorest poor who are unlikely to benefit from microcredit the way the “rich” poor can. One possibility is microsavings.

Savings for the Future

As skepticism of microcredit has grown, microsavings—the extension of formal savings vehicles to poor people who would otherwise not have access—has become popular as a way of alleviating some difficulties of poverty, such as volatile, irregular incomes. When poor people are given the chance to save and accumulate even small sums over time, this enables them to withstand unexpected financial needs and dips in their income without having to borrow and indebt themselves. This stabilization of spending is known as consumption smoothing.

Fikkert and Mask positively champion microsavings as an alternative to microcredit:

The historical focus of the microfinance industry on “microcredit-for-microenterprise” often overlooked the fact that poor people, who are highly vulnerable, would often prefer to save than borrow, as saving is less risky for them.

Just as microcredit is not a guaranteed path out of poverty, though, microsavings is even less so. Sherratt too raises the possibility of microsavings as a means of helping the poor, but she cautions that its effects may be salutary yet limited:

Village savings and loans groups…where the emphasis is on a small group saving each week with just a few at a time borrowing, and the money coming from and staying in the community, stand a better chance of being helpful help. They will not do a great deal to alleviate poverty and will not lead to development, but they do not do the harm of microcredit, and being able to smooth consumption when on the poverty line is a genuine good.

Fikkert and Mask take the small good of consumption smoothing and magnify it, explaining how it can lead to even better outcomes in the future:

Although stabilizing a family’s consumption seems less exciting than increasing it, the effects may be more profound than first meets the eye. For when a household is brought back from the edge of a cliff—the vulnerability line—the effects can be dramatic. With death less imminent, it becomes possible for the household to catch its breath a little, to have a bit more peace of mind, to dare to think about the future, and maybe even to acquire a small dose of one of the most powerful antidotes to human suffering: hope.

More concretely, studies have shown that poor people’s participation in savings and credit associations can lead to “superior risk management,” “improved management of finances,” and “enhanced food security,” among other benefits.

Research on the impact of microsavings on poverty is still in progress, but it would behoove us to employ it where possible, if indeed it can serve the poorest of the poor.

Eyes Wide Open

Foreign aid as a solution to poverty became largely discredited when multiple studies arose challenging its effectiveness. Christians subsequently turned to microfinance as a way to truly help the poor help themselves.

My purpose in writing this incomplete treatment of the current state of microfinance is to exhort Christians to remain vigilant in ascertaining the true value of our efforts. Microfinance can still help the poor, but we owe it to “the least of these” to determine as best we can whether our particular strategies for helping them are in fact helpful, even if that means scrutinizing a favored approach.

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