This Will Make You Understand Why Microfinance Is Not Lifting People Out Of Poverty (1/5)
MICROFINANCE, A LOVE STORY PART 1: THE FIRST DATE
The first two blogs of the ‘Developing India from the Bottom-Up’ series have enabled some understanding of what goes on in the lives of the poor, in a rural setting, and how to reflect upon it. A possible tool for lifting people out of poverty, microfinance, has enjoyed a lion’s share of the global attention. However, there have been many debates on microfinance and its actual effectiveness in combating poverty. This third blog on ‘Developing India Bottom-up’ will give an introduction to the world of microfinance, with examples specifically drawn not only from India and Bangladesh, but also other countries like Ethiopia, Mexico, Mongolia, Bosnia and Pakistan. Different from the first two blogs in that I built mostly upon my personal experience, this third instalment has a more academic character, driven by extensive literature study and research in the history and world of microfinance. It aims to offer a coherent overview of the ongoing love story between microfinance and the impact it can make for the poor; it’s rise, the crises it faced, whether it is effectively lifting the poor out of poverty or not, and which aspects we might need to rethink in the microfinance business.
PS: Henceforward, I use microfinance, microcredit, and microloan interchangeably.
The Triple Whammy
Three characteristics distinctly define the financial lives of the poor:
- Low income
- Volatile income
- Lack of access to financial services
Firstly, people in the very base of the pyramid live on less than 2 dollars a day on an average (The said income of $2 per day can vary between $0 and $10). While this might not be a wholesome definition of being poor, it certainly shows that these people simply don’t have enough money on the average.
Secondly, their income is highly volatile on almost a day-to-day basis. Consider, for example, a construction worker that earns a daily wage. If he/she falls ill one day, he/she loses that day’s income. Thus insecurity or volatility of income is the second factor.
A third factor is made apparent by the story of Muhammad Yunus, a well-known name in the world of microcredit and a professor of economics from Bangladesh. During a visit to Jobra, Bangladesh in 1976, he saw the Jobra women producing furniture from bamboo having to pay exorbitant rates for bamboo. Most of their profits were lost to the money lenders. Prof. Yunus then decided to give the women money himself - 27 dollars in total to 42 women - so they could start free of the heavy interest and start making a good profit. When he was repaid in time, he wanted to extend this to more people and approached banks with this idea of lending to the poor. However, they were very reluctant to lend to the poor, whom they thought they were not creditworthy. So turns out, the third factor is a lack of credit opportunities.
The authors of Portfolios of the Poor call these three financial constraints the ‘triple whammy’: low income, high-income volatility and a lack of access to financial institutions.
Why do poor people don’t have access to commercial banks?
Firstly, as apparent from the story of Mr Yunus, banks were very reluctant to lend money to the poor. A study by Irfan Aleem, which looked at money lenders in Pakistan, established that it a lender takes days to screen and check the borrower and his intended use for the money.
There are thus costs involved for just monitoring the client. These costs increase with the physical distance between the bank and its client. It is costlier to monitor a remote villager who has no access to e-banking; Yet affordability, scale up efficiency, and e-banking literacy obstructs this access to the rural poor. However, e-wallets in Tanzania and Kenya like M-PESA give some hope for changing that in the near future.
Secondly, if the lender is an employee of a bank, (s)he needs to be paid a salary. So it might be that the amount to be lent plus interest gains to a poor person, might be much lower than these fixed costs, and thus not make it worthwhile for a bank to lend. Or the other way around; a bank can cover these costs by charging a very high-interest rate, which is high enough to form a barrier to borrowing money.
But public banks could lend instead, right?
So why doesn’t the government jump in here? Maybe hand out some good subsidies to make banks lend to the poor, and let the public banks cover their costs in the process? Because this kind of programs has led to high default rates due to a moral hazard on the banks’ part, which now held incentives to approve risky loans and employ negligent behaviour, sometimes as a political means. The latter is showed by a study from Shawn Cole, who points out that the money lent via public banks in India went up when an election was about to happen, resulting in swinging districts. The point is that public lending often fails or is inefficient.
In dearth of access to banks, where do villagers borrow from?
As seen in the case of the Jobra women, there are definitely money lenders in the villages, charging very high-interest rates. Development economists Esther Duflo and Abhijit Banerjee argue that there are quite a few of them in every village, implying a competitive setting at first sight. But these economists found that they are actually monopoly lenders in the villages, which enabled them to charge extreme rates. They have very ‘loyal’ clients too, as people prefer familiar creditors/lenders.
So why would someone not just switch and go for a money lender that charges less? Money lenders and villagers in the same area know each other very well. It turns out that switching looks suspicious, and switchers are automatically treated as riskier clients. Economists call this adverse selection:
“it occurs when one party to a transaction possesses information about a hidden characteristic that is unknown to other parties and takes economic advantage of this information. “
The money lender will wonder why this person is switching, and won’t trust you enough, which is reflected in a higher interest rate (than you had before), making switching unattractive. It takes time for the money lender to trust the villager, and only then might the interest rate be lowered. However, if the money lenders charge too high, villagers will switch in the end, indicating the presence of an upper limit for interest rates. The outcome is that money lenders in the same region will end up with approximately the same interest rate.
To get a rough idea about the height of the interest rates, a study of Aleem shows that the money lenders in Pakistan charge an average annual interest rate of 78.5%. The aforementioned development economists find that fruit vendors in Chennai (Tamil Nadu, India) are charged 5% per day to borrow money to buy and sell fruits on the daily market. A compounding rate of 5% after 1 month comes to an insane 400%!
“There is scope for increased incomes since it will lift people out of the viscous debt cycle and it offers entrepreneurs to setup of more profitable businesses!”
Landowners are charged somewhere between 21% — 40%, while people without land are charged rates between 28% — 128%. Not only are these rates high, but they also vary highly in any one region. It also turns out that rich people get larger loans. But then, the rates of default are very low. People are somehow able to pay back. This implies that if somehow these interest rates are lowered, and access can be increased to the poor, there will be scope for increased incomes since it will lift people out of the vicious debt cycle and it offers entrepreneurs to set up of more profitable businesses!
Upcoming: Part 2 — Falling in Love
This first article showed the triple whammy of the poor in their financial lives: low income, high-income volatility and a lack of access to financial institutions, and discussed in more detail why they lack access to banks. The next article will discuss the ideas on how to improve the access.
Many thanks to Ramyaa Bommareddy, Shahzeb Yamin, Supriya Krishnan, Sabine Kleve for their valuable input and patience in developing this article.
