Making credit accessible to poor people is a laudable aim. But as a tool for fighting global poverty, microcredit should be judged by its effectiveness, not good intentions.
How effective is micro credit as a poverty-fighting tool? In 1976, Muhammad Yunus, the 2006 Nobel Peace Prize winner, launched the pioneering institution in the field, the Grameen Bank in Bangladesh. The industry’s growth has been explosive since Grameen opened its doors. According to a recent story in The Economist, “there are now some 10,000 microfinance institutions lending an average of less than $300 to 40 million poor borrowers worldwide.” These institutions have made important advances relative to the array of moneylenders and pawnbrokers that had previously controlled the provisioning of banking services to the world’s poor.
At the same time, considered on its own, Grameen-style initiatives have limited capacity to fight global poverty, especially when placed in a policy setting dominated by neoliberalism. Neoliberalism became the ascendant economic model throughout the developing world in the late 1970s, at roughly the same time that the Grameen Bank began operations. The main tenets of neoliberalism include macroeconomic policies focused on eliminating inflation rather than expanding job opportunities; cutting government subsidies — including credit subsidies — and related systems of support for domestic businesses, including micro enterprises; and opening domestic markets to imports, multinational investors and speculative financiers. These policies in developing countries have produced slower economic growth, increasing inequality, and no progress in reducing poverty — that is, an insurmountable headwind countering the efforts of the Grameen Bank and its confederates.
How the Grameen Model Works
Regardless of the larger policy issues, the Grameen model has made undeniable contributions in bringing financial services to poor people. The first contribution is the simple recognition that credit and related services — including bank accounts and insurance policies — can be important resources for advancing the well being of the poor, just as they are with everyone else. The second is in targeting women as loan recipients, empowering the women within their families and helping them to sustain their home-based micro enterprises.
Grameen’s most important advance has been to develop an alternative to traditional collateral as a basis for lending to the poor. Under a traditional system, you can’t obtain a loan until you have sufficient assets to surrender to the bank, moneylender, or pawnbroker in the event that you fail to make loan repayments. But poor people, by definition, have few assets to pledge — perhaps a few livestock animals, a small plot of land, or jewelry. Losing these few assets to a creditor would likely bring destitution. Grameen’s innovation was to create borrowing groups, typically of five women. Each group member could receive loans only as long as everyone made payments. This promotes both mutual support among group members as well as peer pressure to keep up with payments. It also created opportunities for large numbers of poor people to become creditworthy for the first time.
Counteracting these positive innovations, the average lending rates by Grameen and other micro finance institutions far exceed standard measures of affordability. Real annual interest rates (i.e. after controlling for inflation) on group loans range between 30-50%, according to a 2004 survey in Microbanking Bulletin. These rates are perhaps lower than what moneylenders typically charge, but remain punishingly high. Imagine a working class family in the U.S. taking out a $100,000 mortgage to purchase a home, then having to pay $30-50,000 per year in interest alone in order to keep their home. Defenders of such arrangements in the micro finance world contend that, accounting for the risks to the lender, these rates are appropriate; and that anything less will not attract profit-seeking bankers into this market. According to this approach, micro finance can only reach its full global potential — lifting out of poverty the more than 1 billion people of the world now living on roughly $1/day — if it can attract profit-seekers into the business, not just aid agencies and private do-gooders.
In addition, the Grameen Bank has long prided itself on maintaining repayment rates as high as 95%. However, the accuracy of these figures have been disputed, including in a careful Wall Street Journal report in 2001. Some observers contend that, in fact, Grameen allows distressed borrowers to roll over or stretch out their repayments rather than declaring them in default. This may well be the most effective and humane approach under the circumstances. But again, it is clearly inconsistent with the hard-nosed business model supported by an increasing share of micro finance enthusiasts.
Context is Everything
But whether the credit terms are low or high, micro enterprises run by poor people cannot be broadly successful simply because they have increased opportunities to borrow money. For large numbers of micro enterprises to be successful, they also need access to decent roads and affordable means of moving their products to markets. They need marketing support to reach customers. They need a vibrant, well-functioning domestic market itself that encompasses enough people with enough money to buy what these enterprises have to sell. Finally, micro businesses benefit greatly from an expanding supply of decent wage-paying jobs in their local economies. This is the single best way of maintaining a vibrant domestic market. In addition, when the wage-paying job market is strong, it means that the number of people trying to survive as micro entrepreneurs falls. This reduces competition among micro businesses and thereby improves the chances that any given micro enterprise will succeed.
These additional measures for supporting micro enterprises — a decent transportation infrastructure, support in marketing the products of micro enterprises, a high level of domestic demand, and an abundance of decent wage-earning jobs — have all been closely associated with what used to be termed the “developmental state” economic model. Different versions of the developmental state model — including state socialism, import-substituting industrialization, and the East Asian state-directed economies — prevailed in developing countries for the first 30 years after World War II, before these models were overtaken by neoliberalism. Each of these developmental state models encountered serious problems. But on balance they all achieved successes in promoting economic growth and greater equality. This is in contrast with the neoliberal record of declining average growth rates and rising inequality.
One of the key institutions of the developmental state model that was largely dismantled under neoliberalism is the state-directed development bank. State-directed development banks provided cheap, long-term credit for domestic businesses that enabled these businesses to develop their productive and marketing capabilities at a sustainable pace. The MIT development economist Alice Amsden concludes in her major study The Rise of the Rest: Challenges to the West from Late-Industrializing Economies: “From the viewpoint of long-term capital supply for public and private investment, development banks…were of overwhelming importance.” Amsden documents this in the cases of Mexico, Chile, Korea, Brazil, and Indonesia. Amsden also points out that the government’s role in providing subsidized long-term credit was substantial even in developing countries where development banks themselves were of relatively minor importance. These cases included Malaysia, Thailand, Taiwan, and Turkey.
It is true that, in the countries that Amsden cites, the subsidized credit went to large-scale enterprises focused on breaking into export markets. But the general approach can also be adapted to dramatically expand the availability of affordable credit to small and micro enterprises producing primarily for domestic markets.
A Proposal for Kenya
A good case study of how this might be done is Kenya, where, under the auspices of the International Poverty Centre of the UN Development Program, two colleagues and I are working on an “employment-targeted” development model that gives prominence to issues of credit access for the poor. At present, Kenya already has a widespread system of micro-finance institutions in place. Its commercial banking system is also generally well-developed.
Despite this, Kenyan farmers, small formal businesses and informal micro enterprises are starved for credit. This is because commercial banks do not generally lend to these sectors while the micro finance institutions themselves do not have sufficient resources to provide large-scale funds.
The solution seems straightforward: to bring into much closer alliance the formal commercial banking system and the micro-finance institutions. Our proposal is to inject a major pool of subsidized credit equal to roughly 20% of total private investment in Kenya. These funds would be made available to commercial banks on condition that they in turn make loans to the microfinance institutions. The micro-lenders will be far more adept than the traditional commercial banks at making loans to small businesses, informal enterprises, and agricultural small holders.
We propose that government guarantees be set at 75% of the total amount of loans that commercial banks make to microfinance institutions. This will enable interest rates to fall dramatically — specifically by the amount at which the loan is being guaranteed and the bank’s risk is correspondingly reduced. This means that, with a 75% government loan guarantee, if the market rate for a micro-credit loan was 40%, the subsidized rate would be 10%. This would make the loan affordable for borrowers while still maintaining market incentives for lenders. The creative methods of establishing eligibility for loans pioneered by the Grameen Bank could be applied effectively within this framework.
Even assuming default rates on these guaranteed loans as high as 30%, the total cost to the Kenyan government of paying off the guaranteed portion of the loans to creditors would be no more than about 5% of its total fiscal budget. This is a relatively small price for creating credit access for the poor throughout the country at interest rates 75% below market rates.
This example suggests that the way to realize the promise of micro credit is to embed the best features of the model within a broader developmental strategy for promoting growth, decent employment, and poverty reduction. Operating within the context of a neoliberal policy framework, micro credit initiatives will continue to face overwhelming obstacles in fighting global poverty.