Ruminations on Microfinance

Ruminations on Microfinance by Dale W Adams Professor Emeritus The Ohio State University February 2, 2023 Fifty years ago, I attend a seminar in the Central Bank of Bangladesh and was first exposed to what later was called microfinance. There, Professor Mohammad Yunus from Chittagong University described a microlending program for poor women that he managed in a village near his university. Based on my earlier experiences with somewhat similar small-famer credit programs (SFCPs), I was skeptical about the future sustainability and effectiveness of his efforts. Most of the SFCPs I had seen suffered from policies that eventually wrecked most of them. Bangladesh was a Muslim country, for example, where the charging of interest was frowned upon and called riba (an unjust gain). At best, making small loans to poor people is relatively expensive so I thought Professor Yunus faced a stiff wind to sustain his efforts in a culture that frowned on charging any interest, let alone rates that allowed lenders to sustain their programs. Twenty years later J.D. Von Pischke and I wrote a skeptical article wherein we suggested that the burgeoning microfinance industry might face some of the same pitfalls that crippled earlier SFCPs. Dale W Adams and J.D. Von Pischke, “Microenterprise Credit: Déjà Vu:” World Development, Vol. 20 No. 10, (1992), pp. 1463-1470. After thirty year, it may be useful to revisit our déjà vu feelings about microfinance. A Nobel Prize, tens of millions of clients, and many organizations providing microfinance, on what appears to be a sustainable basis, indicates that the microfinance industry avoided some of the pitfalls that doomed SFCPs. What were these pitfalls, and has the experience with microfinance shown that small loans are an effective poverty-alleviation tool, which SFCPS were not? Interest Rates For most SFCPs, a huge pitfall was charging nominal interest rates that did not cover their costs of lending, including loan losses. To make matters worse, many of these loans were made in countries that suffered substantial inflation, resulting in real rates of interest that were typically decidedly negative. My sense is that the microfinance industry generally charged substantially higher nominal interest rates than did SFCPs. Furthermore, they were fortunate to operate in economies that mostly suffered much less inflation than did the earlier SFCPs. Nonetheless, it is worth mentioning that an NGO in Mexico (Compartamos) affixed interest rates to their loans that approached the rates charged by reviled moneylenders. Fortunately, this appears to have been an outlier in the microfinance industry and most microlenders pursued more enlightened interest rate policies than did SFCPs. Transaction Costs Excessive transaction costs -- for both lenders and borrowers -- were other pitfalls in SFCP efforts. D.W Adams and G.I. Nehman, “Borrowing Costs and the Demand for Rural Credit,” The Journal of Development Studies, (1979), 15/2, pp. 65-175. Also, Ahmed Humeida Ahmed and Dale W Adams, “Transaction Costs in Sudan’s Rural Financial Markets,” African Review of Money, Finance and Development, (1987) No. 1, pp. 1-13. On the basis of the amount-of-money-lent, small loans are the most expensive for lenders to administer. A lender does about the same amount of paperwork and spends roughly the same amount of time making a loan of $100 as in making a loan of $10,000. These lender transaction costs are a major determinant of their profits. Something similar happens on the borrowers’ side. A client seeking a small loan, especially if they were a new borrower or had sketchy collateral, may endure long lines in applying for loans, inconveniences that are not experienced by preferred clients (former clients, those with excellent collateral, and those seeking large loans). These preferred clients may negotiate a new loan over the phone, while non-preferred borrowers are forced to wait in long lines outside the bank and visit the lender multiple times to fully traverse the borrowing process (applying for a loan, return to determine if the loan application was approved, withdrawing funds, and later repaying the loan). These visits to lenders by farmers occurred primarily during planting or harvesting times when the opportunity cost of the small borrower’s time was highest. For borrowers of small amounts, the transaction costs they incurred often exceed their interest payments, and this was especially true in SFCPs. Another common feature of SFCPs was that lenders were geographically located at some distance from their borrowers which exacerbated the transactions cost problem for farmers who sought small loans. Again, my sense is that the microfinance industry adopted several innovations that reduced these troublesome transaction costs for both lenders and borrowers. Group lending is one prominent example of this. In addition, the microfinance industry often shrank the geographic distance between lenders and borrowers, thereby reducing borrowers’ transaction costs. Without these innovations, the microfinance industry would likely not have prospered. Savings As Robert Vogel aptly pointed out, savings were the forgotten half of SFDPs. Robert C. Vogel, “The Forgotten Half of Rural Finance,” in Undermining Rural Development with Cheap Credit by Dale W Adams, Douglas H. Graham, and J.D. Von Pischke (eds.), (Boulder Colorado, Westview Press, 1984) pp. 248-265. With few exceptions, most SFCPs ignored providing deposit service to rural clients. Instead, loanable funds were mostly provided by donors and governments, often through central bank facilities on highly concessionary terms. The interest rates on these “outside funds,” combined with the low interest rates charged on loans for small farmers, effectively suffocated lenders’ interest in mobilizing deposits in rural areas. This led to four types of problems: (1) It denied poor people in rural areas the opportunity to use financial savings to manage the ups and downs in their lives. Dale W Adams, “Easing Poverty Through Thrift,” Savings and Development (2009) 33/1, pp. 73-85. (2) The use of outside money made rural lenders vulnerable to political intrusions, such as loan forgiveness mandates and making loans based on political factors, rather than based on creditworthiness. (3) Financial intermediation involves an institution using its facilities to both make loans and to capture deposits, thereby allowing it to realize economies of scope. (4) And perhaps the most beneficial benefit of doing both loans and deposits (intermediating) is that it enables a financial system to help reallocate resources more efficiently in an economy. Two-handed financial markets play a unique role in facilitating this subtle reallocation process. Because SFCPs involved little deposit mobilization they were mired in the problems mentioned above. Initial, the microfinance industry suffered from “deposit amnesia” and mostly ignored savings. My sense, however, is that major segments of the industry have gradually become successful in capturing deposits from their poor clients. Grameen Bank II in Bangladesh, Bank Rakyat in Indonesia, BanRural in Guatemala, the promoters of self-help financial groups in Africa, and some credit unions have done a bang-up job of mobilizing voluntary deposits. Macroeconomic Environments SFCPs in many countries operated in macroeconomic conditions that adversely affected their performance. This included the previously mentioned inflation. It also included large amounts of food-aid, food-price-controls, and moribund farm technology that adversely affected farm income, and ultimately the ability of farmers to repay their loans. An earlier “Green Revolution” would have helped the SFCPs. Again, my sense is that the microfinance industry was more fortunate regarding the macroeconomic environments in which they operated. Microfinance Accomplishments Far-and-away the most important contribution of the microfinance industry has been showing that large numbers of poor people -- especially women -- are creditworthy. This disclosed that tens of millions of poor people could be responsible borrowers/savers and thereby benefit from having access to these services. Nonetheless, I remain uneasy about the widely-held-narrative that microfinance enables most micro-borrowers to invest in thriving microenterprises. Certainly, some of this occurs, but I sense that most microloans, both from formal and informal sources, are used to manage the hazardous conditions in which poor people live. This includes smoothing consumption, paying school fees, repaying old debts, helping a relative, patching the roof of a dwelling, or dealing with sicknesses and deaths. Even in cases where micro-loans are primarily used to create a new enterprise, or to expand an existing business, the overall economic benefits of these efforts are likely muted. For example, a non-governmental organization may provide micro loans for ten women to become new vendors of fruits and vegetables in a central market. This may enhance the economic status of these new vendors. But -- and this is a big but -- the economic gains realized by the ten new vendors most likely comes at the expense of all of the other fruit and vegetable sellers in the market, who may also be poor. Again, my sense is that most loans made to new microentrepreneurs occur under such circumstances. The new entrepreneur’s gains come at the expense of other poor sellers which results in poverty being moved around rather than being reduced. Rare is the micro borrower who offers a new product or service that is not already provided by other poor people in the neighborhood. Shortcomings of Microfinance There is much to admire in what the promoters of microfinance have accomplished. Nonetheless, at least three major shortcomings remain in the industry. The first being that major elements of the industry still do not provide deposit services and remain dependent on “outside money.” Savings are an important service for poor people, allow the industry to play a larger role in efficient resource allocation, and enable intermediaries to realize economies of scope. A second major shortcoming is the problem of scale. There are far too many small organizations providing microloans. Small organizations typically cannot qualify for prudential regulation that is essential in handling deposits. Moreover, small organizations typically do not cover an extensive area of service that allows them to play a significant role in allocating resources more efficiently over a substantial geographic area. In my opinion, the performance of the industry would be enhanced by numerous mergers. The third major shortcoming is one that pains me to report. Despite all the hoopla that surrounds the industry, my sense is that microfinance is not an effective tool for eliminating poverty, despite the flurry of flawed impact studies that claim otherwise. Dale W Adams and Robert C. Vogel, “Through the Thicket of Credit Impact Studies,” in Jean-Pierre Gueyie, Ronny Manos, and Jacob Yaron (eds.), Microfinance in Developing Countries, (London: Palgrave MacMillan, 2013), pp. 34-61. It has proven to be more of a palliative. I make this claim with some trepidation since the past five decades have seen breathtaking declines in world poverty rates. If association was always a proof of causation, the recent growth of the microfinance industry and the commensurate decline in poverty would disprove my assertion. If more microlending is not the answer for poverty, what is? My response to this question is that overall economic growth is the best way to reduce poverty. Jobs are what poor people need, not more debt in the guise of benevolent credit programs. Jobs, in turn, result from freer trade, rational pricing policies, new technologies, investments in rural infrastructure, and law-and-order. Healthy and vibrant financial markets are useful in supporting development but should not be called upon to lead the parade. I conclude that the experience with both the SFCPs and the microfinance industry support that assertion. 5