30 March 2014

economic and political weekly

H T Parekh finance forum
NIELS HERMES, ROBERT LENSINK
According to the United Nations
(UN), in 2002 almost one-fifth of
the world population (i e, 1.3 billion
people) was living in extreme poverty,
earning less than one dollar a day.
In recent public debates microfinance has
been mentioned as an important instrument
to combat poverty. Therefore,
microfinance has received a lot of attention,
both from policy-makers as well as
in academic circles. Especially during
the past 10 years, microfinance programmes
have been introduced in many
developing economies. Well known examples
are the Grameen Bank in
Bangladesh, Banco Sol in Bolivia and
Bank Rakyat in Indonesia. The Grameen
Bank system of group lending (established
in 1976 by Muhammad Yunus, a
Bangladesh banker and economist), in
particular, has been copied in other developing
countries. Between December 1997
and December 2005 the number of microfinance
institutions increased from 618
to 3,133. The number of people who
received credit from these institutions rose
from 13.5 million to 113.3 million (84 per
cent of them being women) during the
same period [Daley-Harris 2006].
To support the view that microfinance
can be an important instrument to fight
poverty, the UN declared 2005 to be
the international Year of Microcredit.
Recently, the attention for microfinance
and its role in reducing poverty was
further increased when Muhammad
Yunus received the Nobel Peace prize.
According to the Nobel Committee,
microfinance can help people to break out
of poverty, which in turn is seen as an
important prerequisite to establish long
lasting peace [Nobel Committee 2006].
This has led to an almost euphoric attitude
among policy-makers and aid organisations
about potential poverty reducing effects
of microcredit.
The question, however, is whether
microfinance really will be able to significantly
reduce worldwide poverty? In
this article, we provide a critical evaluation
of the discussion on the potential
contribution of microfinance in reducing
poverty. We do not deny that
microfinance may potentially play an
important role in improving the income
of the poor. At the same time, however,
we feel that recent discussions on
microfinance have to be put into the
right perspective in order to preclude
overly optimistic expectations about
the impact microfinance may have on
reducing poverty.
The remainder of this article is organised
as follows. In the next section we provide
a short background to the microfinance
concept. This is followed by a critical
review of the arguments made by proponents
of microfinance as an important
instrument to combat poverty. Next,
we discuss measurement problems
that studies on the impact of microfinance
are confronted with, which is followed
by a review of available evidence from
recent empirical impact studies. We
conclude this article by discussing our
view on the potential contribution
microfinance can make in reducing
global poverty.
A Short Description
Microfinance institutions aim to provide
credit to the poor who have no access
to commercial banks. In general, these
institutions receive financial support from
western donors, NGOs or commercial
banks, who lend to microfinance institutions,
often against below market interest
rates. The microfinance institutions in turn,
lend this money to domestic small companies
and poor agents. The size of the
loans varies, but is often small. According
to MixMarket (www.mixmarket.org),
the average loan size in 2005 was only
about $ 470.
In addition to loans, microfinance institutions
also provide a wider range of
financial services, such as savings funds
and insurance services. Moreover, they
also play an important role in training
potential borrowers how to run a firm, and
deal with health provision. These noncredit
services have become more important
during recent years. This article,
however, focuses primarily on the role of
microfinance institutions in providing
credit to the poor.
A recent survey among 518 microfinance
institutions in Africa, Latin America,
eastern Europe and Asia reveals that the
majority of the microfinance borrowers
are served by institutions in south and east
Asia. The largest microfinance institutions
are found in countries such as
Bangladesh, India, Indonesia and Thailand.
Bank Rakyat in Indonesia serves
over 3.3 million clients; Grameen Bank,
ASA and BRAC, all located in Bangladesh,
have 4 to 5 million active borrowers. In
India, large microfinance institutions
are SHARE (8,14,000 active borrowers)
and Spandana (7,72,000 borrowers)
(www.mixmarket.org). Surprisingly, the
extension of services of microfinance
institutions to poor people (outreach) in
Impact of Microfinance:
A Critical Survey
It is unclear whether microfinance contributes to a reduction in
poverty or is the most efficient method to reduce poverty without
additional measures in areas such as education, health and
infrastructure. The entry of commercial banks into microfinance
may increase the competition for traditional microfinance
institutions and reduce lending to the core poor, even if it improves
financial sustainability.
The H T Parekh Finance Forum
is coordinated by Errol D’Souza,
Shubhashis Gangopadhyay, Subir Gokarn,
Ajay Shah and Praveen Mohanty.
Economic and Political Weekly February 10, 2007 463
the most populated countries in Asia, such
as India and China, is relatively low [Weiss
and Montgomery 2004].
Microfinance institutions use innovative
and unconventional methods to reduce
lending costs. The main problem with
lending to the poor is that information
costs are high as compared to the size of
the loan. It is generally known that information
costs of lending may be high since
lenders are not able to distinguish projects
with respect to their risk profiles when
allocating credit (adverse selection problem)
and borrowers may be able to apply
the funds to different uses than those
agreed upon with the lender (moral hazard
problem). Commercial banks use several
methods to reduce these costs, such as
screening potential borrowers, and monitoring
the progress of the project. These
methods, however, are too costly if a bank
would lend small amounts of money to
potential poor clients in remote areas.
Moreover, commercial banks often ask
borrowers to pledge collateral. However,
the latter solution assumes that collateral
is available, which is often not the case,
particularly not for the poor in many
developing countries.
Microfinance institutions also use
methods of screening and monitoring to
reduce the costs of lending. Yet, these
methods are adjusted to local circumstances,
enabling them to offer small-sized
loans without incurring too high costs. The
most well known example is the use of
group lending with joint liability. With
joint liability lending, the group of borrowers
is made responsible for the repayment
of the loan of an individual group
member, i e, all group members are jointly
liable. The advocates of group lending
argue that joint liability lending provides
clear incentives to borrowers to monitor
and screen each other. Moreover, the
monitoring and screening of group members
is efficient and cheap, because members
usually live close to each other and/
or have social ties (also referred to as social
capital in the existing literature). When
social ties are present, group members are
supposed to be well-informed about each
others’ projects and that this information
is almost freely available. Ideally, then,
the microfinance institution does not need
to take care of the monitoring and screening
of group members.
Despite the focus on group lending in
the academic literature on microfinance,
microfinance institutions often provide
individual-based lending. In fact, at the
moment there is a strong movement from
group based lending to individual-based
lending systems. Even well known
microfinance institutions, which traditionally
were focusing on group lending, such
as the Grameen Bank of Bangladesh, have
started to use individual-based lending.
With individual-based lending, the information
costs are reduced by means of
regular contacts between the borrower and
the microfinance institution (relationship
lending), and by making future loans
dependent on regular repayments (so-called
dynamic incentives). Nevertheless, group
loans are still the most important in terms
of the amount of borrowers that receive
a loan. According to a study by Lapenu
and Zeller (2001), based on a survey among
1,500 institutions around the world carried
out in 1999, 68 per cent of borrowers of
microfinance institutions receive a loan
through group lending programmes. Therefore,
the remainder of this article will mainly
focus on group loans.
Contribution and Critique
The advocates of microcredit argue that
microcredit can help to substantially reduce
poverty [Littlefield et al 2003;
Dunford 2006]. Access to credit can contribute
to a long-lasting increase in income
by means of a rise in investments in income
generating activities and to a possible
diversification of sources of income; it can
contribute to an accumulation of assets; it
can reduce the vulnerability due to illness,
drought and crop failures, and it can contribute
to a better education, health and
housing of the borrower. In addition,
microcredit can contribute to an improvement
of the social and economic situation
of women. Finally, microfinance may have
positive spillover effects such that its impact
surpasses the economic and social improvement
of the borrower.
Notwithstanding the predominantly
positive view on microcredit, several
authors doubt that microcredit can contribute
to a substantial reduction in poverty.
Many critics show that microfinance does
not reach the poorest of the poor [Scully
2004], or that the poorest are deliberately
excluded from microfinance programmes
[Simanowitz 2002]. First, the extreme poor
often decide not to participate in microfinance
programmes since they lack
confidence or they value the loans to be
too risky [Ciravegna 2005]. The poorest
of the poor, the so-called core poor, are
generally too risk averse to borrow for
investment in the future. They will therefore
benefit only to a very limited extent
from microfinance schemes. Second, the
core poor are often not accepted in group
lending programmes by other group
members because they are seen as a bad
credit risk [Hulme and Mosley 1996;
Marr 2004]. Third, staff members of
microfinance institutions may prefer to
exclude the core poor since lending to
them is seen as extremely risky [Hulme
and Mosley 1996]. Finally, the way
microfinance programmes are organised
and set up may lead to the exclusion of
the core poor. Examples for this exclusion
are the requirement to save before a loan
can be granted, the minimum amount of
the loan that needs to be accepted and the
requirement that a firm is registered before
the loan can be granted [Kirkpatrick and
Maimbo 2002; Mosley 2001].
Several critics also argue that group loans
lead to high transaction costs. The main
advantage of group loans according to
the advocates of microfinance is that
group loans drastically reduce monitoring
costs, since group members live in the
same village and know each other well.
Therefore, they are able to assess the riskiness
of a project against low costs (some
even believe that in group lending
programmes monitoring is almost costless).
Additionally, group members can prevent
any moral hazard behaviour without costs
by using social sanctions. This, however,
ignores the fact that group members
sometimes live far away from each other,
and need to spend time and energy to
assess each other’s projects [Marr 2004].
Moreover, most microfinance schemes
have regular group meetings. During these
meetings, information about the projects
is exchanged and repayment problems are
discussed. These group meetings often
imply high transaction costs [Armendáriz
De Aghion and Morduch 2000; Murray
and Lynch 2003]. Obviously, then, these
costs may reduce the positive income
generating effects from access to credit.
In addition, it has been argued that
sometimes the size of the needed loan
exceeds the maximum amount that can
be borrowed in terms of a group loan.
This especially hampers the future growth
of those agents who have invested in
successful and growing projects [Khawari
2004; Madajewitcz 2003]. Group loans
are rigid, and often it is very difficult
to adapt the loan to the desired credit
needs of individual borrowers within
the group.
464 Economic and Political Weekly February 10, 2007
Finally, some authors criticise the impact
of microcredit on women. Many
microfinance schemes have a clear focus
on women. Research shows that women
are more reliable and have higher payback
ratios. Moreover, women use a more substantial
part of their income for health and
education of their children [Pitt and
Khadker 1998]. Thus, women play a very
important role in reducing poverty within
households. However, the critics argue
that often women are forced to hand over
the loan to men, who subsequently use the
loan for their own purposes. This may lead
to an additional burden for women if they
are held responsible for the repayment
[Goetz and Gupta 1996].
Microcredit and Poverty
The theoretical discussion about the
impact of microfinance on poverty reduction
calls for thorough empirical research.
Therefore, it is surprising that there are
only a few solid empirical studies available
on the possible poverty reducing effects
of microcredit. A major problem is how
to measure the contribution of microcredit.
Three issues are of importance: first, which
contribution is seen as the most important
(improvement of income, accumulation of
assets, empowerment of women, etc);
second, does microcredit reach the core of
the poor or does it predominantly improve
income of the better-off poor; and third,
do the benefits outweigh the costs of
microfinance schemes [Dunford 2006]?
The latter issue deals with the question of
the extent to which subsidies to
microfinance organisations are justified.
Most studies measure the impact of
microcredit by comparing recipients of
microfinance with a control group that has
no access to microcredit. This approach
may be problematic, however. First,
changes of the social and/or economic
situation of the recipients of microcredit
may not be the result of microfinance. For
instance, it is well known that relatively
rich agents are less risk averse than relatively
poor agents. This may induce rich
agents to apply for microcredit whereas
poor agents do not apply. In this situation,
an ex post comparison of income of the
two groups may lead to the incorrect conclusion
that microfinance has stimulated
income. Second, in order to improve the
probability of microfinance being successful,
microfinance organisations may
decide to develop their activities in relatively
more wealthy regions. Obviously,
this biases any comparison between recipients
of microcredit and the control group
[Karlan 2001; Armendáriz De Aghion and
Morduch 2005].
Results
The empirical literature on the outreach
of microfinance, in terms of the number
(breadth) and socio-economic level (depth)
of clients who are served by microfinance
institutions is vast. However, most of these
studies suffer from being anecdotal and case
study driven. Moreover, only some of the
outreach studies are published in established
refereed international scientific
journals, so that it is difficult to value their
quality. Nevertheless, some conclusions can
be drawn based on the existing literature.
Most studies conclude that microcredit
positively contributes to poverty reduction.
Microcredit, therefore, may help to
solve the poverty problem. This seems to
be good news. However, there is much
discussion about the question of the extent
to which microfinance reaches the core
poor. Here, a new measurement problem
arises, i e, how to identify the core poor
[Dunford 2006]. Nevertheless, Khandker
(2005) and Eda Rural Systems (2004) find
that the extremely poor benefit more from
microfinance than the moderately poor.
On the other hand, several other studies
indicate that it is the “better off” poor
rather than the core poor who stand to
benefit most. Evidence for this is given in,
for e g, Hulme and Mosley (1996) and
Copestake et al (2005).
It is also important to know what costs
are involved in making microfinance a
successful instrument to combat poverty.
Even if microcredit positively contributes
to a reduction in poverty, it is unclear
to what extent these results cannot be
reached by other more cost-efficient
instruments. Providing microfinance is
a costly business due to high transaction
and information costs. Recent research
shows that most microfinance programmes
are still depending on donor subsidies
to meet the high costs, i e, they are not
financially sustainable [Cull et al 2007].
A controversial question is whether
these subsidies are justified. Unfortunately,
this question cannot as yet be answered
due to a lack of solid empirical research.
A Panacea?
After having reviewed the debate on
microfinance and poverty, the conclusion
must be that it is still unclear whether
microfinance substantially contributes to
a reduction of world poverty. Nor is it clear
whether microfinance is the most efficient
method to reduce poverty. Much more
solid empirical research is needed.
In addition, it should be noted that the
outreach of microcredit is still small. Despite
the enormous increase in microcredit
to poor borrowers, in 2004 only 6 per cent
of borrowers with an income below $ 365
were able to borrow from microfinance
institutions [Daley-Harris 2006]. It is not
to be expected that microfinance, without
additional measures in the area of education,
health, and infrastructure, is able to
substantially reduce poverty.
Moreover, recently we observe a trend
towards a further commercialisation of the
microfinance sector. Among other things,
this has led microfinance organisations
to decide on providing a wider range of
financial services. We also see a move from
traditional group lending to individual loans.
This move seems to be bad news for the
poor, since the fraction of poor borrowers
and female borrowers in the loan portfolio
of individual-based institutions is lower
than for group-based institutions. At the
same time, individual-based microfinance
institutions seem to perform better in terms
of profitability, as has recently been shown
in a study by Cull et al (2007). Due to the
trend of commercialisation of the sector,
financial sustainability of microfinance
institutions is becoming more and more
important at the expense of using credit
to help overcome poverty.
To some extent, the trend towards financial
sustainability is counteracted by
establishing special programmes for the
core poor. Especially in Bangladesh,
programmes have been initiated to specifically
support the core poor, for instance,
by the well known institutions of BRAC
and ASA. These programmes not only
focus on credit, but also aim to provide a
broad range of services for the poor, such
as training, health provision and more in
terms of the general social development of
this category of poor. Yet, the impact of
these programmes is still unclear, and the
outreach is small, at least for the moment.
Fortunately, there is another, potentially
hopeful, development. The involvement
of traditional commercial banks in
microfinance is growing rapidly around
the world. In several developing countries
large state banks and private banks have
started to provide microfinance services.
In Pakistan, for instance, a number of
Economic and Political Weekly February 10, 2007 465
private commercial banks have moved into
microfinance. In Malaysia, Nepal and
Thailand there are programmes stimulating
commercial banks to become involved
in microfinance. In India the National Bank
for Agriculture and Rural Development
(NABARD) recently initiated a programme
to involve private banks in microfinance.
According to recent studies the growth of
microfinance in India is led by a number
of commercial banks such as ICICI, HSBC
and ABN AMRO, together with private
venture capital funds and social venture
capitalists [Lakshman 2006; Iyer 2006].
A possible advantage of the move of
commercial banks into microfinance may
be that these banks can provide credit to
the poor, without being dependent on donor
subsidies. Commercial banks have diversified
portfolios, and are able to use profits
from lending to wealthy clients to finance
(subsidised) loans to the poor, i e, crosssubsidisation
would take place. At the same
time, however, one may question why
commercial banks would do this. To some
extent, this trend can perhaps be explained
by the increased attention to socially
responsible entrepreneurship, at least
among the large western commercial banks.
Probably more importantly, however, will
be the fact that these commercial banks will
try to use subsidised loans to the poor as
an instrument to enlarge their future profitmaking
portfolio, based on the assumption
that lending to them will make them more
wealthy clients in the future, who can afford
to pay market-based interest rates.
A potential disadvantage of the increased
involvement of commercial banks is that
traditional microfinance institutions are
confronted with increased competition in
the market for micro loans. While increased
competition may lead to increased efficiency
and stimulate financial sustainability, it
may also reduce the scope for lending to
the core poor, an argument we already
highlighted above. Moreover, increased
competition and increased supply of loans
may result in higher levels of indebtedness
of the clients as they may take up multiple
loans from different sources at the same
time [Ciravegna 2005]. This may lead to
lower repayment rates, endangering the
long-term sustainability of the programme
[Vogelgesang 2003]. Lower repayment
rates, in turn, may lead to less favourable
credit contracts for the poorest borrowers,
for instance because interest rates are raised,
which may lead them to drop out from the
loan portfolio of microfinance institutions.
Research shows that whereas wealthier
borrowers are likely to benefit from increasing
competition among microfinance
institutions, it also leads to lower levels
of welfare for the poorer borrowers
[McIntosh et al 2005].
The trend of commercial banks entering
the market for microfinance appears to be
one of the most important challenges for
the microfinance business in the near future.
The potential of this trend in terms of
reducing poverty is still unclear, however.
Further research into this important issue
is therefore highly desirable.
Email: b.w.lensink@rug.nl
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EPW