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Opinion: Is it time to rethink microfinance?

March 17, 2010

Microfinance has evolved into a popular instrument of poverty reduction. While the Nobel Peace Prize for Muhammad Yunus in 2006 boosted public awareness, the image of micro credits has developed cracks in recent years.

Mohammad Yunus speaking at a conference
Managing Director of the Grameen Bank, Mohammad YunusImage: AP

Is it time to reevaluate Microfinance? Microfinance institutions (MFIs) have sprung up like mushrooms since the 1990s, but not all have been managed professionally and some countries are now facing problems with this burgeoning area of finance.

Outside financing, provided by official and private donors, and for the most part not by mobilising local savings, has often set incentives for an expansion with which manpower capacities have been unable to keep pace.

In Morocco and Bosnia-Herzegovina, for instance, this has led to difficulties in a good number of MFIs. The outcome has been closures, mergers, and intensified government regulation.

Competition has decreased quality

Workers with sewing machines in Bangladesh
Micro credits are often used to start small businessesImage: picture-alliance / Godong

There have also been problems in South Asia, the region with the widest dissemination of microcredit. In some regions in India, Bangladesh, and Pakistan, microcredit is now so widespread that MFIs, under competitive pressure, have shown a propensity to lower their credit standards, a practice that has had adverse effects on the quality of their credit portfolios.

For their part, borrowers have shown a growing inclination to repay their microcredit by taking out another loan with a different MFI or from a money lender. This is one reason for the high repayment rates reported for MFIs, over 95 %, although these figures have started to decline in South Asia.

Coping with over indebtedness

To come to grips with the problem of multiple borrowing from multiple MFIs and the accumulation of debts of many borrowers associated with the practice, there is talk now of setting up credit information offices with which all loans, including microcredit, would have to be reported.

And finally, a contentious discussion has emerged in recent years on the poverty impact of microcredit. A good number of studies and evaluations have, to be sure, come up with positive results. They indicate that the incomes of borrowers have risen, as have their families' levels of education and health.

But only in rare cases is it possible to prove that this effect is due, unambiguously, to microloans. Recent, more methodologically rigorous studies do not come up with a clear picture; indeed they are unable to prove any convincing positive effects on poverty reduction. Why is that?

Used and abused

Bolivian Jaqueline Callisaya selling vegetables at a market
Jaqueline Callisaya from Bolivia set up a market stall thanks to a micro creditImage: Oicocredit

More often than assumed, microloans are used not for micro business investments but for a multiplicity of needs that may emerge, almost daily and always unanticipated, in the imponderable life of a poor household that lacks any regular income: illness, crop failure, sudden price hikes.

However, the fact that microloans contribute to steadying household incomes must be seen as positive. This may make it possible for the children of such households to attend school regularly.

But it does not entail any durable increase in incomes, to say nothing of economic transformation towards the higher productivity levels that could serve as a durable basis for higher incomes.

The sewing machine financed with a microloan is, as a rule, unlikely to develop into a garment company; the pig in the back yard is unlikely to serve as the foundation for a competitive farm.

Still, microcredit does have the potential to alleviate the effects of poverty and often to improve people's chances, and precisely those of women, to lead to a self-determined life.

While that, no doubt, is a valuable contribution to poverty reduction, it does not mean escape from poverty for millions, let alone the foundation for an economic transformation of the kind that took place, say, in East Asia – without microcredit.

Misuse of capital

Dr.Peter Wolff
DIE's Dr. Peter Wolff is an expert on development financingImage: DIE

There are critics of microfinance, including Ha-Joon Chang, a Korean development economist teaching at Cambridge, who see in microfinance an economic misuse of capital, which would be better invested not in unproductive micro-businesses but in dynamic medium- and large-size companies, as was done in Korea's model for success. But this need not be a matter of either-or.

The "transformative" impact of microfinance is widely overestimated. The object of a poverty-reduction strategy must be, alongside microfinance, to finance larger-size, competitive firms as well as infrastructure. Otherwise poverty reduction is likely to remain very modest.

Author: Peter Wolf
Editor: Anke Rasper

Dr. Peter Wolff heads the department “World Economy and Development financing”, at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE).

The German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) is one of the leading think tanks for development policy world-wide. DIE draws together the knowledge of development research available worldwide, dedicating its work to key issues facing the future of development policy.

The unique research profile of the DIE is the result of the cooperation between research, consulting and professional training. DIE is building bridges between theory and practice and works within international research networks.