The Ups and Downs of Microfinance

Stephen DeAngelis

August 25, 2009

I first started blogging about microfinance in November 2006 in a post about programs that work in fighting poverty [Programs that Fight Poverty]. In a subsequent post entitled Financing the Poor, I wrote: “Microfinance is an important tool in the development kit. It fits neatly with our Development-in-a-Box™ philosophy because it is standards-based (there are some time proven rules about how and to whom loans are made) and it encourages local participation in communities of practice.” Most the “rules” used by microfinance institutions were first developed by Professor Muhammad Yunus and his Grameen Bank. Yunus started his bank as a way of providing credit to the poor in Bangladesh. Since he began lending to the poor back in the 1970s, Yunus’ ideas about microfinance have swept the globe — even landing in the United States [“Grameen America Reaches 1,000 Borrower Milestone; Muhammad Yunus Receives 2009 Presidential Medal of Freedom,” Grameen America press release, 12 August 2009].

“Since January 2008, Grameen America has lent more than $2.3 million dollars to women at or below the poverty line. Each Grameen America loan allows a low-income entrepreneur in the United States to start or expand a small business. The company helps lift people out of poverty with small, low-interest, collateral-free loans. With the support of their group of five and weekly meetings, borrowers have maintained a high repayment rate and accumulated more than $165,000 in savings accounts in their names. Many borrowers were underserved by commercial banks and lacked savings accounts and ATM cards before joining Grameen America. Based on strong demand for its microcredit services, Grameen America now is expanding nationally to serve new communities. In New York, the organization recently began lending in Brooklyn and Upper Manhattan. The new branch in Nebraska has disbursed more than $90,000 to 65 borrowers. Grameen America aims to provide microcredit to low-income communities across the United States that can benefit from basic, accessible financial services and education. Other states have expressed interest in opening a Grameen America branch. Potential future locations include California, North Carolina, Arkansas, Illinois, New Jersey, Washington D.C., Maryland, and Massachusetts.”

In the first post mentioned above, I focused on an article by Tina Rosenberg, a New York Times editorial board member who reviewed eight programs that have been successful in addressing poverty [“How to Fight Poverty: 8 Programs that Work,” 16 Nov 2006]. This is what she wrote about Professor Yunus and his program:

“In 1976, a Bangladeshi economist named Muhammad Yunus came upon a group of 42 artisans – but perhaps the more appropriate word is ‘slaves.’ They made crafts such as chair seats, and used materials lent to them each day at exorbitant rates of interest by the buyer of their work. They were forever in debt, unable to turn enough profit to buy their materials in advance at market prices. Mr. Yunus gave the group a loan from his pocket that averaged 62 cents per person. With that, they bought their freedom. Twenty years later, the Grameen Bank, the organization Mr. Yunus founded, has lent small sums of money to 6.7 million people in Bangladesh, almost all of them women, many of whom had never before touched money. It offers savings, insurance, home mortgages, pension funds, scholarships, credit for families to buy fertilizer, build latrines or dig wells, and a program of no-interest loans for beggars, so they can offer candy or dried chiles for sale as they go house to house. Microcredit now reaches nearly 100 million clients in more than 100 countries. The World Bank has found that microcredit accounted for 40 percent of the entire reduction in moderate poverty in rural Bangladesh—and that it had an even bigger impact on extremely poor borrowers. … what Mr. Yunus and Grameen did – why they are sharing the 2006 Nobel Prize for Peace — was show how an idea helping a few hundred people could be expanded to help millions. … Microcredit started as an antipoverty program, but continues as a business. That is one reason it has grown and grown while other forms of aid fight for governments’ dollars and attention.”

While mostly good things have resulted from a growing number of microfinance institutions providing microcredit, sometimes too much of good thing can bring bad results. In one Indian community, for example, too much microcredit has created a “credit bubble” that is a “mini-me” version of credit woes found in America [“A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum,’ By Ketaki Gokhale, Wall Street Journal, 13 August 2009]. Gokhale filed the story from Ramanagaram, India, and wrote:

“A credit crisis is brewing in ‘microfinance,” the business of making the tiniest loans in the world. Microlending fights poverty by helping poor people finance small businesses — snack stalls, fruit trees, milk-producing buffaloes — in slums and other places where it’s tough to get a normal loan. But what began as a social experiment to aid the world’s poorest has also shown it can turn a profit. That has attracted private-equity funds and other foreign investors, who’ve poured billions of dollars over the past few years into microfinance world-wide. The result: Today in India, some poor neighborhoods are being ‘carpet-bombed’ with loans.”

Just because a loan is small in size doesn’t mean that it comes with a small price tag. Interest rates on microloans (which can vary from 24% to 39% annually) are higher than interest rates on traditionally-secured loans because the risks are greater and the overhead for making such loans is the same whether you are borrowing $100 or $10,000. That means the extremely poor run the same risk of getting in over their heads as anyone who secures a loan. As I commented in another blog: “Credit is a double-edged sword. Muhammad Yunus began Grameen Bank because he understood that credit means financial power — a source of power normally denied to the poor. On the other hand, as the credit crisis in America has demonstrated, extending too much credit can cause an entire economy to falter.” Gokhale reports that people in Ramanagaram got caught up in the borrowing binge and began to get loans from new microfinance lenders to pay off loans from previous lenders and each new loan was for a larger amount. It’s easy to see how such borrowing can get out of hand. As one source for Gokhale’s article notes, this is happening because “too much money is chasing too few good candidates.” In Ramanagaram, the situation has become a crisis. People have become so indebted that they can no longer repay their loans and microloan “sharks” are feeding on fears.

“Local mosque leaders have started telling people in the predominantly Muslim community to stop paying their loans. Borrowers have complied en masse. The mosque leaders are also demanding that lenders give them an accounting of their finances. The lenders say they’re not about to comply with that. The repayment revolt has spread to other communities, including the nearby city of Channapatna, and could reach further across India, observers say.”

If repayment revolts spread globally, it will be tragic — not for lenders but for the poor. Yunus established his Grameen Bank because he recognized that without access to credit the poor don’t have the financial tools they need to grow their small businesses and improve their lives. He was careful to loan only what he felt people could afford and established borrowing groups that could support one another in making repayments. If the microfinance scheme collapses, as a result of an ill-advised repayment revolt created by over-borrowing, one path out of poverty will be closed to millions of people. Unlike the current credit crunch in the United States, the problem in the developing world (as noted above) seems to be that there is too much money chasing too few good loans. The reason there is so much money available is because microfinance has proved profitable. That is because the rules that Yunus established for making loans — rules that have generally been followed by others in the microcredit sector — have assured that the repayments rates are very high. As a result, those in the lending business have made excellent returns on investment. Success breeds success and as returns on investment have remained solid more and more money has been attracted to the sector. It’s the perfect storm for another credit bubble and that’s what’s happening in Ramanagaram.

“‘We are very worried about this,’ says Vijayalakshmi Das of FWWB India, a company that connects microlenders with financing from mainstream banks. ‘Risk management is not a strong point for the majority’ of local microfinance providers, she adds. ‘Microfinance needs to learn a lesson.’ Nationwide, average Indian household debt from microfinance lenders almost quintupled between 2004 and 2009, to about $135 from $27 or so, according to a survey by Sa-Dhan, the industry association. These sums are obviously tiny by global standards. But in rural India, the poorest often subsist on just a few dollars a week. Some observers blame a fundamental shift in the microfinance business for feeding the problem. Traditionally, microlenders were nonprofits focused on community service. In recent years, however, many of the larger microlending firms have registered with the Indian central bank as a type of for-profit finance company. That places them under greater regulatory scrutiny, but also gives them wider access to funding. This change opened the door to more private-equity money. Of the 54 private-equity deals (totaling $1.19 billion) in India’s banking and finance sector in the past 18 months, microfinance accounted for 16 deals worth at least $245 million, according to Venture Intelligence, a Chennai-based private-equity research service. The influx of private-equity cash is the latest sign of the global rise of microfinance, pioneered by Bangladeshi economist Muhammad Yunus decades ago. … As of last December, there were over 100 microfinance-investment funds globally with total estimated assets under management of $6.5 billion, according to the Consultative Group to Assist the Poor, or CGAP, a research institute hosted at the World Bank. Over the past year, investors have poured more than $1 billion into the largest microfinance funds managed by companies, a 30% increase. The extra financing will allow the industry to loan out 20% more this year than last, much of it to countries such as the Ukraine, Cambodia and Bosnia, CGAP says.”

The inevitable result of too much money chasing too few good loans is that bad loans are going to be made and the astonishingly high repayment rate of microloans is going to take a dramatic dip. Anytime a sector stops using common sense in order to achieve short-term gains it’s asking for trouble. It seems almost inconceivable that on the heels of a global recession created by greedy and unscrupulous lenders in the developed world that similar tactics are beginning to create a potential financial crisis among the world’s poorest people. Gokhale reports that microfinance institutions are knowingly making “liar loans” to people who claim the loans are to support a business when the money is actually being used for other purposes. Unfortunately, some worthy loan candidates are already being affected by the repayment revolt. Microlenders in Ramanagaram have stopped providing loans to Muslims claiming the risks are just too great. Greedy lenders and unscrupulous borrowers are hurting honest people with legitimate needs. The global community should take stock of what’s happening in Ramanagaram and take steps to ensure that it doesn’t happen elsewhere.