In this essay, written in 2001, the subject is true micro-credit-- loans of less than $100. Small lending programs are often called micro-credit when they are actually farm credit or rural lending or start-up capital efforts. I am not sure why there is this confusion about credit products, but that is a subject for another day.

---

A Critical View of Microcredit

There is one nearly irrefutable argument in favor of programs to promote microcredit: almost everywhere it is tried, hundreds if not thousands of people voluntarily enroll. But is this because the poor see it as a tool to break out of poverty, or is microcredit used as the only available response to an almost unimaginably severe liquidity problem? Or could it be that the program's 20 to 50 percent interest rate is simply a better price than the local moneylender's 120 percent? Access to cash is clearly a key attraction of micro-credit programs, but providing liquidity is not the objective of microfinance programs. The real question is does microcredit help the poor escape poverty?

The United States alone has spent $2 billion on microfinance programs around the world in just the past five years, so it seems reasonable to raise this question, but in fact it is a topic rarely discussed. The industry itself does a poor job of addressing this question.

Studies have shown that during an eight year period, among the poorest in Bangladesh with no credit service of any type, only 4 percent pulled themselves above the poverty line. But with individuals and families with credit from Grameen Bank, more than 48% rose above the poverty line.

Considering that the Grameen Bank has made loans to over three million people, that would mean that nearly a million and a half Bangladeshis have risen out of poverty thanks to these small loans. That sounds very positive, but unfortunately this eye-catching claim is only an unattributed and unsupported statement shown on a website that promotes broader use of microcredit (The Virtual Library on Microcredit, www.gdrc.org). On Grameen's own website, there is no such claim nor any other information even related to this issue. Nothing on either site evaluates microfinance in this way.

From a more impartial source, the New York Times, comes this troubling passage:

But there are still no stringent evaluations of microcredit programs generally viewed as credible by experts. "Energetic, entrepreneurial people do well with microcredit," said Jonathan Morduch, an associate professor of public policy and economics at New York University. "But others who are less skilled and trained, how do they do? Can very poor households get decent returns or not? That's the big question policy-wise."

(Yet) today there is a growing push for the nonprofit groups and banks that run such programs to reach deeper into the ranks of the poor, though there is little rigorous evidence judging whether the very poor benefit from microcredit, economists say. (Debate Stirs Over Tiny Loans for World's Poorest, NYT, April 29, 2004)

There are several more serious questions about microfinance, and some will be brought forward here.

In raising these issues, it is not my intention to deride microfinance, nor do I wish to delay action to reduce poverty, to decrease opportunities for the poor and disadvantaged, or to slow the flow of development resources directly to the people who need it the most. Yet, it appears that there is a rush toward a much talked about scheme without an adequate understanding of what that scheme can and cannot do, and about what our development objectives are or should be.

The objective of development work is to deliver relevant, effective, and efficient service to beneficiaries toward an understood goal which is, in the case of finance programs, economic growth. At first glance, microfinance is this, but microcredit is not microfinance, credit is only a tool, and, in any case, no one knows if microfinance is actually successful in socio-economic and microeconomic terms.

Let us first understand what actually happens in microcredit.

On the corner outside my Tashkent office is an older man. He is there every day behind a table from which he sells a bit of this and a bit of that. He joins a microcredit program and borrows $50 at 50% a.p.r. for three months; he will pay back $56.25.

With the fifty dollars he borrowed, he goes to the market and buys some items for resale. He sells it at his table at a 60% mark-up to yield $80 in revenue. That 80 minus the 56.25 repayment leaves him $23.75. Over the three months, that is $7.91 a month.

That is not bad. A pension in this country is between $6 and $14 a month, so the marginal income made possible by the microloan is very important to him.

But, how does that, as one typical program report put it, "give microentrepreneurs greater opportunity to grow their businesses"? Is selling cigarettes one at a time a business? And how is eight bucks a month going to start a business with sustainable employment?

That question about sustainable employment might sound ridiculous, but the program description goes on. Under program objectives and goals it says that "a major focus is to achieve financial sustainability (of the microlending institutions... and) to give micro-entrepreneurs greater opportunity to grow their businesses".

But only one paragraph later, it is changed; the goal is to "...reach not less than 1,600 people by the end of the second year, 2,400 by the end of the third year, and 3,200 people by the end of the performance period." In the span of one paragraph, job creation and income generation are gone, and success is quantified only by sustainability of the micro-finance institutions the project will create. Microfinance itself is too often the objective of a development program, and that should not be.

Far more rigor is needed in defining and sticking to the true goals of development finance so that programs like this can be avoided, but it is simply and broadly accepted that microfinance contributes to economic development, so the success indicator becomes microfinance instead of economic development, and the existence of thousands of clients is considered an indicator of economic improvement. This is a classic example of petitio principii, begging the question, using the matter to be proved as part of the argument.

Throughout the microfinance industry, very little effort has been made to verify or measure the economic impact. Indeed, as observed with a surprising nonchalance in a World Bank report on Latin America, "The impact of microfinance on the poor remains controversial."

In fact, it is likely that the macroeconomic effect of a successful microcredit program can be quite bad.

In the absence of a local bank, the accumulating interest earnings of a growing microcredit organization must be placed in a bank outside the area. As a result, already scarce financial resources leave the target area. The more the organization grows, the more money it accumulates. The more money it accumulates, the more money leaves the poor area and goes to a bank in another, probably more prosperous place.

And in underdeveloped countries, funds in a bank are often lent only to one of the bank manager's cronies. When those funds are MFI deposits, the poor people in a successful microcredit program are providing loan capital for the country's well-connected elite.

---

Microcredit is not microfinance, and savings, it seems, is always considered as an 'add-on', something for the project to try later, after the MFI is established. Why is that? Why is savings promotion conditional? Perhaps if we were to plan for success, we could properly appreciate the value of saving and help the poor build assets from the start.

As it is now, it is very rare to see a project with a plan to promote savings, but saving is more important than borrowing in poverty reduction. The Corporation for Enterprise Development promotes savings programs in the US, and points out that "without assets, poor families are likely to remain poor. Michael Sherraden, author of 'Assets and the Poor', observes that, 'Few people have ever spent their way out of poverty. Those who escape do so through saving and investing for long-term goals.' And without asset development policies, only a very few poor families will have the opportunity, incentive, and institutional supports necessary to save for and acquire productive assets."

And 40-60% interest rates on loans are not conducive to wealth accumulation, but discussions of interest rates will come later.

At this point, though, another macro-economic factor should be noted: savings are a key factor in establishing a proper money supply for a country. Savings leads to the sort of money supply an economy needs by adding short term savings to cash (M2 and M1). In undeveloped economies M1 is usually far too large compared to M2. Without savings, the economic actors are dependent on cash and barter, and economic growth is virtually impossible.

This is the case in the former soviet states of Central Asia, for example, and from a development standpoint, this is a very important issue. Before the collapse of the USSR and subsequent currency crises, people in this region had a rather high propensity to save. With proper incentives and confidence building measures, they might gradually return to retail banks, and their savings would make a significant contribution to long-term economic growth.

Instead, throughout the FSU and in most other places, microfinance is used as a substitute for banks. Initially, this was perfectly sensible; the poor needed access to financial intermediation services because banks do not want to bother with such small amounts. However, as the role and goal of microfinance became obscured, microfinace came to be seen by development planners as wholly independent from the banking system, a replacement for banks.

This loss of focus is a problem. If we assume that increasing participation and sustainable MFIs are only the first stage towards our goal of a normal banking function, then it is reasonable to expect an implementation plan for a later stage of microfinance, the entry into mainstream banking. Sadly, there is little evidence of such advance planning.

Instead, in this writer's experience, plans focus on building groups and numbers of borrowers, on simple expansion of the basic model without foreward thinking about the needs of the borrowers. Possibly, this is because graduating borrowers to larger loans is actually a marketing program.

Everyone realizes that in poor societies there is a need for loans of a few thousand dollars, but this alone does not justify grafting on a program to graduate microborrowers to larger loans. What would justify a program of larger loans is an adequate number of qualified potential borrowers, a market for the financial product.

To learn if adding larger loans to a microlending program is workable, there must be an analysis of the program's existing membership to quantify the demand for larger loans. Given the predominance of traders in these programs, this demand will always be very small because few traders can manage dramatically larger sums and because few traders can make the transition to creating and managing productive enterprises.

Moreover, as most implementers understand, managing a $100 group loan is completely different from a $2,000 individual loan. Due diligence, loan service, and more are required for the larger loans to succeed. In program design, this means that little of the structure of MFIs is transferable to the larger loan program.

Consequently, it is highly unlikely that graduation beyond a few hundred dollars will occur in any great number in even the best microfinance programs. So once again, we return to the simple measures of membership rolls which are short-term indicators at best.

From time to time, however, reports of jobs created are cited as a measure of progress, though these are not as frequently cited as they once were.

It is both ironic and fortunate that job creation claims from microfinance programs have faded from prominence in recent years. It is ironic that they are not often mentioned because job creation and income generation are the real goal of all economic development programs, but it is fortunate that they are rarely publicized because so many of the numbers reported in the past were simply unbelievable and easily challenged.

Some of the more egregious claims were discredited by comparing the new job claims to the area's unemployment statistics, when it became immediately evident that such economic growth as would be required to create such a quantity of jobs never happened.

In those rare instances where the figures are plausible, it is still rare to find any differentiation between commercial and productive work. Every microfinance project acknowledges the predominance of traders in the membership, but little sustainable employment can be reliably identified.

---

The issues in the foregoing discussion arose out of a preliminary look at only the objectives of microfinance programs. When examined further, when we look at the practice and implementation of microcredit and microfinance programs, still more questions reveal themselves. A few of these with brief comments:

A) Women are disproportionately represented in microprograms. Perhaps that is good; inferentially at least many believe women in developing economies are more responsible with money than men are. On the other hand, since microcredit is primarily used by traders, what happens when a woman takes on this added activity?

In an assessment report by Facet BV, a Dutch development firm, a problem common to most microcredit programs was observed: many microloans are used for household needs. This possibility might even be an attraction to women borrowers. In any case, not all of the borrowed money is available for income generating activities.

No news there, but since women almost always retain responsibility for maintaining the household, the study showed, this means that the woman is forced to work harder in the household to generate the time needed to be able to work to generate the revenue to repay the loan.

B) NGOs are, in the view of most implementers, the best vehicle for delivering microfinance services. That view is taken as the starting point as often as not, and the only question is whether the program should be run through existing organizations and associations or whether new NGOs need to be formed. A search for options, it seems, rarely occurs.

As noted earlier, a main reason for this is that microfinance is usually seen and used as a substitute for banks. There is good reason for this-- if banks worked, microfinance might not even be needed-- but it would seem wise at least to try a program to resurrect retail banking through smaller, more progressive banks and credit unions.

Mainstream banking is more beneficial for development and for savers, and it should be an objective of development agencies to promote a banking culture.

C) It is widely assumed that poor people do not save, but this is not true at all.

Even in the FSU, where banks and currencies collapsed quite recently and thoroughly destroyed any confidence people have in local banks and their countries' currencies, people save regularly. Instead of putting money into banks, they hold dollars, buy and hold assets like carpets and livestock, or pool their funds with family members for a business venture.

Even in much poorer societies, in India and Bangladesh, home-grown savings schemes abound. An excellent review of these programs is in the book The Poor and Their Money by Stuart Rutherford. (Now out of print but available online in PDF.)

Putting aside terms like microcredit and microfinance institution, Rutherford looks at the financial issues involved from the perspective of the poor and sees that all of the various programs intended to serve their financial needs are actually variations on savings activity. He describes the variety of approaches as roads to a "usefully large lump sum". It is a brilliantly simple perspective, and it shows that from a starting point different than that of most foreign-funded programs, serving the poor versus building an institution, sustainability is achieved because the programs deliver what the poor people really need.

And it is productive assets that poor people need.

D) Debt and debt service among borrowers of small loans is worth a further look as well. A World Bank study of microfinance programs in Latin America and Africa showed that borrowers would draw funds from any source they could to repay because they knew that successfully repaying a small loan would qualify them for the larger loans in the microcredit program's lending cycle.

At best, this means the smaller loans are not what the borrowers needed. They were using the smaller initial loans as stepping stones to gain access to the larger sums that are actually useful to them. At worst, it raises the issue of potential future fraud and increasing default. If the participation in the microcredit program was insincere, risk will only increase with larger sums at stake.

In either case, this is bad news for the microfinance programs.

E) Every decent microcredit program manager can recite the program's most current default and delinquency rates, but few truly know how much default and delinquency actually exist because they are hidden in the groups. Default rates are difficult to know in group lending.

Of course, program managers are aware of this problem. Understanding it is the main reason why most microcredit programs organize groups in the first place, and the low level of final defaults becomes a strength of solidarity programs. Even so, the group approach conceals critical information from lenders, and information management is a cornerstone of MFI development.

Moreover, the most recognized flaw in group lending is how the stronger members, the ones who might have the chance to build small enterprises, are called upon to cover the delinquencies of the weaker members. This is understood, but the consequence is rarely faced: this directly reduces the likelihood of larger, sustainable businesses growing out of group microlending programs because the best candidates for growth are held back by the added costs of group member failures.

F) Interest rates are one of the most discussed topics in microfinance, and there is no need to repeat the discussion, but no essay on micro-finance would be complete without a section on interest, so here are two observations.

First, you are undoubtedly aware that the case for lower interest rates to make borrowing more affordable and leave more revenue with the borrower is routinely set aside in favor of sustainability. This question has been conclusively won by the MFI, and so-called "subsidized" loan programs are rarely seen.

But the fact is microcredit is enormously subsidized by foreign donors. True, this subsidy is scheduled to end after some years, but if the aim is to stimulate employment and income generation, it can be argued that the foreign subsidy should go more directly to the businesses to more immediately and reliably increase employment. The interest rate debate should not be ended.

Second, and of increasing importance, Islamic areas are seeing more foreign assistance, they are very poor, and microfinance will be in the development mix.

Of course, you've heard that interest is forbidden in Islam, but do you know why?

There is a line of reasoning in hadiths about how money is only a store of value and not a productive asset so it is morally wrong to make a gain from nothing of value, but this is a tortured argument that has been built over centuries to explain Mohammed's order to his followers to stop borrowing from usurious moneylenders whose interest rates where keeping so many poor. Mohammed was a political leader, and his orders were practical; to assure they would be obeyed, he told the people that god wanted it that way.

Today, as fanatics try to drum up support, foreign programs which demand 50% interest will be an obvious example of infidel subversion.

---

As this essay has posed far more challenges and questions than it has praised or answered, the author feels compelled to repeat a line from the introduction: It is not the intention to deride microfinance to delay action to reduce poverty or to stall development activities that help people in need. Quite the contrary is in fact true. It is hoped that due consideration to all aspects of micro-finance programs, from design through implementation and on to their externalities, will make the programs more effective.

The main argument in this paper is that while microcredit contributes to mitigate a number of factors that contribute to vulnerability, as it is practiced it is not likely to help people rise out of poverty.

Access to credit is certainly a problem in most poor countries, and programs which provide credit beyond a certain loan threshold will be useful, but to a large extent the value of a loan, indeed its basic purpose, is contingent on how poor the household is to start with. The poor need assets, not credit.

Comments are encouraged.

---