The Truth about Microfinance
TRANSCEND MEMBERS, 28 Aug 2023
Moin Qazi - TRANSCEND Media Service
Anita Rathod learned about microfinance from a neighbour a decade ago. She joined a group of local women to secure small loans — worth a few thousand rupees at a time — and build up her cooking business. Rathod eventually opened a small fast-food restaurant in a busy suburb. She took her largest loan, worth Rs200,000), from India’s largest microlender Bandhan Bank in March 2020. It went disastrously wrong from there. Her restaurant closed when the country entered a national lockdown weeks later, and her 40-year-old husband suffered a heart attack — she says from stress. The shop is now closed, its colourful signboard dusty and dented, and Rathod can no longer repay her loan. “It’s out of my hands,”. “On top of everything, my husband had a heart attack. How could it get worse?” Rathod is one of the millions of microfinance borrowers and small-business owners in India struggling to pay their debts, threatening what has been one of the country’s biggest economic success stories and a pillar of its financial system. The main lifeline of Credit to these smaller businesses are non-bank financial companies and microfinance institutions Those people are no longer able to borrow from banks because those banks have become risk averse, so that whole channel is very dry.
Microfinance refers to the financial services provided to low-income individuals or groups typically excluded from traditional banking. Most microfinance institutions focus on offering Credit in the form of small working capital loans, sometimes called microloans or microcredit. However, many also provide insurance and money transfers, and regulated microfinance banks offer savings accounts. Microfinance seeks to address the needs of the unbanked by fostering economic justice and financial inclusion for all. India’s microfinance sector has served 6.6 crore borrowers as of March 31, 2023, with an outstanding loan amount of INR 3,48,339 crore across all states. This is comparable to the size of the credit card industry in the country.
Credit expansion in recent decades has allowed low-income Indians to take loans to pay for everything from dairy cows to new houses to job-creating small businesses. This microfinance model, which has been used across the developing world, has been hailed for helping to provide the financial security and inclusion needed to lift millions from poverty. High repayment rates rewarded the Indian lenders that extended Credit to them, making it among the healthiest pockets of a financial sector otherwise plagued by one of the world’s highest bad loan ratios. It contrasted virtuously with large-scale corporate lending to “Bollygarch” tycoons, some of whom have made failed bets on sectors like power or airlines or have been accused of siphoning off the money held up for decades as something of a “miracle cure” for global poverty, microfinance became one of the world’s most high-profile and generously funded development interventions. Everyone seemed to talk about how small loans could unlock endless opportunities for the world’s poorest people.
Microfinance and Financial Inclusion
Microfinance was conceived as a solution to world poverty by Muhammad Yunus, offering people in developing countries reliable access to loans and other financial products. But the question that perpetually dogs the sector is whether it works.
It has now been fifty years since he began experimenting with microcredit as a professor in Bangladesh, more than forty years since he established Grameen Bank to spread the idea, and more than fifteen years since he and Grameen shared the Nobel Peace Prize.
Yunus was driven by the idea that many of the world’s poor are entrepreneurs who could bootstrap their way out of poverty if only they had access to start-up capital. But in practice, loan recipients are often already in the middle class, at least relative to local standards. And Yunus did not anticipate the course becoming a commercial one, which he now blames for higher interest rates.
Lakhs of people in developing countries depend on microloans to raise funds to grow a business or stay afloat in hard times. And thanks to digital platforms, smartphones, and free-moving global capital, increasing numbers of people in the rich world are using their money to lift others out of poverty.
Microfinance programmes, small-scale special-purpose vehicles for the poor and underprivileged that generally fail to meet the eligibility norms of formal financial systems, were supposed to provide the poor with the capital they need to start small businesses. Many self-employed entrepreneurs are women who make a living with tailoring, weaving, snack vending, noodle-making, and setting up their sewing workshop or vegetable stall. Informal Credit could not provide adequate working capital for these small businesses, and the lack of financing often prevented them from growing and becoming sustainable. Low-wage workers primarily take out micro-loans to pay off other unpaid debt, meet vital needs, such as food, medicine, or school costs, or fund their children’s weddings. It is less common to use loans for business and agricultural purposes.
Microfinance was once applauded as the world’s most powerful tool for eliminating poverty. The early microfinance boom brought many benefits. An obvious one is a decline in the use of loan sharks. The shift saved people money. The interest rates formal lenders charge are lower though some microcredit outfits are purely commercial operations.
Until the late 2000s, many hailed microfinance as a financial magic bullet. It hasn’t entirely turned out that way. It is now widely acknowledged that microfinance is not a magic bullet. However, it does provide a tangible and calculable boost to poor communities in their efforts to escape the cycle of poverty. It is now widely reported that the effects of microfinance loans on poverty, health, and other social outcomes have been “small and inconsistent.”
There are doubts about whether microfinance helps the poor or drives them further into poverty with aggressive client recruiting and high-interest lending. Experts are questioning the myth that the poor can easily climb poverty with some credit or that microcredit can be financially self-sufficient. The reality is far more complex.
Microfinance is now on a slippery slope, moving from good to bad. Microfinance is facing trouble because the purity of its mission has been diluted. When it started, microfinance was a financial tool used for social good. It has increasingly become a social tool for generating money, so it has lost much of its original sheen. This is one reason microfinance often runs into heavy weather and hits periodic roadblocks and default crises.
There is a vast difference between the rhetoric of ending poverty and the services offered in villages and slums. Where interest caps have been introduced, micro-loan providers required up-front fees from customers structured as percentages of the loans, ensuring that effective interest rates remain higher than the cap.
Loans of microfinance institutions to women from these groups have come in for much flak. Some borrowers squander money or start businesses that fail. There’s a need for strong discipline. Loans can be malignant. Some companies are too risky. And the temptation is always present to spend the loan on white goods. And the stark truism is that most loans to these women from MFIs are pipelined to their husbands.
Yet, when done right, microfinance can make a significant difference in the lives of impoverished women, particularly when used as a cover against sudden emergencies and for smoothening consumption.
Millions of self-help props are still wedded to the original mission and creed. Through them, women are transforming their lives and their communities. The sisterhood is so close-knit and persuasive, and the sorority so intense that women have begun to think of themselves differently.
Conditions and Results
Low-income households, particularly the rural poor, are exposed to unsteady money flows. The reasons are many, including seasonal unemployment related to the agricultural labour cycle, sickness or death in the family, among many others. Given the variability and vulnerability of their income, they value formal microfinance because it is more reliable, even if it is often less flexible than their other tools to manage their cash flow. Banks offer cheaper Credit but are mired in thickets of red tape.
Microcredit is primarily targeted at women, meaning that the worries of daily income for household needs and debt repayment fall overwhelmingly on female shoulders. When liability levels become unsustainable, many are forced to seek out debt bondage—labour to pay off microfinance loans—in hazardous occupations. The fact is that microloans do help some people, but they also carry severe risks. Those who are financially illiterate or unfortunate are at considerable risk of sinking into a debt spiral when this lending goes wrong. Complementary elements like micro-insurance and remittances protect vulnerable families from health shocks and enable breadwinners to send cash quickly wherever needed.
Despite early success, the growth of self-help groups had slowed in the last few years. The microfinance scene in the nineties was dominated entirely by self-help groups(SHGs). And they became a critical armour for banks in draining the swamps of poverty before microfinance institutions (MFIs) started swarming and courting them and making them their darlings for a purely business goal.
They introduced a new idea of do-goodism and a touchy-feely morality to smokescreen, a mega business of making profits off the poor. MFIs selectively plucked the most honeyed self-help groups to pad their portfolios and profits. These groups have blossomed through the efforts of public banks, government, and not-for-profits, and sadly, no one is talking about it.
This was when the original character of these self-help institutions got destroyed. Sadly, microfinance institutions used this precious social capital built by community volunteers for a narrow commercial agenda. The focus shifted from thrift to Credit. It became an irresistible tale of chasing money. Barring some socially conscious players, most institutions lapped on the “Bottom of Pyramid” bandwagon. Herein lies the nemesis of the great microfinance crisis of Andhra Pradesh and the obituary of the original philosophy of self-help groups.
However, the original concept of self-help groups is being stoked up from the embers. The NRLM is a powerful programme for repositioning these groups as core to India’s women empowerment and poverty alleviation approach. Unlike the new microfinance paradigm, where Credit is the sole function of self-help groups, the emphasis of SHGs in its pure avatar is on savings—loans come later. Savings are integral to poor households’ risk management strategies; they constitute the first line of defence for poor families to cope with the external shocks, emergencies, and life-cycle events to which they are so vulnerable.
The Commercial Approach
The microcredit sector has shifted from a not-for-profit approach to a neoliberal model dominated by commercial banks. While loans were tightly regulated in terms of amounts, interest rates, and collateral, and were often underwritten by states when necessary, lending has expanded to allow more unstable borrowers to take part without state protection or relief in times of crisis. Microcredit has been a victim of overhyped rhetoric, imprudent lending, and the profit-focused nature of capitalism. Thus, microcredit requires a delicate and ongoing balancing act between undesirable extremes. It’s no wonder that accusations fly when the balance is lost.
Microfinance needs a relook and must undergo soul searching. Thinking outside the borrowing box is essential, as microfinance must move beyond its traditional roots. Recent evidence suggests that relatively simple tweaks to microcredit products—including flexible repayment periods, grace periods, individual-liability contracts, and the use of technology—may change their impact on clients and institutions. Microfinance businesses should consistently apply best practices in evaluating repayment capacity, offering transparent terms and conditions, and using credit bureau information to avoid overstretching clients’ debts.
To enable the poor to work their way out of poverty, they must be allowed to move up the steps of the financial ladder through graduated Credit. Loans should be made available in staggered doses, with every new tranche disbursed after the satisfactory repayment behaviour of the clients. This will also ensure that vulnerable groups do not get into a debt trap, making credit dispensation more efficient and qualitative.
The biggest problem is that people who get these small loans usually start or expand a straightforward business. The most common business using microfinance is retail selling groceries, where there are often too many players creating fierce competition and people don’t earn enough money to get out of poverty.
Not only are borrowers often innumerable, illiterate, and unfamiliar with interest rate calculations, but they frequently have little or no awareness of local demand for goods and services. Consequently, they often fail to establish successful income-generating ventures and cannot repay their loans.
There has been a lot of rethinking in the microfinance fraternity. One central premise that has been discredited is that capital is not people’s only crucial financial need. This seems clear now, and microfinance organisations are expanding the range of their credit offerings. While we must still consider the risks and ethical dilemmas as we push microcredit aggressively, the power of an entire range of microfinance services to help us achieve a more equitable world is becoming increasingly evident.
There has been a growing awareness among microfinance institutions that Credit is undoubtedly not transformative. Although certain people can use microfinance to alter their future and build their businesses, that is not the case with most who receive a loan. Most are going to use it to smooth out their consumption.
Credit can be both an opportunity and a risk for low-income families. It is necessary to open doors, but it can also be a barrier. A person can dig into a lot of debt, preventing the ability to move up financially. Loans can be malignant. Some people shouldn’t take on debt. Some businesses are too risky. However, the temptation is always to take these costly loans and scrimp on groceries. When they miss loan payments because a lingering illness keeps them away from their business, they get into the regular default cycle. That’s acute over-indebtedness.
Access to small loans for tiny businesses by itself won’t miraculously enable the poor to take their company to a new level. It will not build a steady business because many face several barriers. A modest cash injection cannot generate a stable income, or create a profitable cycle of trade and income, mainly when most of these people’s daily struggle involves making a living, feeding their families, educating their children, and staving off ill health.
The notion that microfinance has the potential to spark sustained economic growth is misplaced. The ideal view of microfinance is that budding entrepreneurs use these small loans to start and grow businesses—expanding operations, boosting inventory, diversifying products, etc. But the reality is more complicated. Microloans are often used to “smooth consumption,” tiding a borrower over in times of crisis.
The direct evidence of microfinance’s impact is less than overwhelming. In several cases, these financial activities can damage the prospects of poor people. Microloans create opportunities for people to utilise “lumps” of money to augment incomes and mitigate vulnerability, but that doesn’t necessarily mean investing in businesses could lead to sustained revenue growth. Not all microloans produce beneficial results, especially for those engaged in low-return activities in saturated markets that are poorly developed and are prone to regular environmental and economic shocks. The sector glosses over the fact that much Credit is spent on consumption. Over-indebtedness is a chronic problem in some countries.
Simple loans do not well serve poor households in isolation. Minimalist microfinance provides a bandage where a major operation is needed, and at worst, it deepens the wounds. In contrast, most microfinance portfolios may be commercially sustainable and attractive to conventional investors. Reaching the still-excluded will continue to require innovation and experimentation. More than microloans, the poor need investments in health, education, and sustainable farm and non-farm-related productive activities. In the present dispensation, costly private capital crowd out other, more traditional interventions such as healthcare and education.
Marguerite Robinson, an author and consultant on microfinance, puts it concisely: “Credit is a powerful tool that is used effectively when it is made available to the creditworthy among the economically active poor participating in at least a partial cash economy—people with the ability to use loans and the willingness to repay them. But other tools are required for the poor with prior needs, such as food, shelter, medicine, skills training, and employment.”
The Model of Practice
The present model of microfinance practices—minimalist microfinance in which Credit is the only intervention—is unlike the classic avatar that shows dollops of genuine good. Socially embedded institutions provide clients with information and hand-holding. Still, most microfinance clients have no training, education, or role models in business and therefore are unlikely to cultivate successful micro-enterprises independently. They need a comprehensive suite of financial tools that work in concert to grow savings, mitigate risk, fund investment, and move money. Many micro-enterprises fail due to a lack of local demand, fierce competition, or the inadequate technical skills of entrepreneurs. Microfinance best serves those who have higher skill levels and better market networks. Its loans are hardly a tool of resilience, especially when widespread shocks threaten borrowers and the industry itself.
The hard truism is that microfinance has been saddled with misplaced expectations, and we have lost a sense of its more modest, even though critical, potential. It is only one instrument in a broader development toolbox, but in certain conditions, it happens to be the most powerful. It can make the poor more resilient, but it is not the answer. It all has to do with how we are using it and how we are defining the outcomes.
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Moin Qazi, PhD Economics, PhD English, is a member of the TRANSCEND Network for Peace Development Environment and a member of NITI Aayog’s National Committee on Financial Literacy and Inclusion for Women. He is the author of the bestselling book, Village Diary of a Heretic Banker. He has worked in the development finance sector for almost four decades in India and can be reached at moinqazi123@gmail.com.
Tags: Finance
This article originally appeared on Transcend Media Service (TMS) on 28 Aug 2023.
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