Unravelling the fundamental design of microfinancing

Microfinance — an approach to financial inclusion based on providing small denomination loans and other financial services to poor people, who lack the collateral, credit history, or other assets — has generated considerable enthusiasm, not just in the development community but also at political levels. It has infused an entrepreneurial spirit in tiny entrepreneurs like clay-brick makers, seamstresses, and vegetable sellers.

It continues to thrive despite being under fire from legions of critics. One plausible reason for the lingering faith in the power of microfinance is that it provides a convenient strategy for investors to demonstrate that they are active fighters against poverty and are trying to save the poor, while making a substantial amount of money from them. It is built on a false belief that credit is the most vital need of the marginalised.

One of those who have thoroughly studied the phenomenon, Thomas Dichter, says the idea that microfinance allows its recipients to graduate from poverty to entrepreneurship is inflated. He sketches out the dynamics of microcredit: “It emerges that the clients with the most experience started using their own resources, and though they have not progressed very far — they cannot because the market is just too limited, they have enough turnover to keep buying and selling, and probably would have it with or without the microcredit. For them, the loans are often diverted to consumption since they can use the relatively large lump sum of the loan, a luxury they do not come by in their daily turnover.” Microfinance has come under increasing scrutiny in recent months. Stories of astronomical interest rates driving the poor deeper into poverty, compounded by tales of malicious moneylenders intimidating borrowers to the point of suicide, have recently come to light in the international press, exposing fundamental flaws in the design of institutional for-profit microfinance.   

Not only are borrowers often innumerate, 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 therefore, cannot repay their loans.

The present second generation microfinance is far different from the first generation model, which focused on organic growth, the success of the original model was largely on account of the green field methods — where Micro Finance Institutions (MFIs) laboriously promoted their own groups, nurtured them and painstakingly created a culture of credit discipline and high repayment based on peer respect and mutual trust. These principles were slowly abandoned by many MFIs because of their urgency to grow fast.

Microfinance, including microcredit, is often considered to be an instrument that promotes empowerment. While it can stabilise livelihoods, broaden choices, provide start-up funds for productive investment, help poor people to smooth consumption flows and send children to school, it can also lead to indebtedness and increased exclusion unless programmes are well designed.

Debt can both unlock you and lock you. Debt is one thing that has both the greatest promise and, perhaps, also the gravest peril. Debt or credit, the cash that we borrow from lending institutions, exists for a reason. Before you apply for it, you should ask yourself if you have a valid reason for it or you are taking it just because people are lining up the way pollsters queue up for freebies. The second question you should ask yourself is whether it is part of your financial plan. If it is, are you sure you are going to get a return higher than what you will be paying for it. This financial return should also cover your own effort that will go into generating that return.

The vast majority of microfinance clients have no prior business or banking experience and little formal education. The intermittent income of clients makes it difficult for them to pay back their loans consistently. When microenterprises fail to make profits, clients have reduce their consumption, sell valuable assets, take on more debt from expensive  sources, or default on their loan. Research has shown that microfinance clients have been known to, sell their furniture, scrimp on food borrow from loan sharks, and take additional jobs to pay-off their loans.

According to Naila Kabeer, Professor of Gender and Development at the London School of Economics, women who have some prior experience of entrepreneurship and are not engaged in it for purely subsistence reasons, are likely to benefit greatly from microfinance activities, given the barriers they face in accessing formal financial institutions. But for poorer women who are struggling to get their enterprises on a viable basis, financial services on their own are unlikely to be enough and may even end up plunging them into debt. These women would need financial services as part of a larger package of supportive measures, which address their human capital deficits, their unpaid domestic responsibilities and perhaps also lack of self-confidence and fear of taking risks.

In the world of microfinance, women borrowers are viewed as autonomous individuals who make independent choices in the marketplace. But this is not the reality. Rural women live in extended family structures. These women’s identities are relational, shaped by factors such as marital kinship, ethnic, and tribal allegiances. They negotiate complex kinship and social obligations. Husbands, sons, and fathers-in-law often take control of women’s loans — a phenomenon known as pipelining of loans from women to the male members of the household.

It’s not surprising to learn, therefore, that in most cases men control the loans that women receive. The men may simply use the money for their own purposes; in addition to male control, other problems affect a woman’s ability to repay a loan. In case of a default, they suffer humiliation and public shame which heightens tension both at home and in the community. Such humiliation of women in a public place gives males in the household and in the lineage a bad reputation. In extreme cases, peers may take the defaulter to the police station. For a man, if he is locked inside the police stations for several days, it would mean almost nothing to other people in the village. But if this happens to a woman, it will bring shame to her household, lineage and village.

Access to small loans for tiny businesses by itself won’t miraculously enable poor to take their business to a new level. It will not build a steady business because a lot of them face several barriers. A modest cash injection cannot generate a stable income, or create a profitable cycle of trade and income particularly when the daily struggle of most of these people has to do with making a living, feeding their families, educating their children and staving off ill-health.

The biggest problem is that people who get these small loans usually start or expand a very simple business. The most common business for microfinance is simple retail — selling groceries, where there are often too many people, fierce competition, and where they don’t really earn enough money to get out of poverty.

Not only are borrowers often innumerate, 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 therefore, cannot repay their loans.

Most microfinance clients have no training, education, or role models in business, and therefore, are unlikely to cultivate successful microenterprises on their own. They need a comprehensive suite of financial tools that work in concert to grow savings, mitigate risk, fund investment and move money. Many microenterprises fail due to lack of local demand, fierce competition or inadequate technical skills of entrepreneurs. According to the World Bank, microfinance actually best serves those who have higher skill levels, and better market networks.

It may appear that the naysayers are ready to sound the bugle and shout out “the king is dead, long live the king”, but microfinance can redefine itself as a leaner, more modest business with a social conscience and a mission-oriented goal, and continue to be profitable. Although, only time will tell.