Microfinance is trendy. But is it just another development fad, or is there evidence that microfinance really helps to stimulate economic growth? Even if there is, should donors do more to support microfinance?
My take on this is that microfinance, provided on a commercial basis, is self-evidently good. But that does not mean that we should welcome the stampede to subsidize microfinance. There are not strong arguments – either in principle or from evidence – that this is the best way to use scarce resources to help poor countries to grow.
Here I look at six reasons why microfinance is no panacea.
This is the International Year of Microcredit, no less, and throughout the world ten thousand microfinance institutions service some 40 million customers. Grameen Bank of Bangladesh, the world’s largest and most successful MFI, serves more than five million clients.
Donors and foundations are climbing on the bandwagon.
- On Friday, the founder of EBay, Pierre Omidyar and his wife Pamela gave $100 million in eBay stock to Tufts University to create a fund that will invest in international microfinance, or lending to people who are too poor to qualify for traditional loans.
- On the same day, Bill Clinton launched a new microfinance fund based on $75m from several multinational companies, charities and government development agencies.
- The Shell Foundation has announced $100m in micro loans.
We celebrated the blogswarm that supported Kiva. And here among the self-appointed experts in the blogosphere there is rare consensus between the Globalisation Institute, WorldChanging, NextBillion, Global Growth.org, the PSD blog, Adventures in Ethical Consumerism, Dan Drezner, Cafe Hayek, Unitus, Atlas Blogged, and others.
So presumably we have good theory and evidence to suggest this is an effective way to help the poor? Err … not exactly.
Microfinance enables people to lift themselves out of poverty. It is bottom-up, empowering people to lead their own development instead of top-down development. Support for microfinance removes market failures that put barriers in the way of the poor. What’s not to like?
Let’s be clear: access for the poor to financial services is definitely a good thing. Access to credit can help households to increase their consumption, reduce risk and increase food security, reduce malnutrition, and empower women. (ref: Khandker)
But saying that commercially provided microfinance is good is not the same thing as saying that it is a good idea for donors, philanthropists or governments to subsidize microfinance. Here’s why.
First off, it is not clear that there is a market failure to correct.
On Friday, The Financial Times (who should know better) said this:
In practice, however, there is a market failure: capital does not flow to start-ups in poor countries. The returns are not high enough to compensate for the risk.
That isn’t a market failure. If the returns are not high enough to compensate for the risk, then the market is doing exactly what it should by excluding the poor from access to credit.
(An aside: the fact that some people are too poor to obtain goods or services that we wish they could afford – such as food, water, credit, health care, transport etc – is not a market failure in the economic sense.)
If the market incorrectly perceived the risk, or if there were government regulations or taxes that made credit unaffordable, then there would be a market failure, and there would be a case for policy intervention to correct it. But in this case, the best approach would be to correct the market failure directly. If governments have better information than markets about default risk, then they should publish it. If there are taxes that make credit unaffordable, they should be abolished. It is very unlikely that, if there is a market failure, the best approach is to provide subsidized loans.
Second, subsidies for microfinance suffer the same shortcomings as other industrial subsidies.
Most microfinance institutions get some or all of their funding from grants or loan guarantees from individuals, philanthropists, foundations, and governments and international institutions such as the World Bank.
When developing country governments subsidize businesses through export subsidies, import tariffs, public procurement, grants or tax breaks, they are roundly denounced as interventionist and corporatist. They are not praised for supporting bottom-up, market-led growth. It is economically inefficient to use public money to distort the market. So why are subsidies to the cost of capital for small businesses any different?
Third, these subsidies may stifle competition that would improve financial services for the poor.
The poor desperately need access to affordable credit and insurance markets and other financial services. They are most likely to get that as the financial services industry, through a process of competition, drives out costs and produces effective and affordable services that meet their customers’ needs.
If we have donors and governments supporting uneconomic microfinance institutions, that evolution of the financial services industry isn’t going to happen. (The obvious parallel is domestic firms behind a protectionist import tariff which have no incentive to become competitive in world markets). The unintended consequence of well-meaning support for the microfinance industry may be that it delays the very evolution of the industry that the poor most need.
Fourth, increased access to credit may not significantly improve productivity in the absence of complementary inputs.
Almost all studies of access to credit find that most loans taken by the poor, especially in the rural and informal economies, are NOT taken for the purpose of investment in businesses but to finance consumption. This is not a bad thing – the poor benefit from the insurance that access to credit provides; but it suggests that hope that microfinance will enable people to grow their way out of poverty may be too optimistic.
There are few really good empirical studies of the effect of access to microfinance on investment; but such as there are show that returns to access to credit depend crucially on access to other complementary production inputs such as seeds, irrigation, or transport. Without the presence of these other factors of production, access to credit has little or no impact.
(Another aside: even in cases in which the borrower is formally a woman, there is a great deal of evidence that women only rarely control the use of the loan.)
This fourth point is not an argument against microfinance (which, as you will recall, is unquestionably A Good Thing): but it is an argument that microfinance is a complement to, not an alternative to, all those other policies to improve the opportunities for the rural poor (many of which are despised as "top down" interventions by the most articulate advocates of microfinance).
Fifth, there is an opportunity cost to these subsidies.
The total subsidy to Grameen Bank is about $20 per person per year, or $0.22 per dollar-year borrowed. (Schreiner, 2003) It seems likely that this is good value for money in the sense that the recipients of the subsidized loans use them in ways that produce a surplus of more than the cost. But there are many development investments for which funds are not available (because aid resources are scarce) that would yield a positive return. The question is whether the return to subsidizing credit for the poor is the best possible investment compared to, for example, the purchase of vaccines, teacher training, building roads, R&D into more productive crops, or the cost of peace-keeping in conflict-ridden countries.
Measuring the impact of microfinance is hard to do. An individual who takes the initiative to access credit is likely to have above average entrepreneurial skills; and will typically have a higher income than someone who does not access microfinance. It is difficult statistically to separate the effect of this entrepreneurial trait from the impact of access to credit. As far as I know, there are no studies using fully random assignment to measure the effectiveness of microfinance schemes which would permit a comparison with other development interventions.
We do know that investment in these public goods – such as vaccines – produces huge benefits, far exceeding their costs. The returns to microfinance would have to be very large indeed to justify their position as the intervention of choice for well-meaning donors. And yet the best evidence we have is indifferent on the impact of access to credit. (ref IFPRI, 2000)
Sixth, subsidies for microfinance is no more "bottom up" or less interventionist than many other government and donor policies
Here is The Economist:
What makes microfinance such an appealing idea is that it offers “hope to many poor people of improving their own situations through their own efforts,” says Stanley Fischer, former chief economist of the World Bank and now governor of the Bank of Israel. That marks it out from other anti-poverty policies, such as international aid and debt forgiveness, which are essentially top-down rather than bottom-up and have a decidedly mixed record.
Eminent though Stan Fischer is, this does not bear a moment of reflection.
All economic growth will come about because of the efforts, investments, courage, luck and skills of individual people, working to improve their lives and those of their families. This process requires access to a range of complementary inputs, such as skills, market infrastructure, inputs for their production (eg seeds, tools, labour), access to credit, good health, information, and security.
When countries receive debt relief or aid, they can use those resources either to provide those goods and services which are needed to enable the private sector to have successful businesses (eg investing in security, education or health), or to help to reduce the obstacles that the government has erected (eg taxes).
Providing public subsidies for credit is no more "bottom up" than providing subsidies for road-building or education. Indeed, it is arguably more interventionist than many other policies, since it takes governments and donors from the business of ensuring efficient supply of public goods such as transport infrastructure or security (which would be undersupplied by the free market) into the business of subsidizing services that should be efficiently provided by the market.
Lest I be misunderstood, let me repeat that the poor need access to credit, insurance and other financial services. That they cannot afford these services demands policy action; in just the same way as the fact that they cannot afford to access food, education, health care, transport, communications, security, housing.
But it does not follow that well-meaning donors, whether rich philanthropists, governments or international institutions, should subsidize credit. If there are market failures, we should identify and correct them. If there are not, we should allow the market to work, and concentrate instead on good public policy: correcting market failures, ensuring the affordable supply of public goods, and creating an environment by which the private sector can invest and grow. It is not at all clear that subsidizing microfinance is a high priority for helping the developing world to grow its way to prosperity.