Article written by: Shrey Srivastava
Microfinance in recent years has been touted as one of the most potentially effective poverty alleviation programs in the developing world. From the humid paddy fields of Bangladesh to the cluttered squalor of rural India, the bottom-up approach to economic development has indeed proved both efficient and successful in combating the wide variety of issues faced by those living in absolute poverty.
Essentially, what this global game-changer is is an access path to financial services for those in poverty who lack many of the things that make people (or businesses) successful debtors (such as a verifiable credit history). This could help them lift themselves out of the poverty trap, for example by providing the funds to help them start start successful businesses. When Muhammad Yunus came up with the idea during a 1970s Bangladeshi famine, however, he had, by his own admission, never thought that the greed of man could turn his brainchild into just another failed poverty alleviation plan.
Of course, in addition to this, there’s a variety of reasons why the programme doesn’t work perfectly, the most important of which I’ll go through in this article. Despite this though, it has to be said that despite its flaws, microfinance has “changed the game”, so to speak, and is by far one of the greatest ideas, in my opinion, in recent economic thought. With the right economic agents involved, it could still be a major warrior in the fight against absolute poverty in the developing world, however, it will need to surmount some obstacles first.
To provide some context, let’s take the perspective of Afghanistan, one of the poorest countries in the world. In Bamiyan, about 240 km northwest of the Afghan capital, Kabul, a field study microcredit initiative was put in place, whereby low-interest small-scale loans were provided to impoverished Afghans in the hope that they would spend the money in such a way that they were pulled out of the clutches of the poverty trap.
Alas, even though a strong potato crop within the area would provide a promising source of growth for any business set up using microcredit funds, the funds were disappointingly used partly by the Afghans to finance consumption. While you might think of this as simply a strange Afghanism, such phenomena have been witnessed all across the developing world, and when one thinks about it, it makes quite a bit of sense. When you’re in that type of situation with barely enough funds to ensure your next meal, it’s natural that any injection of cash would be used to ensure that you’re able to fund consumption of all your necessities.
In addition to this, not everyone is an entrepreneur; not everyone possesses the set of skills to turn a theoretical business plan into a workable business model and not everyone is willing to take the risks that an entrepreneur takes. Hence, the notion of microcredit, and microfinance in general that everyone can become an entrepreneur is slightly flawed and something which has a large negative impact on the potential effectiveness of microfinance to pull people out of the poverty trap by facilitating entrepreneurship.
While the microfinance initiative aforementioned in Afghanistan was only a pilot study, another significant drawback of microfinance is its potential inability to secure the low interest rate loans that are so critical to its success. This is because many of the areas which microfinance targets are rural and therefore hard to reach. Actually reaching these areas both to administer loans and enforce their repayment would take a large investment in both physical and human capital, something which raises the cost of making loans and therefore (assuming microfinance firms are profit minded as well as socially conscious) increases the interest rate which these firms have to charge in order to generate their target return on investment.
The loan sharks who charge exorbitant interest rates to impoverished rural dwellers suddenly now look not too different from the microfinance institutions themselves, with the two now differing in intention only (and perhaps a few percentage points on the sky-high interest rates offered). Although the economies of scale generated through lending to a group of people at once go some way towards mitigating this, even slightly lower interest rates than aforementioned would be hard to repay for individuals who often have irregular income flows and don’t earn all that much in the first place.
Even though the previous two points are entirely valid when looking at the viability of microfinance to meet its end objectives, the idea definitely still has some merit. Alas, when implemented in real life, it fell flat due to economic agents (namely firms) acting in their own self-interest. Of course, the firms I’m talking about are the large banks that to a large extent caused and amplified the huge negative impact of the 2008 financial crisis on the global economy. Banks have taken over the microfinance scene in recent years and charge rates of 100 percent or more to impoverished borrowers who obviously don’t have any chance of repaying loans at these huge interest rates.
The idea that the majority of institutions offering microfinance facilities could be both socially and profit driven has therefore been shown to be untrue in reality, as these large banks seem to only desire profit above the social and economic betterment of their poor debtors. While regulation in disadvantaged areas remains tenuous at best and extremely difficult to implement, profit-driven institutions take advantage and reap massive profits at the expense of clients. Therefore, they represent a massive blockage to the road which microfinance could have taken to drastically reduce global poverty rates. It is hence my opinion that only once banks’ motives change, or banks are purged from the microfinance system altogether can microfinance continue to transform lives at the breakneck pace it once did.
This’ll be difficult, but it’s worth it – ideas like this one don’t come about all too often.