Questions and Answers on microcredit

Par R. RAMAKUMAR
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R. RAMAKUMAR, "Questions and Answers on microcredit", CERISCOPE Pauvreté, 2012, [en ligne], consulté le 26/05/2017, URL : http://ceriscope.sciences-po.fr/pauvrete/content/part4/questions-and-answers-microcredit?page=show

What exactly is microcredit? Since when does it exist?

The specific definition of microcredit differs from country to country. However, defined generically, microcredit refers to the provision of “small loans” to the poorer sections of the population without the surrender of any physical collateral. The definition of small loans, the eligible beneficiaries and the conditions regarding the utilization of funds and terms of repayment vary from country to country.

Small loans to the poor on special terms has existed for a long time in many countries.. There is evidence that the “Irish Loan Funds,” which were inspired by Jonathan Swift in Ireland in the early 1700s, was one of the first forms of providing poor people with small loans without collateral. Across Europe, Africa and Asia, there were numerous savings and credit institutions in the 19th and early-20th centuries that could be regarded as the progenitors of today’s microcredit institutions. These institutions also provided “small” loans to groups of borrowers without any collateral. In the 20th century, many developing countries implemented Integrated Rural Development Programs (IRDP), under which, public banks provided small loans to small farmers and agricultural labourers.

While these early experiments are important, the modern form of microcredit is modeled on the Grameen Bank in Bangladesh founded by Mohammed Yunus in 1975. Over the years, the Grameen model of microcredit has emerged as a substitute for “formal” provision of credit to the poor through public banks. It has been argued that public banks historically neglected the credit needs of poor households on the grounds that they lacked collateral to surrender to the banks. As a result, the public banks left the poor “unbanked”. This was where a bank like the Grameen Bank stepped in.

Mainstream economic theorists argue that implementation of “formal” (public) lending programmes directed at the poor faces three important problems. First is the problem of exact targeting, which would ensure that there are no errors of inclusion (where the “non-poor” end up getting credit meant for the poor) and no errors of exclusion (where the poor fail to receive the credit designed for them).. Second, is the screening problem - distinguishing the good (creditworthy) from the bad (not so creditworthy) borrowers. This problem arises from the fact that poor borrowers do not generally maintain accounts of their past business activity and are unable to furnish any documented plan for the business for which they are seeking the loan. Third, public agencies may not be able to monitor and ensure productive usage of loans. There is also the problem of enforcement. If there are problems with loan repayment they may not be able to take legal action against the borrowers due to the absence of any collateral. . Costs associated with these last two problems largely account for the “transactions costs” of lending. According to Yunus, formal lending agencies often leave the poor unbanked due to the high levels of transactions costs incurred in lending to the poor. Grameen Bank claimed that its model of microcredit addressed these problems in innovative ways.

The Grameen Bank model of microcredit attempted to resolve the targeting problem either directly, by specifying the member’s eligibility requirement on the basis of asset ownership, or indirectly, by making the loan amount small and imposing additional conditions, such as requiring attendance at weekly member meetings that discouraged borrowing by the non-poor..

It attempted to overcome the screening problem by lending to groups of borrowers rather than to individuals. The concept of group borrowing was based on the idea that solidarity among like-minded people living in similar social and economic conditions is crucial to the success of this program. As a group, the poor were better able to understand the character and use of the proposed loan. Moreover, the loans were given only for activities for which repayment was guaranteed and which were certain not to turn into bad investments.. These included activities, such as poultry raising, paddy husking, cattle fattening, rice and other seasonal crop trading, handloom weaving and grocery shop-keeping.

Finally, the problem of monitoring was taken care of individually as well as through the group. The Bank insisted that the loan be put to the use specified by the borrower within a period of seven days and required small weekly repayments.

In practice, the implementation of microcredit in most developing countries has been associated with the policy of financial liberalization. As I shall explain below, certain central features of microcredit fit in well with the requirements of financial liberalization. Typically, financial liberalization aims at reducing the central role of public banks in the financial system and promoting private financial interests. In line with this, in most developing countries, provision of microcredit has been promoted as a substitute for the provision of credit by the State in which credit is provided through/by non-governmental organizations (NGOs).

Where does microcredit come from? Which country (ies) was (were) the first to use microcredit? And why?

As mentioned, the modern form of microcredit is heavily based on model of the Grameen Bank in Bangladesh.

In the 1970s, Mohammad Yunus, the founder and until recently the head of Grameen Bank, was the Head of the Department of Economics at Chittagong University. The story of Grameen begins in 1974. Yunus previously worked in Jobra, a village surrounding the University at its Chittagong campus. In Jobra, he saw the dark face of poverty, worsened by that year’s drought. Deeply moved, he and a few of his colleagues decided to help the villagers. Studies in the village led Yunus to the important recognition that the poor in Jobra, who were mostly engaged in bamboo-based small-scale self-employment, were caught in deep debt traps. Usurious rates of interest and oppressive terms and conditions set by the private moneylenders ensured a perpetuation of their indebtedness and poverty. Yunus concluded that credit was the major factor determining the economic position of people in this village.

Yunus requested a bank in Jobra to provide inexpensive loans to the poor in the village. However, the bureaucratic ways of working of the public sector bank prevented it from providing loans without any collateral. Disappointed with their efforts to obtain inexpensive loans, Yunus and friends at the University finally decided to become moneylenders themselves. Thus was born Grameen, which was to spread later to other parts of Bangladesh and the world.

Grameen’s practices were to be different from those of the existing banking sector. According to Yunus, the requirement of lump sum repayments in banks made defaults a common feature. To help the borrowers “overcome the psychological barrier of parting with large sums”, he instituted a daily payment program. When made daily, the repayment amounts would be so small that the borrowers would not find it difficult to repay promptly. For example, a 365-taka loan could be repaid in one year at the rate of one taka a day. However, Yunus found it difficult to implement this programme and later switched over to weekly repayments.

In order to obtain loans from Grameen, borrowers were required to approach the bank in groups, each group consisting of five members. The loans were provided first to one member and sequentially to the remaining members in pairs. The prompt repayment of installments by members at every stage was a pre-requisite for members at the following stages to become eligible for loans. In Yunus's opinion, such sequential lending helped minimize the probability of default by imposing peer pressure.

The target group of Grameen was women. Yunus justifies this targeting on two grounds. First, among the poor, women are socially and economically the most deprived. Second, they are more reliable than men in the repayment of loans. Moreover, women are more forthcoming and successful in improving the welfare of the household as a whole.

Following Grameen’s example, several other institutions were set up for providing microcredit in Bangladesh and other developing countries. Some of them are state-controlled, such as the Bank Rakyat Indonesia and Badan Kredit Kecamatan in Indonesia. Most others are primarily non-governmental (NGO) in nature, such as BRAC (Bangladesh), Banco Sol (Bolivia), SANASA (Sri Lanka) and Muzdi Fund (Malawi). These NGOs depend on international donors, such as IFAD, SIDA, OECF, OXFAM and CARE for funding.

How many people are involved today? And who are the people giving money?

Most countries of the world do not have data related to the number of loan accounts that could be called “microcredit”. As a result, it is difficult to estimate the actual number of people involved in microcredit today. However, the Microcredit Summit of 2007 estimated that, globally, about 133 million people are touched by microcredit, and about 93 million of them could be defined as the “poorest”. Interestingly, the Summit also recorded that about 90 per cent of the ‘poorest’ are reached by just 67 microfinance institutions (or just 2 per cent of all microfinance institutions). Another study by the World Savings Bank Institute (WSBI) in 2005, using a different definition for microcredit, put the total number of borrowers at about 190 million.

Data on the microfinance institutions (MFIs) that provide microcredit are also hard to come by. According to some estimates, there are more than 10,000 MFIs in the world. However, official documents report a much lower number of MFIs. According to the 2007 World Microcredit Summit, there were 3,316 MFIs as on 31st of December 2006.

The most widely used global database on the subject is the MIX Market database, where data is largely self-reported. As per the latest information for 2009, only 2,004 MFIs provided data to the database. For these 2,004 MFIs, the total number of borrowers was 92.2 million; the gross loan portfolio was $ 65 billion; total deposits amounted to $ 27.1 billion; average loan balance per borrower was $ 523.4.

Do people receive help other than money, such as advice or counseling?

Yes, sometimes. One of the important non-financial services claimed to be offered by MFIs is related to women’s empowerment. Here, some MFIs claim to offer business and leadership training to female borrowers, others claim to offer training related to women’s rights while others claim to offer counseling or legal services to female borrowers affected by domestic violence.

Do people receive any help from the State or public organizations?

Not always. In some cases, governments provide special subsidies for MFIs in the form of either grants or tax-waivers on products. In certain other cases, governments provide discounts on interest rates charged to the MFIs.

Do you think that microcredit can eradicate poverty?

Untill now, I have uncritically explained the concept of microcredit and its features. However, when it comes to impact analyses, it is hard not to be critical.

Over the last few years, microcredit has attained celebrity status in the dominant development discourse. It is claimed that microcredit has transformed the lives of the poor across the world through its innovative methods of small-loan provision. The argument here is that microcredit raised the incomes of the poor so much that they moved above the income-poverty line. At the International Microcredit Summit, sponsored by the World Bank in 1997, Mohammad Yunus declared that the “summit [was] about creating a process that will send poverty to the museum...”

The problem, however, is that careful studies by scholars have not supported this argument. There is not yet a respected study in social sciences that has shown conclusively that microcredit has reduced income-poverty in a significant way. Most studies that do claim so are based on questionable methodologies. Princeton economist Jonathan Morduch wrote in the Journal of Economic Literature that “while strong claims are made for the ability of micro-finance to reduce poverty, only a handful of studies use sizable samples and appropriate frameworks to answer the question.” As a result, “even the most fundamental claims remain unsubstantiated.” At best, studies have shown that microcredit serves as a weak survival strategy for the poor. While studies show that incomes have been raised, these increases are also admittedly marginal.

How is it then that the concept has endeared itself to a wide range of international organisations and governments?

In my view, the most important reason is that NGO-led microcredit provision fits in well with the principles of financial liberalisation. A major objective of financial liberalization is the retreat of public institutions from the provision of credit to the poor. In this view, microcredit institutions are seen as the alternative when public banks withdraw. The NGO provision of microcredit has been promoted across the world by institutions like the World Bank as a substitute for state-led formal credit provision.

Mohammad Yunus’ worldview has been no different. In his book Banker to the Poor - Micro-lending and the Battle against World Poverty (Pacific Affairs, New York, 1999), his basic argument is that a bank on the Grameen model can be effective only in a capitalist and free market-driven economy. He said, “I do believe in the power of the global free market economy and using capitalist tools. I believe in the power of free market and the power of capital in the market place”. He further argued, “I believe in the central thesis of capitalism: the economic system must be competitive...[and] profit maximizing.”

A good example of the adherence of microcredit institutions to the principles of financial liberalization is the evidence on the interest rates charged. An important objective of the earlier policy in developing countries of “social and development banking” (that preceded the current policy of financial liberalization) was to augment the supply of credit to rural poor, and to do so at an affordable cost. It was recognized that a high rate of interest can shut out poor borrowers from the credit market. Thus, under the policy of social and development banking, differential interest rates were introduced into the formal system of credit. Poorer borrowers received loans at lower interest rates compared to non-poor borrowers.

However, in the 1990s, proponents of financial liberalisation sharply criticized the policy of administering interest rates. The argument put forward was that administering interest rates led to “financial repression”, which undermined the profitability of operations of the banking system. Hence, the argument went, banks should be given a free hand to charge rates of interest as determined by the market forces of demand and supply.

Let me, here, take the Indian case as an illustration. In India, one of the major objectives of financial liberalisation in the banking sector was to eliminate subsidies on interest rates. A booklet released by the National Bank for Agriculture and Rural Development (NABARD) in 1997 asserted that the argument that “rural poor...need credit on concessionary rate of interest and soft terms” is a “myth.” Similarly, the Reserve Bank of India’s (RBI; India’s central bank) Cell on microcredit in 1999 noted, quite outrageously, that “freedom from poverty is not for free. The poor are willing and capable to pay the cost.” Thus, in 1999-2000, India fully deregulated interest rates on microcredit by banks and NGOs.

The available evidence shows that deregulating the rates of interest led to a significant rise in the costs of credit for poor borrowers in India. Final rates of interest on microcredit are in the range of 24 to 36 per cent per annum. Interestingly, the average annual interest on a home loan or a car loan in India is about 10-11 per cent. Large administrative costs of delivering microcredit, a feature noted across countries, is the primary reason for the high interest rates. These administrative costs have resulted in a system in which the various participant-links in the credit chain charging margins. This margin is charged by each participant and goes primarily towards covering the transaction costs – costs of information, negotiation, monitoring and enforcement of the credit contract – incurred in the delivery of microcredit. In the end, the burden of large margins is simply transferred to the poor borrowers in the form of high interest rates.

High rates of interest on loans are effectively a burden on the incomes of the poor. Further, given the low capital intensity of investments made through microcredit and the resulting low profit margins, high rates of interest dampen the possibility of any significant savings on the part of the poor borrowers. As the poor largely borrow to meet consumption-related requirements, they feel the burden of high interest rates is felt even more strongly.

It is often argued that in spite of the higher rates of interest charged, microcredit can raise the incomes of the poor significantly. However, this argument stands on very weak grounds. Under certain simple assumptions, it follows that the rural micro-enterprises that the borrower initiates with the small loan should have a rate of return of at least 24 to 36 per cent to break even. For a medium-sized industry, a rate of return (before interest payment) of about 24 per cent is generally considered to be respectable. For smaller industries, the rate of return would be lower. A rate of return of 24 to 36 per cent for a small rural enterprise is thus a highly unrealistic target, given the low organic composition of capital.

In Bangladesh too, the practice of high interest rates on microcredit has had many distressing consequences on the repayment behaviour of borrowers. Aminur Rahman pointed out in a study in the Tangail district, that most of the timely repayments were made not from income from assets acquired withGrameen Bank loans, but through further borrowing from private moneylenders. This meant that the borrowers began a new Grameen loan “with a deficit on the capital”, which led to the creation of “debt cycles” for the borrowers. In another study in Madhupur Thana in northern Bangladesh, Saurabh Sinha and Imran Matin noted that “most of the informal loans repaid with Grameen loans were taken to repay earlier Grameen loans.” According to Sinha and Matin,

“High levels of cross-financing deplete the capital of the loan, and reduce the value of the new loan that is used to repay or service the old. The process turns into a ‘vicious cycle’ as smaller investments into directly productive enterprises yield less returns, thus requiring even higher loans the next time to repay the original loan. It erodes the profitability of any enterprise, especially if a high interest loan is taken from the informal market.”

Microcredit can take credit for having moved the unbanked poor into the free market of capital. But whether the free market has freed these subjects from poverty and deprivation is a question that has not yet been answered.

Can we consider turning poor people into entrepreneurs to be the best solution?

The question is not whether the poor can become entrepreneurs or not. Indeed, the promotion of entrepreneurship among the poor is a good idea in itself. The real question is whether the larger policy framework under which microcredit is operationalized is one that weakens the entrepreneurial capabilities of the borrowers and ends up disempowering them instead of empowering them.

First, microcredit policies always function independently of any planned socio-economic transformation in the economy. Second, there are doubts about whether the small-scale  business enterprises that develop through microcredit can act as propelling forces of growth in the economy. Third, the size of loans provided through microcredit is generally so small that they only help the borrowers generate the principal and interest from the investment, leaving very little as savings. In sum, the kind of entrepreneurship unleashed by microcredit is hardly empowering.

Hasn’t microcredit become something like a disguised consumption credit that allows the poorest to buy the items that cover their daily needs?

It is not correct to say that consumption credit per se is bad. In fact, for landless labourers in rural areas, consumption credit (for instance, to pay fees for children in school, to pay for health expenses and to pay for social ceremonies) is an important requirement. Because they do not have assets, they do not need production credit. While reducing landlessness or asset poverty is important as a medium term goal, meeting consumption credit requirements of asset-less households is important in the short-term. It is indeed a fair criticism of public banks that they have failed to meet consumption credit requirements of the asset-less rural population.

However, the issue here is that in the case of microcredit, such consumption credit is provided at very high interest rates. In fact, with no income flowing in from the credit, borrowers find it increasingly difficult to repay loans with these high interest rates. This is the reason why we see debt cycles, as noted earlier; another more expensive loan is taken to repay an already expensive microcredit loan.

The solution lies in linking the microcredit to public institutions, so that consumption credit can be provided to poor households at affordable interest rates and reasonable terms and conditions.

What can we say to people who argue that microcredit prevents other programs such as those aimed at improving health, education, etc, from developing) or other investors from ensuring development and creating jobs?

When public policy focuses disproportionately on microcredit, seeing it as the panacea for poverty alleviation and channels all scarce funds to it, then it is indeed the case that funds for other programmes are squeezed out. Such an imbalance in public policy arises from a misconception that can be traced back to Mohammad Yunus' ideas on microcredit. Yunus has stated: “if we can come up with a system which allows everybody access to credit while ensuring excellent repayment --- I can give you a guarantee that poverty will not last long.” This is a flawed idea. Lack of access to credit forms only a part of the reason why poverty persists. Poverty is primarily a structural problem in the economy; it persists due to unequal socio-economic relations. For instance, most developing countries have yet to pass through the fundamental stage of land reforms.

Thus, the original conception of microcredit is itself one that rejects the real causes of poverty. If the state ends up accepting this false premise, then the sidelining of other sectors, such as education and health, in policy, is inevitable.

What about the abuse?

There is serious abuse at many levels.. I will, again, use the recent Indian case as an illustration. In India, the practice of charging high interest rates on microcredit has had many distressing consequences on the repayment behaviour of borrowers. In the State of Andhra Pradesh in southern India, often called the MFI-kingdom of India, borrowers have been subjected to extreme forms of harassment due to delays in repayment. Many harassed borrowers have committed suicide. In early-2006, the Andhra Pradesh government closed down about 50 branches of MFIs following allegations of charging usurious interest rates and illegal harassment of borrowers. In 2006, there were reports that about 10 MFI-borrowers had committed suicide in just one district - Krishna – in the State. More suicide stories emerged after 2006. In 2010, there were at least 30 reported suicides of MFI-borrowers.

While systematic studies on debt cycles of borrowers and malpractices of MFIs in Andhra Pradesh have yet to be made, news reports on each suicide committed in 2010 are instructive. Here is the story in Indian Express of Karri Ammaji, 48 years old, of Katheru village in Rajahmundry rural mandal in Andhra Pradesh:

“She had borrowed Rs 2 lakh from four micro finance companies (MFIs) at 10 per cent interest, and had stood surety for a loan of Rs 2 lakh taken by her relatives…She had been under enormous pressure to cough up repayment instalments, and was due to pay one of Rs 4,000 on Monday…Of the total amount she had borrowed, she had only repaid a meagre amount. Her co-members in the SHG mounted pressure on her to pay up…In the grip of panic, she reportedly jumped into a well near her house. Wife of a labourer, she is survived by four daughters”.

Similarly, Times of India reported the case of Talari Balanarsu from Annaram village in Machareddy mandal in Andhra Pradesh:

“Talari Balanarsu, 28, hanged himself in his house…in the afternoon. A Gulf returnee, Balanarsu took Rs 20,000 from a private MFI. “His debts mounted as he had taken a loan of Rs 1 lakh from relatives, local villagers and private moneylenders for various needs,” a villager said”.

From Rajahmundry in Andhra Pradesh, the same Indian Express report noted that:

“Collection agents are widely reported to use abusive language against defaulting borrowers. MFIs tend to appoint agents locally to make collections…Some have been reported to ask women to take up prostitution to be able to pay their instalments…This is in contrast to what they say when they come to your doorstep to offer loans. They promise that there will be no harassment.”

A Times of India report from Guntur district in Andhra Pradesh noted that:

“In Guntur, a farm labourer, Borugadda Sudha, 27, tried to end her life by jumping into a well but she was rescued by villagers. Sudha took Rs 15,000 from an MFI to make both ends meet after her husband Ganapathi Rao, a casual labourer at a foundry, died six months ago. She has a two-month-old baby.
Following non-payment of loan instalments, two women representatives reached her house and allegedly abused and threatened her. They detained her and released her only after her relatives assured them of loan repayment. The police who picked up the representatives did not register a case.”

A Times of India report from Visakhapatnam district in Andhra Pradeshnoted that:

“Agents of a micro-finance company allegedly abducted a 10-year-old girl to “punish” her mother for failing to repay their weekly loan instalment at Narsipatnam in Andhra Pradesh’s Visakhapatnam district.
Daralamma, a daily wage labourer, filed a police complaint on Tuesday, saying the agents abducted her daughter, Durga Anushka, on Saturday last when she was away in Anakapally for medical treatment. “My sister said the agents accompanied by three self-help group women came to our home and took away my daughter. They had threatened her that they would release Anushka only after I clear the dues,” Daralamma said.”

And finally, Times of India reported a “government study”, conducted by Sujata Sharma, project director of District Rural Development Authority (DRDA) of Warangal in Andhra Pradesh:

“…a government study has found that some MFI agents themselves are encouraging the debtors to commit suicide so that their loans are repaid. This happens because the borrowers are covered by insurance… According to sources, the MFIs draw up an insurance cover for the borrower at the time of loan disbursement. In the eventuality of suicide, they recover the amount under the Loan Protection Fund (LPF) by which 10 per cent of the loan amount is deposited with the RBI which repays the remaining loan amount due from the defaulter.”

It is important to note here that the way in which microcredit developed in India inevitably led to this mad rush to ensure high repayment rates. There is a difference that needs emphasis here. Until now, I have been referring to the term “microcredit” and not “microfinance”. These two terms have different meanings. While microcredit refers to small loans without collateral, microfinance typically refers to microcredit, savings, insurance, money transfers, and other financial products targeted at poor and low-income people. Over time, most microcredit agencies in India tried to transform themselves into microfinance agencies.

With the expansion in activities from microcredit to microfinance, the portfolios of MFIs grew sharply. The MFIs took over the task of identifying and encouraging “Joint Lending Groups” (JLGs) that needed loans and other financial and non-financial services. The typical progression of an MFI was to begin as a not-for-profit unit using grants and mature gradually into a for-profit Non-Banking Financial Company (NBFC). The NBFCs needed new infusion of funds and suddenly, microfinance became an attractive destination for private equity (PE) investors. This was the beginning of the era of equity capital in microfinance that began in the early-2000s. The interest of PE investors in MFIs grew as returns on equity in these institutions increased. According to MFI trackers, the returns on equity in MFIs grew from 5.1 per cent in 2008 to 18.3 per cent in 2009; the compound growth rate of returns on equity was 105 per cent between 2005 and 2009.

The equity route of raising funds for MFIs has a rather straightforward problem. Investors are not angels, and their only attraction to invest in MFIs is the relatively high rate of yields which generally are sustained by raising interest rates on loans. Cost-cutting measures, such as the use of technology, contributed only at the margins to raising yields. In other words, higher interest rates sustained higher yields of MFIs, which in turn led to higher PE investments. Put differently, if yields were relatively low to attract investments, MFIs could raise interest rates to improve yields.

MFIs cannot avoid this dilemma when they adopt the private equity or IPO route to capital infusion. They become slaves of the highly volatile system of financial flows in the market. The consistent pressure to keep yields highforces them to maintain even higher interest rates in order not to lose funds. The burden of this Gordian knot is borne by the poor borrowers.