Helping poor people help themselves is the main idea behind microcredit. Because a whole stratum of society in developing countries has no access to bank credit, microcredit (as well as microfinance which includes a host of financial services for the poor and the famous Grameen Bank) is seen as a solution that could unleash the forces of entrepreneurship and help people transition out of poverty by moving them from the informal to the formal economy. Microfinance is now more important than ever with 2005 being the UN ‘International Year of Microcredit’.
Microcredit typically brings a small group of women together who each are involved in starting-up a small enterprise. Some bring their families into their business, but what matters to the system is that the loans are given out to the women only. They are supposed to be more responsible than men and can better vouch for one another, even though the sums involved are very small by Western standards – a few hundred dollars at most. Because the group is liable for the behavior of its members, monitoring is very strong, and the risk of default is limited.
Since the inception of the idea more than two decades ago, microcredit has become one of the silver bullets against poverty in the developing world. It is seen to fill the gap left by the formal banking system, and the goal is to reach 100 million borrowers by the end of this year. The logic is that if the poor can finally have access to loans, then they may find their way out of poverty. Ultimately, the objective is for borrowers to graduate, that is, to establish some form of credit worthiness and to grow their business enough to interest regular banks. Establishing a relationship with a bank could indeed be the quintessential step leading to the transition into the formal economy.
The Economist recently ran an article on Microcredit in India: Helping Themselves. India has almost two million self-help groups of about 15 women who collectively handle almost 69 billion rupees. Though the country has many public-sector banks, agricultural credit co-operatives and a post office with 154,000 outlets, its rural poor have little access to credit. Microcredit is now growing fast in India, and the government is about to embark in programs to foster its growth.
This article reminded me that a few months ago, Stephen Daley and I published a Mercatus Policy Comment on Microfinance in the Philippines. Steve went to the Philippines in 2003 and 2004 to do research on what stops poor people from joining the formal world and to study the effectiveness of microfinance in the slums of Manila (where he spent a few weeks). What he found does not entirely support the now dominant view that microlending to the poor could be a major solution to poverty.
While it is true that many groups of women have benefited from microcredit, very few have been able to set up successful businesses. Moreover, those who started businesses that became successful did not graduate into the formal banking world for the most part. They still maintained close ties with informal moneylenders – the Mumbais – and preferred paying higher rates of interest rather than dealing with banks.
Our study shows that the poor lack access to credit because of institutional reasons. In the Philippines for instance, it is regulation, corruption and the lack of well defined property rights that stop poor entrepreneurs from seizing opportunities, not the lack of credit.
An instance of institutional deficit is the situation with moneylenders. In many countries they are perceived as taking advantage of the poor. Our experience in the field shows the opposite. Most of the time, moneylenders are entrepreneurs filling a gap that others overlooked by providing loans to the poor. In the Philippines, Mumbais are treated like pariahs. They cannot be citizens and are not allowed to own real property or establish businesses. The truth is that in spite of the constraints put on their ability to do business, they have established relationships with poor people in need of credit. One of the reasons why poor people in the slums of Manila do not enter the formal world is because their credit suppliers cannot do so either. As a result, the evolution from informal to more formal credit arrangements cannot naturally take place.
Microcredit was originally based on private savings handled by non-profit organizations and other private organizations. Many governments in various parts of the world (including the US government which is funding $200 million in 2005) are now willing to help finance microcredit organizations. It is unclear what effects this will have on the incentives that microfinance groups face.
While Steve and I agree that microcredit ought to be tried and developed, we share The Economist’s skepticism regarding its potential large success. It does bring financing at low cost to poor people, but it does not necessarily overcome the difficulty for poor people to enter formal economic relations. In our view, microcredit is just a band-aid solution to relieve poverty in the short run.
The sad story is that there are many institutional changes that would be immensely beneficial to the development of financial markets in poor countries that should be implemented urgently, but are not. We believe these changes would have a greater impact on the future of millions of people than government financing of microcredits.
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