Micro finance: A Panacea for Poverty?

Hari R. Lohano

Micro finance is the newest darling of aid communities. Donors are eager to provide funds for these schemes. More than 1000 microfinance institutions-commercial bank’s, credit unions and non-governmental organizations (NGO’s) are providing microcredit in more than 100 countries. There are more than 7 billion dollars in outstanding loans. Microcredit Summit, 1997, rallied support to seek more than $20 billion to provide microfinancing to 100 millions of poor for the next ten years, 2010.

Microfinancing has become so ‘popular’ that when President Clinton visited Bangladesh he posed with Mr. Younus Khan, the founder of Grameen Bank and borrowers in the country. These programs are regionally concentrated, with nearly 76 percent of total loans disbursed in Asia, 21 percent in Latin America and 3 percent in Africa.

In South Asia most of the excitement is based on the fame of a few of the best micro-finance organizations. These include Grameen Bank, Bangladesh Rural Advancement Committee (BRAG) in Bangladesh. Each of these reach millions of depositors and borrowers. Majority among them are women. More than 1000 NGO’s are providing microcredit in the country.

Impressed with the “successful” and “exciting stories” of micro financing, the present set up has announced that the government will establish a micro finance bank (MFB) very shortly in the country.

Similarly multi-donor and government supported Pakistan Poverty Alleviation Fund (PPAF) is also launching a big initiative to reduce poverty mainly through the provision of micro financing in the country.

Other major NGO’s providing microfinancing in the country are Agha Khan Rural Support Program (AKRSP), National Rural Support Program (NRSP), Sarhad Rural Support Program (SRSP), Orangi Pilot Project (OPP), SUNGI Development Foundations, Kashf Foundation (Kashf), Sindh Agricultural & Forestry Workers’ Cooperative Organization (SAWFCO), Thardeep Rural Development Program (TRDP). Moreover some international donor agencies like OXFAM and Save the Children Fund (SCF) also provide providing microfinance through intermediary NGO’s in different parts of the country.

The main intention and objective of the NGO’s to provide microcredit and government’s proposed plan to establish the MFC is to reduce poverty through the improved access of microfinancing to poor in the country.

The main question is not, whether micro-finance is better than nothing for its users. For a developing country, like Pakistan, which is already facing severe poverty and shortage of public resources to fight against the poverty, the main question, however is a) does the microfinance reduce poverty? And b) whether microfinancing is better than some other policy instruments to benefit the poorest sections in the country? The question is addressed after tracing the roots and advantages of the micro financing.

Roots of Microfinancing

Microfinancing means small size of loans. The origins of micro financing can be traced to Europe. The late nineteenth century saw booming of credit cooperatives to help lower income groups through credit. The cooperatives grew to serve 1.4 million in Germany in 1912. These programs were then replicated in Ireland and Italy. The government of Madras in 1880, then under the imperial rule, introduced the programs to address poverty in India. . By 1912, over four hundred thousands Indians belonged to the new credit cooperatives. By 1946 their members exceeded 9 million.

The cooperatives during this time period took hold in the State of Bengal, now Bangladesh. In the early 1900’s, these programs were so well known in Bengal that the leading merchant of Boston, USA, spent time in India to learn about the cooperatives in order to later set up similar programs in Boston.

The credit cooperative eventually lost steam in Bangladesh, but the notion of group lending had established itself and after experimentation and modifications, became one of the bases for the Grameen model in the country. It is, just not coincident that when Bill Clinton was still Governor, it was Muhammad Younus, founder of the Grameen Bank, who was called on to help and set up the Good Faith Fund in Arkansas, USA.

Main Advantages of Microfinancing

Micro-financing mechanism has many comparative advantages then the formal bank lending for large number of small size of loans. Firstly, loans are provided on the basis of group lending. Main benefit of the group lending is that it reduces the transaction cost of credit delivery and mitigates problems of adverse selection. This may also provide benefits by inducing borrowers not take risks that undermine the bank’s profitability. Peer monitoring with in the group reduce the risk of default and moral hazard. For instance, in-group lending the responsibility of the credit is not only individual, but the whole group and community is responsible for the repayment of loan. Incentive for other members is that if repayment is timely the other members will get loan facility. In case even if one member defaults, the whole group will be effected adversely from the loan facility.

Secondly, microcredit enables substitution of physical collateral. Majority of these programs do not require physical collateral as demanded in the formal banking. It is substituted often with social collateral and a fixed proportion in emergency fund or pledge of fixed proportion of borrowing in favor of the organization. For instance, Grameen Bank uses a small proportion of emergency fund as collateral. Similarly, national rural support program (NRSP), one of the leading NGO in micro financing, in Pakistan does not require any physical collateral.

The organization, however, substitutes it with social collateral and pledging of one forth of each borrowing amount in advanced in the favor of the organization. If a borrower is taking loan of RS. 10,000. He/she has to pledge RS. 2,500 in advance. Therefore, social reputation and ability to pledge the fixed proportion of the applied loan is substituted with the physical collateral.

Thirdly, the instrument provides dynamic incentives. To secure high repayment rates, micro financing programs begin by lending small size of loans and then increasing loan size upon satisfactory repayment. The repeated nature of interaction and threat to cut off loan in case of default is used to overcome asymmetric information problem and improve efficiency of loaning. Therefore, these incentives motivate high recovery rate and low default rate. For instance, the recovery rate for Grameen Bank is above 90 percent. Similarly, in Pakistan, the recovery rate for NRSP is also above 90 percent.

Fourthly, the cost of borrowing is lower for the clients. As no physical collateral and other formal requirements are involved in the loan procedure, transaction cost is lower for the borrower. Similarly, it is also believed that the rate of interest paid by the borrower in these schemes is lower than the interest rate charged by local moneylenders in their areas.

Some Shortcomings of the Microfinancing

With all the above advantages, however, microfinancing is not free from shortcomings. New empirical evidence from across the countries suggest that microfinancing is probably not well suited for all segments of the poor. The instrument has limitations regarding the targeting efficiency, financial and economic sustainability and potential for growth in the economy.

In Bangladesh, for instance, only a one fourth of micro finance clients are hard-core poor. In East Africa the main clients are not the poorest but vulnerable non-poor, those who have assets to escape poverty but can easily become impoverished again. Currently released UNDP Report (2000) writes that “the hard-core poor, having few assets, are reluctant to take on the risks of credit, and when they do, it is usually for emergencies and consumption not for production”.

Even the minimal collateral requirement, like social collateral and the one fourth pledge of the loan amount, potentially excludes the poorest practically from micro financing schemes. Shahidur R. Khandher, one of the leading experts on micro financing, in his book “ Fighting Poverty with Microcredit: Experience in Bangladesh”, also writes that “some poorest of poor, who are eligible for credit do not receive credit”. One of the main reason for the often exclusion of the poorest from these schemes may be that poor are less visible, very shy and often live outside main stream of the economy. Similarly, the eligible ultra-poor lack human capital and tend to not borrow from the microfinancing programs. Therefore, the main beneficiaries of these schemes are more likely to have some skills and collateral and thus to be willing to take the risk of engaging in small-scale entrepreneurial activities. These are generally not the poorest of the poor.

Micro finance schemes, contrary to the general perception that are self sustaining in generating resources for their operation, in majority of the cases, are highly subsidized. Subsidies play crucial role for institutional development and survival of micro lending because of high cost of groups lending, community mobilization and training to poor to make them credit worthy. Jonathan Morduch in an influential article, “ The Microfinance Promise”, The Journal of Economic Literature, December, 1999, also argues that many of these institutions are offering subsidized loans to households, have continued to need subsidies to survive

Even the legendary bank in micro financing, Grameen Bank, is subsidized and depends upon donor funding. If the bank had to rely only on income from lending and investments, it would have instead suffered losses of $34 million between 1985 and 1996. If the bank selects financial sustainability or a break-even strategy, it would have to increase interest rate above 30 percent. So, the majority of the micro financing schemes are mainly dependent on the donors subsidized funding. Once the donor funding is over the future of the programs becomes uncertain.

Pakistan’s Experience with Microfinancing

The experience of the country in microfinancing is not different from the above countries. The NGO’s working in the micro financing are facing the same issues of poor targeting, dependency on the donors, and low coverage of the poorest in the society. For instance, NRSP, is one of the largest lending NGO for microfinancing in the country. It is providing micro credit since last seven years in the different parts of the country. Its total disbursement is above RS. 2.0 billion. The number of its borrowers is over one hundred thousand. The majority of its borrowers, however, are not the poorest people in the country. The borrowers in the program are mainly the better off among the poor. The total coverage of the program is very limited. Even if every borrower in the micro credit program of the organization is considered poor, its total coverage of the poor in the country is just 0.22 percent of the total poor in the country.

If the entire network of NGO’s, who are providing micro finance in the country, is taken into account, the total number of their borrowers is hardly one million. It is just above the 2 percent of the poor section of the population in the country. Therefore, the coverage of microfinancing schemes is very low in the country.

Majority of the NGO’s mentioned above who are providing microfinance are either receiving funding from the government or donor agencies. Their main source of income are these sources and, not from their own activities. The organizations are not able to achieve self-sufficiency at the present level of their operations. Therefore, the problem of sustainability persists with these schemes.

Viability of the Proposed Microfinancing Bank (MFB) in the Country

In the light of the above scenario the establishment of the proposed microfinancing bank (MFB) in the country raises many doubts about its effectiveness to reduce poverty, sustainability to survive in the long run, and opportunity cost of resources diverted from other potential projects towards the MFB.

The banking sector in the country has a long history of poor targeting and high default rate in the economy. The past experience of cooperative societies in the country is also that of a disaster. Million of rupees were lost in these schemes on the name of credit. Mainly their borrowers as well as defaulters are from the high-income group and influentials in the society.

An evaluation of the pilot project for micro financing of the National Bank of Pakistan (NBP) for the future establishment of the proposed MFC is also not very encouraging. The bank does not have any mechanism to identify the poor regions and poorest in the country to provide micro credit. There are no poverty profiles that can indicate, which regions are the poorest and which villages or localities are severely impoverished in different provinces of the country. Therefore, the loans are mainly provided on the basis of subjective criteria which increases the chances of poor targeting of the scheme.

Similarly, the bank does not have the experience, culture and environment for providing microcredit to poor in the country. The procedure for credit and collateral requirements of the bank are so complicated that it not only excludes the poorest from the scheme but it also increases the chances of leakage in the scheme. In fact, during a field visit by the author in one of the pilot project areas in Sindh, it was observed that the bank borrowers are paying extra charges/commission for receiving the inputs from the bank recommended dealers.

Ironically, there is neither women staff nor woman borrowers in the pilot project area of NBP, whereas one major objective of the program is “the empowerment of women through micro financing and women should be 33% among the borrowers”..

Conclusion

Micro financing has claimed more and more of the aid from donor agencies and government budgets, however, it may not always be the best way to help the poorest. The fervor in microcredit may siphon funds from other projects that might help the poorest more. Even if micro financing is worth supporting, it should not be a sole instrument to reduce poverty. The poorest of poor may not participate even if they are eligible.

Therefore, there is need for government and donor agencies to study if the poor gain more from the more small loans than from other anti-poverty programs, like, food for work program (FFWP), health care, and physical and social infrastructure in poor regions of the country etc. The role and potential of macro economic policies for creating suitable institutional environment for equitable economic growth to reduce poverty and improve welfare of society should not be under-estimated. The ‘ new magic’ of micro financing schemes in the country can only complement the process of high and equitable growth.

(The author is an economist at Social Policy & Development Centre, SPDC).