Are Microcredits really the Rock Stars of International Aid?

There are more problems in the Third- World than we can count: Poverty, child mortality, lack of democracy, low education, corruption, HIV, Malaria, hunger, lack of gender equality, crime… These are heavy problems that need to be solved in order to achieve a world worth living for our future generations.

Reducing extreme poverty is one of the most important UN millennium goals.
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The problem is: There is no magical pill that can cure poverty. And that makes fighting against it very frustrating and long- winded.

Since the 1980s microfinance and microcredits play an important role in international aid and the fight against poverty. The concept sounds good in theory, but that does not necessarily mean it works.

The aim of my post is to explain the major idea of microcredits, to present businesses that developed from this trend and to present the opinion of experts on this field as well as current issues and challenges.

  • What is the major idea?

    First of all, one has to distinguish between microfinance and microcredits:
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    Microcredits are small loans given to poor people to start their own small business. They become “microentrepreneurs”, start to generate income and improve their living situation. The amount of a loan can vary between several dollars or even several thousand dollars, depending on the country and the type of business.
    Microfinance comprises a broader set of services like insurance, savings and money transfer. Micro Finance Institutions also offer non- financial services for microentrepreneurs such as education in healthcare and environmental protection.
    You can find a short video explaining both here.

    The idea came from Muhammad Yunus, winner of the Nobel Peace Prize in 2006 and founder of Grameen Bank.
    In 1976, he worked as an economics professor at Bangladesh’s University of Chittagong. In the close village Jobra he met a young mother that made bamboo stools by hand to earn money. The problem was that she was too poor to buy bamboo herself which would have cost twenty- two cents. She had to borrow it from merchants who set their own prices as a part of the deal. As a result, she only earned two cents from every stool. Yunus realized that once she had twenty- two cents to buy bamboo on her own, she could set the prices like she wants to and then could earn much more. So he lent the money to her out of his own pocket. This is how he got the idea to give people like this young mother small loans so they could start their own businesses.

  • Who hands out microcredits?

    Microcredits are handed out by monetary financial institutions (MFI) aka banks or credit institutions.
    The State of the Microcredit Summit Campaign Report 2006 from Sam Daley- Harris states that worldwide 3,133 microcredit institutions provided loans to 113.3 million clients.

    The most famous example for a MFI is the Grameen Bank founded by Muhammad Yunus. Instead of the conventional banking where the people get credits who are creditworthy Grameen Bank created a banking system based on mutual trust, accountability, participation and creativity, as they say.
    But there are many other MFIs, like Acción International and Opportunity International. Many of these non- profit organisations are ranked by myphilanthropedia, an organisation that evaluates the organisation’s work to improve the effectiveness. The list of the top- ranked organisations can be found here and the non- ranked list here.

    • The two sides of the medal

      As good as all of this sounds in theory, there are always two sides of a medal. I found out many critical points during my research and want to present some of them now:

      Do MFIs have too high interest rates?
      MFI have around 27% interest rate per year which appears to us very high. Could it be that the MFI are not as social und unselfish as they claim to be?
      The MFIs justify the high interest rates with high operation costs, for example for borrowing the money from banks, for collecting the money and for covering the risks they take. The MFIs also stress that local borrowers want much more interest than they do, so it is better for the people to get a loan from a MFI.
      But as studies proved, the really poor people do not take the risk of getting a loan, because they know if they cannot pay it back, their situation will be worse than without the loan.

      Does a high reimbursement rate really measure success?
      The MFIs proudly present their rates of reimbursement, because they are surprisingly high. For example in 2004 in Morocco the five largest MFI recorded a reimbursement rate of 100%. Rates of over 95% are very common. And today, there are 100 million people receiving microcredit loans from more than 3,000 institutions.
      This sounds very good at first, because we automatically think that the people are able to pay back the loan because they successfully earned enough money to do so.
      But the academics Datar, Epstein and Yuthas argue that MFIs often lend money to groups. If one member of the group is not able to pay back the loan the others have to make up for it. This causes more suffering for every group member and the one with the default has to fear the anger of the others, sometimes even violence. There are even cases of suicide because of that.
      In conclusion, one cannot say that high reimbursement rates measure the success of a credit.

      Are micocredits a good weapon in the fight against poverty?
      Well… To answer this, one would need clear evidence of the impact of microfinance. The problem is that there is generally a lack of evidence like this. There is often no data whether an aid helped or not.

      Cynthia Kinnan, Abhijit Bannerjee, Esther Duflo and Rachel Glennerster propose to use randomized controlled trial techniques, which is same approach that is used to test new medication, so they can compare a group of people who used such a loan to a group of people under identical conditions who did not use a microcredit. The resulting data could deliver the needed evidence.
      The findings were published in April 20013 in a report you can find here.
      To summarize the report very shortly, microcredits does not “paint a picture of dramatic changes in basic development outcomes for poor families,” according to Kinnan.
      The results maybe will disappoint some people, but the truth is that most things just need their time. And the test was “only” carried out for three years.

      Abhijit Bannerjee concludes: “Poverty has been with us for thousands of years. If we have to wait another 50 to 100 to eradicate it, so be it.”

      Aneel Karnani, School of Business, asserts that a surer way to end poverty is to create safe jobs in bigger companies and to increase worker productivity, rather than to promote micro- entrepreneurship. Find his article here. The UN Development Programme agrees:

 

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