In 2002, Lize, a widow with 5 children, was unable to work for three months due to illness. When she recovered, many of her fishing nets were ruined. Lize decided to apply for a loan with Hluvuku-Adsema Fundo de Credito Male Yeru…Since then she has been granted four loans, the first one in January 2003 for a total of around US$260… With these basic financial services, Lize’s commercial activities recovered allowing her to support her extended family of sixteen members and start building a new concrete house. In addition, her company has generated four permanent job posts, seven temporary ones, and supports the business of self-employed women that buy her fish to sell in Catembe and Maputo.
This story is typical of those used to promote microcredit: the practice of providing small loans to the global poor who don’t have access to existing lending services. Microcredit is a type of microfinance, which includes a variety other financial services provided on a small scale. Microcredit is an intuitively appealing idea, especially for market-oriented people: the global poor can lift themselves sustainably out of poverty, all they need is some capital to start a business!
And it seems to have become one of the most popular ideas in charity. 2005 was named the ‘Year of Microcredit’.The microcredit charity Kiva has over 800,000 lenders, the highest possible rating from Charity Navigator, and was endorsed by Oprah… The 2006 Nobel Committee boldly claimed that microcredit “must play a major part” in ending global poverty.
Recently, however, criticism of microfinance has been growing. And that’s a good thing, because it’s far from proven that microfinance, on average, has any positive effects at all.
1) It’s not clearly shown that microcredit makes people better off
Major studies of microfinance struggle to demonstrate causation. The conclusion of Duvendack et al. is typical: “it is widely acknowledged that no well-known study robustly shows any strong impacts of microfinance.”1
Randomized control trials, which can potentially overcome this problem, tend to find that microcredit has little or no benefits.
There have been few studies, but two of the major ones didn’t find any effect. A study in the Philippines found that people provided with microfinance didn’t believe they were any better off. 2 A study by JPAL found that although more businesses were started in the area, there was no effect on business profits, female empowerment, health or education.3 Clearly more research is needed, since this is counterintuitive result. But so far, despite the hype, there isn’t good evidence that microcredit has large benefits.
2) Microcredit is not free or sustainable
Microfinance is attractive because you can loan people money, they pay it back, then you can loan it out again, and again, and again. Or so the story goes.
In reality, microfinance charities incur substantial operational expenses and if the lending occurs at below full interest rates, then it’s more like a cash transfer in disguise. It costs Givewell’s top recommended microfinance charity, the Small Enterprise Foundation, $128 per client served.4 At $5 per net, this is enough to protect about 40 people from malaria.
3) High ‘repayment rates’ can be seriously misleading
The major microcredit charities typically advertise repayment rates over 97%. But there’s no clear definition of what this means. Common definitions of the loan loss rate are often something like “loans lost” divided by “loans outstanding”. This means the measure will be inflated by simply increasing the number of loans outstanding. Since most microfinance institutions are growing, this figure is typically inflated. See GiveWell’s excellent article, and a more recent one for more.
4) A substantial number of borrowers seem to be harmed by the loans
By surveying MixMarket.com, Givewell found that 20-40% of clients drop out of microcredit schemes. It’s unclear why, but the evidence that exists suggests that it’s very unlikely to be success. The most common reason, at around 30-50% of drop outs, seems to be “business failure.” It’s likely that some of these borrowers end up worse-off than they were before they took the loans.
5) Microcredit doesn’t seem to be the best type of microfinance
It’s much less sexy, but one randomized control trial showed that providing zero-interest savings accounts increased investment and how much money people were able to spend.5
Against conventional microfinance wisdom, a study also found that providing consumer loans (loans to buy goods, not for starting businesses) in South Africa increased income and employment.6
This is only two studies, so we can’t draw strong lessons from them. Nevertheless, the evidence we have suggests that microcredit is not the most promising area of microfinance.
Conclusion
Instead of living up to the hype, microcredit is full of myths. There isn’t much direct evidence that it improves welfare. At best, we have some reason to think that microcredit is a service people want, since they often pay considerable amounts of interest for the loans. So, we’d expect it to be doing some good overall. But it’s not a service that seems to have particularly large social returns compared to the other services one could sell to the global poor. A lot more research is needed. In the meantime, it seems that microcredit charities would have more impact by shifting towards consumer loans and microsavings.
Thanks to the Giving What We Can Research Team for collating some of these studies
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References
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Duvendack M, Palmer-Jones R, Copestake JG, Hooper L, Loke Y, Rao N (2011) “What is the evidence of the impact of microfinance on the well-being of poor people?” London: EPPI-Centre, Social Science Research Unit, Institute of Education, University of London, p.2. (Commissioned by DFID)
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Karlan, D. & Zinman, J. (2009) “Expanding Microenterprise Credit Access: Using Randomized Supply Decisions to Estimate the Impacts in Manila” Yale Economics Department, working paper 68, p. 18
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Banerjee, A. Duflo, E., Glennerster, R., & Kinnan, C. (2009) “The miracle of micro nance? Evidence from a randomized evaluation” MIT Department of Economics and Abdul Lateef Jamal Poverty Action Lab
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“Cost per borrower: 128 (USD)” Cost per borrower = (Operating Expense / Average Number of Active Borrowers). Mix Market, “Small Enterprise Foundation MFI Report.”
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Dupas, P. & Robinson, J. (2009) “Savings Constraints and Microenterprise Development: Evidence from a Field Experiment in Kenya” NBER Working Papers 14693, National Bureau of Economic Research, Inc.
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Karlan, Dean and Jonathan Zinman. 2007. Expanding credit access: Using randomized supply decisions to estimate the impacts (PDF). Economic Growth Center Discussion Paper 956. New Haven: Yale University.
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Comments
I’ve heard many reports that microloans are typically used as a way of ‘saving down’ for significant consumer purchases to avoid the temptation to spend savings before they build up (e.g. http://www.econtalk.org/archives/2011/04/munger_on_micro.html). By helping them commit to saving, this is likely to incrementally improve people’s lives, but it won’t lead to much higher incomes. And as you say, can be addressed with savings accounts, or rotating savings and credit associations, rather than charity.
Hi Ben. Thanks for this - it’s really interesting. Mohamed Yunis always says he got the idea for the Grameen bank by looking at how poor people in a village he was involved with would go to loan sharks, and the horrible impacts that would have. Maybe the benefit if microfinance is less about improving people’s welfare, and more as a safety-net that stops them going to loan sharks when disaster strikes. I wonder if this is considered in the research.
Agree with all points, but might add some more:
6) There is mounting evidence that MF encourages parents to withdraw their children from school to work in “micro sweat-shops”.
7) Interest rates are insanely high, often over 100% and occasionally over 200%. Do we really expect the poor to accumulate wealth while paying such rates (although MF investors may)? Kiva may have won some awards, but they don’t even publish interest rates charged to the poor. In fact, no such P2Ps or microfinance investment funds publish these rates. Why not?
8) Even when a micro-business grows, to what extent is this simply displacing another person in the market? When Wal-Mart opens a new store local mon-and-pop stores may close, surely the same happens in MF?
9) Chronic over-indebtedness is the #1 facing the sector according to the 2012 Banana Skins report. There is too much, not too little capital in the sector.
10) The funds and P2Ps are extremely opaque, and relying predominantly on nice photos and stories as suggested here, with very little hard data to actually enable a potential investor to make an informed decision, relying on the hype and emotion of the “idea”. Why the US and European regulators permit such companies to take money from their general public while the rest of the financial services sector have to comply with far more stringent rules of disclosure is a mystery to me, but demonstrates how far up the fanaticism for MF reaches.
11) The self-regulatory initiatives are a joke, funded by insiders, are ineffective in practice, permit membership of some of the worst offenders in the entire sector, and are pure window-dressing designed to reassure naive investors that all is well and maintain the flow of funding into the “miracle cure”.
Not all MF is nonsense, but the good guys are needles in a haystack, while the shady guys are wolves dressed in sheep’s clothing, and unless you know exactly how to distinguish between the two, I would advise extreme caution investing in this sector for anyone with a trace of social motivation. If you simply want to exploit the poor via extortionate loans immune from any regulatory scrutiny, then this is the best sector on Earth.
Hugh Sinclair Author, Confessions of a Microfinance Heretic - How Microlending Lost its Way and Betrayed the Poor
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