Article The changing value of money

Microfinance: a very costly myth

In the 1970s economist Muhammed Yunus lent a little over $120 to a handful of poor women in a small village in Bangladesh. It enabled them to kickstart their own businesses, earning enough money to ameliorate the grinding poverty they had been in. This early success inspired Yunus to set up the Grameen (village) Bank in 1983 so that he could lend money to thousands more poor people in Bangladesh, offering them a route out of poverty, and the modern concept of microfinance was born. Today, Grameen Bank has assets equalling nearly a billion pounds and the bank, along with Yunus, was in 2006 awarded the Nobel Peace Prize “for their efforts through microcredit to create economic and social development from below”. Microfinance and microcredit have been heralded by many in the international community as the most viable solution to poverty with Yunus himself proclaiming that poverty would be eradicated by 2030.

Yunus’s initiatives struck a chord in Washington, with influential figures such as Bill and Hilary Clinton endorsing it. And why shouldn’t they? Those early success stories seemed to prove the underlying narrative of capitalism; the discourse that anyone can make it if they help themselves and work hard. That irresistible tale of rags to riches. Not only that, the achievements of microfinance were a perfect example of the market solving the problems of development and poverty, a fundamental tenet of the neoliberal paradigm that was taking hold in the 1970s.

Of course, all this seemed to conveniently ignore the other irrefutable law of neoliberalism, that profit comes before everything. The neoliberal order was only too happy to endorse the idea of microfinance because it offered a golden opportunity to make vast profits from previously unreachable markets, whilst at the same time providing the feel-good factor that it was helping tackle poverty. The Grameen model was taken and had Wall Street principles applied – high-paid executives and bonus culture as a means of making microfinance institutions ‘more efficient’. With this transformation, the social development side of microfinance was marginalised in favour of commercial viability, and the goal of poverty reduction became little more than a positive PR campaign.

It’s been nearly four decades since the inception of microfinance and microcredit and the industry has ballooned, with over 100 million people now using microloans and over 7,000 organisations offering microfinance services. But in that time there is still little to no evidence that microloans have had a significant impact on poverty. In fact, there is a growing belief that microfinance – and microcredit in particular – is actually making things worse. “The fear is that significant financial flows are flowing out of the poorest communities,” says Milford Bateman, former fellow of the Overseas Development Institute, “rather than being retained and recycled within them to underpin productive investment as the precursor to an escape from poverty”.

It’s not really hard to see why. Debt and credit are two sides of the same coin, and it seems that far from being used to set up thriving businesses, microloans are often being used for “consumption smoothing” i.e. helping to pay for essentials or emergencies. In the case of using microcredit to cover an emergency, a second – even higher interest – loan from a local loan shark is often needed to cover the repayments, causing a dangerous spiral of debt which leads to destitution and the selling of belongings.

Even in cases where the loans are used to start businesses, repayments generally have to start being made within just seven days of the loan being taken out. What successful business do you know that has started turning a profit so quickly? By virtue of their poverty, the receivers of microloans are high-risk clients for banks, and as such, interest rates reflect this. Global interest rate averages for loans from normal banks, especially in developed nations, are around the 13% mark. For microloans, interest averages 35% globally, with rates as high as 125% in Mexico. Professor of Economics at Cambridge University, Ha-Joon Chang says “they’ll never get out of poverty because when you have to pay 30, 40, 50, sometimes 100% interest rate, what business makes that kind of profit?” According to a study carried out in the Indian State of Tamil Nadu, 99% of microenterprises set up with microloans in the region had failed within three years.

Because the borrowers of microloans have few assets, and rarely have history of credit, banks stipulate that borrowers come together in a collective, the group provides the bank with collateral. If one member defaults, the other members of the group have to pay their instalment for them. Microloans often also come with the stipulation that the borrower holds their savings with the lending bank, effectively giving large companies complete control over the finances of impoverished communities. The system is very effective, because in addition to the threat of losing their belongings, a defaulter is also subject to immense pressure to pay their debts by the rest of the community who might otherwise have to pick up the slack, or face losing their savings. Rather than increasing cooperation between the members of the community, this leads to a climate of fear and distrust.

Aside from the fact that microloans are actually generating substantial profits for big banks, the very notion of microcredit as an alleviator of poverty has some fundamental flaws. In reality, microcredit predominantly provides some short term income opportunities for a lucky few but in the medium to longer term it can be seen as a barrier to sustainable development. The majority of microenterprises set up with microfinance provide simple goods and services within the local community. These goods and services will reflect what is available in the area and as such the more microenterprises that are set up in any one community, the more saturated the market becomes, and supply begins to outstrip demand. This can cause a downward spiral, or ‘race to the bottom’ with vendors forced to drop prices, in turn wages drop and there is less income to be reinvested in the community.

The other gaping flaw of microcredit is that it seems to completely disregard economies of scale. With its quintessentially neoliberal focus on the individual producer, the concept of microcredit is seemingly oblivious to the fact that almost every successful modern enterprise or organisation relies on harnessing and coordinating the differing attributes of a large group. The one-person microenterprises fostered by microcredit simply cannot compete in a global marketplace with huge multinationals, and as such, are forced to charge pitifully low prices for their goods and services. Small-scale subsistence farms are actually hugely inefficient and thus microcredit can be seen to be diverting vital funds and resources away from long-term sustainable projects, in poor countries where they are so vitally needed for development.

Finally, as Thomas Dichter so concisely puts it: “The microcredit paradox is that the poorest people can do little productive with the credit, and the ones who can do the most with it are those who don’t really need microcredit, but larger amounts with different (often longer) credit terms.”

Given these glaring fundamental flaws and lack of credible evidence that microfinance actually alleviates poverty on any significant scale, it does really beg the question why it has been heralded as such a poverty panacea? This attitude is epitomised not only by Yunus’s Nobel Peace Prize but also by the fact that the UN made 2005 the ‘International Year of Microcredit’. The answer, as with so many powerful myths, is down to the fact that the proponents of microfinance, Yunus in particular, tell a very compelling story with inspiring, if isolated, examples. But the exceptions do not prove the rule.

What’s more, not only is the story of microfinance compelling, it works in perfect harmony with the dominant paradigm of neoliberalism, and as such, has lots of influential backers. What we must now do is tell equally convincing stories about more sustainable solutions to global poverty: like a global minimum wage; enshrining workers rights, such as holiday and sick pay; providing low-interest credit to cooperatives that harness collective power and work with, not against, economies of scale; and fostering development that works for the benefit of the poor, not the already wealthy.

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