By Nikhilesh SinhaOn
‘This ain’t no upwardly-mobile freeway. This is the road to hell’ – Chris Rhea

Microfinance has become something of a buzzword in the last decade, and while it was something that most people in the development space had knowledge of by the turn of the century, Muhammad Yunus’s Nobel in 2006 was a definite sign that it is an idea whose time has come. More importantly it was recognized as a mechanism which promotes development and that is an effective poverty alleviation tool. I propose to put forward certain arguments which challenge this assertion.

Firstly I will restrict the discussion to micro-credit, where small loans are given to groups of people, usually women, for a standard period, most often a month, at the end of which the group is responsible for repaying the loan along with interest. The interest rate varies but in India tends to be around 24%, or in village parlance, Rs 2 per 100 per month. The loans are fairly small, often no more than a few hundred rupees per individual. The idea is that these loans are advanced without collateral, and can provide access to millions of individuals who would not be eligible for bank loans. Additionally micro-credit provides an alternative to the often exploitative terms offered by the village money lender.

I have no quarrel with the financial access argument, and there is no doubt that millions of women across the developing world have had the opportunity to better their circumstances in the short run. My concern is about the long-term effects. I will argue that micro-credit may lead to long-term depletion of household assets, and that there is a potential for impoverishment as opposed to poverty alleviation.

The incredible thing about micro-credit is that the default rates are ridiculously low, The Grameen Bank in Bangladesh, famously reported a default rate of 1%. This means the groups returned the money (with interest) 99% of the time. This is a higher repayment rate than most commercial banks could ever dream of. Credit card companies would sell whatever they have left of a soul for such figures. The question of course is why does the money come back? The answer lies in the concept of group liability, and the fact that the group will not recieve a further loan until the first is repaid. What is very convenient is that all the monitoring is done by the groups themselves.

In order for an individual borrower to truly benefit from the loan it is necessary that she utilise the loan for a productive purpose, which generates a return of over 24%. Firstly several studies suggest that a large number of these loans are used for consumption rather than productive purposes. Secondly a return of 24% or over is a reasonably high rate of return. Venture Capitalists for instance expect an average return of about 25-30% on businesses. Only a fairly small subset of businesses achieve this rate of return. To return to the subject at hand, in cases where the loans are being used to smoothen consumption, or for business ventures which yield a less than 24% return, borrowers are actually economically worse off than before they took the loan. If this cycle repeats multiple times, we would see long term asset depletion. There is evidence to suggest that this happening in a disturbingly large number of cases.

Of course there are those cases where the picture is much brighter, in fact just the kind of picture we’d like to frame and put up in our hallway, especially if our organisation is trying to attract funds from some well-intentioned foreign agency. And these are the pictures we’d like to cling to. The cases where the borrowers are successful micro-entrepreneurs and have a business which yields enough to beat the 24% red line. Now micro-credit works much like any other form of credit, where you get rewarded for good behavior, and regular repayment allows you to get a larger loan the next time around. The problem is that most micro-enterprises aren’t scalable, and begin to exhibit decresing returns to scale quite early on. This means that with every additional investment in the business, the returns go up by a smaller and smaller amount, until finally there is a point at which investing more might actually yield less than the amount of the investment. We aren’t really concerned about that stage, our tipping point is the stage at which the yield dips below 24%. The truth is that most large businesses cannot predict when this will happen despite some of them paying management consultancy fees larger than the total amount of money disbursed by micro-finance banks across an entire state. For a village entrepreneur this is very very hard to foresee. Also the temptation to borrow a larger sum of money may overshadow the fact that returns are decreasing. So although many may pull themselves out of poverty through this medium, there are a large number who may never make it past, and those who do, may be undone by over-investment.

The next argument is a little more technical, but if you have suffered the author thus far, I would encourge you to delve in.

Credit is a somewhat strange commodity, with most goods, you pay for them before you consume them. With credit unlike with junk food, you can actually develop indigestion before you pay your bill. You use credit today and pay for it tomorrow. Actually in that it does have something in common with junk food. The interest paid is the price we pay for the benefit of being to be able to consume something we cannot yet afford. Now when we borrow money in order to invest it in a venture, we borrow on the basis of expected return, because there is always some amount of risk involved with any venture, or some chance that the venture will fail. Our ability to make wise investment decisions depends upon our ability to evaluate risk. A pertinent question to ask is how competent the average micro-entrepreneur is in perceiving and correctly evaluating risk.

There is another aspect to this decision-making process. Due to the fact that we derive the benefit from borrowing immediately, and pay for it later, our decision on whether to take the loan hinges on how we value the future vis a vis the present. Our appetite for instant gratification at the cost of future regret explains a large part of the sub-prime crisis, as well as a large number of marriages. In the case of a village woman, putting food on the table today is more important than the potentially crippling interest repayment that is to be made at the end of the month. This trade-off between present and future is determined by what is called the individuals discount rate, or tha rate at which she discounts the future. My assertion is that in many cases it may be rational for a micro-borrower to take a larger loan than she will be able to repay. Remember that the screening process is fairly basic, and conducted by peers who may be similarly predisposed.

The final factor which affects the investment choice of an investor is their attitude to risk. Individuals can be divided into three basic groups depending on their attitude to risk. Or to be more acurate there are three types of behavior based on response to risk, because the same person may display different risk behavior in different situations. For the sake of simplicity let’s assume that people always behave true to type.

1. Risk Averse
2. Risk Neutral
3. Risk Loving

Imagine you were given a choice between receiving Rs 100 or the ticket to a lottery where you had a 50% chance of winning Rs 200 and a 50% chance of geting nothing. Now for someone who is risk neutral the two choices are equivalent, she would be indifferent between the two. A risk averse individual would always choose the certainty of Rs 100, and a risk loving individual would always take the chance of the lottery. The reason that these categories are important is because risk behavior can have a profound effect on how the poor make investment decisions. We usually assume that borrowers are risk averse, which means that they always choose the option that involves the least risk. However I would argue that in fact the poor may be inclined to take high risks in order to improve their current situation, and in certain cases display risk loving behavior.

My contention is that a combination of a high discount rate, and a high preference for risk, would result in high rates of failure of micro-enterprises, and thereby a tendency for micro-borrowers to end up worse off as a result of taking the loan.

To sum up, a large proportion of micro-loans are used for consumption purposes, and in these cases the 24% interest payment leaves the borrower poorer. In cases where the the loan is used productively, many micro-enterprises may not achieve a higher than 24% profit margin, leading to a smaller but significant drain on the household. And of the cases where that margin is realised, lack of scalability could result in stagnation before the household is able to break out of the poverty trap. In addition I have outlined behavioral characteristics which induce micro-entrepreneurs to take potentially harmful risks with their borrowings.

I realise that this could be viewed as an alarmist perspective, but my intention is not to dismiss micro-credit as an evil institution. I believe that Dr. Muhammad Yunus’s innovation has changed the lives of millions for the better. However it is unwise to ignore the potential hazards of indiscriminate lending, and also perhaps premature to conclude that micro-finance will inevitably result in wide-spread poverty alleviation, and economic development. I suggest that there is scope for improving the mechanism and a need for redesign.