Comment on Microfinance-BECKER

I applaud the granting of the Nobel Peace Prize to Muhammad Yunus and the Grameen Bank. Sure, reducing poverty has at most an indirect connection with peace by encouraging democracy. Still, the Peace Nobel prize has often been so political- it is different from other Nobel Prizes since the Peace Prize is awarded by the Norwegian Parliament- and frequently of such dubious merit, that it is a welcome change to have the Prize given to someone who has really helped the very poor of the world. Yet, all economists who have studied microfinance agree that it will never be more than a minor factor in ending poverty in any country. Economic growth requires secure property rights, encouragement of private enterprise, openness to international trade, stimulation of education, limited and sensible regulations, and reasonably honest government. Microfinance makes only a small direct contribution to any of these variables. However, microfinance does accomplish something useful, and that is how it should be evaluated. So far microfinance has been mainly oriented toward women, although itthat is not necessary. It started in the primarily Muslim rural areas of Bangladesh, where women had great difficult borrowing money in any way to earn income as tiny scale entrepreneurs. Study of several of these programs suggest that in fact payback rates have been high since borrowers have been subject to great social pressure to repay, they have few alternative ways to borrow, and because of other factors. These studies also suggest that women who borrow gain bargaining power within their families. This shows up as an increase in the education of daughters and also sons, greater spending on medicines, and on women's assets, like gold, in families that have women who borrowed under one of these programs. These programs are usually quite flexible, and sometimes approach the equity type loans that Posner advocates. If someone is having trouble repaying debt due to no fault of her (or his) own, microfinance lenders, as well as other lenders in these communities, often wait until times get better, instead of demanding all payments be made on time. In effect, microfinance often work out to be loans with returns that are quite sensitive to how well borrowers do. Microfinance has spread to rural parts of non-Muslim countries, and these loans too are primarily given to women. Evaluations of the effects of loans in non-Muslim countries also show high repayment rates, and that female borrowers repay at higher rates than, and generally outperform, male borrowers. So loans in other countries appear to have similar effects as in Muslim countries like Bangladesh. I do not believe there is much of a puzzle about why commercial institutions have not made such micro loans. For one thing, enforcement of repayment by any particular borrower from the group of all borrowers in a local area was originated by the Grameen Bank, and would not be easily copied by for-profit banks and moneylenders. But even if commercial lenders could have the same high repayment rates, these loans have not typically earned the rates of return required by commercial lenders in poor countries. The Grameen Bank and other groups active in making micro loans have had some financing from NGO's that do not seek to make commercial returns on their spending. So my belief is that despite the seemingly "high" interest rates on these loans, they have earned returns, adjusted for servicing, risk, and other costs, that are below market interest rates in their respective countries, If private groups want to make gifts to rural women in poor countries, making them through micro loans is a much better way than many alternatives. Loans at considerable interest rates aid donors select among a huge number of persons who believe they deserve help. For by requiring recipients to engage in productive activities that yield enough returns to pay interest and repay principal, micro loans in effect choose to help those with ideas and a willingness to work hard. What is a better way to choose among too many people who are really poor? In my judgment, it is always better as far as possible to reward people who try to help themselves. The focus on women may be a good starting point in many countries since they have entrepreneurial ideas, and yet often have great difficulty in borrowing commercially, or even from their families. Still, one risk here is that the apparent borrower is a woman, but the real borrower is her husband, brother, or father, and she is simply a front for them. Moreover, many men in poor rural areas also have great difficulty getting access to funds, so these programs should include many more male borrowers as they grow in scope. Individuals like Pierre Omidyar, one of the founders of eBay, has made a $100 million contribution to Tufts University for that university to invest in profit-making microfinance programs. I share his apparent belief in the principle that competition among for-profit firms is the best way to organize and allocate resources in an economy. It may be possible to get a fully for-profit sector that has large resources, and makes the small micro loans pioneered by the Grameen Bank. I hope so, but the many for-profit moneylenders and banks in poor countries in the past did not manage to make such small loans at rates that were both profitable and appealing to borrowers. So I am not convinced that his vision and that of some other American entrepreneurs will be successful. But their vision of harnessing incentives from the for-profit sector is the right way to try to improve microfinance.

Comments

[JonathanC]

The issue is not just whether these microlenders have "earned the rates of return required by commercial lenders in poor countries" -- many microlenders earned very high rates of return. The problem is that microfinance lenders can earn such rates only because they invest heavily in monitoring their loans (conventional banks don't have to monitor as intensively because their loans tend to be collateralized, and therefore the borrower retains an incentive to repay, even if the lender isn't poking about to check up on him weekly, as often occurs with microfinance).

The problem is that it is not easy to sell non-collateralized loan bundles (i.e. it is difficult for microfinance providers to leverage up, because outside lenders will be afraid that the microloans can very quickly lose value once they are in someone else's hands, in a way that is less likely to happen if those loans had been collateralized (which rely on third party enforcement and therefore can be collected more easily).
This is why private capital has remained very reluctant to invest heavily in microfinance, even in the face of apparently quite high rates of return (except where donors and other third parties explicitly or implicitly have guaranteed such investments).
None of this is to say that private investors will always stay out, just that it's really a lot harder problem to solve than to just ask the microfinance lender to raise rates or lower costs to improve profitability.

[Chicagoer]

Perhaps in the future you could look into the new $5 Million Prize offered by Mo Ibrahim for African leaders who exemplify good governance. I would very much like to know your economic analysis of the incentives of such a prize

http://news.bbc.co.uk/2/hi/uk_news/6086088.stm

[michael webster]

Could someone explain to me how:

a) the micro loans have high interest rates, but
b) the loans are compatible with the Islamic prohibition on usury?

[david stoker]

The interest rates may seem high by our standards but some of these women were previously paying upwards of 300% interest a year. The loan sharks or suppliers keep them in a kind of bondage. For example, you could have a woman who buys supplies from a man at a price he sets and on condition that she sells any products she makes to him, and so, without other options and even if the profit at the end of a day is only 50 cents, she still enters into the business transaction. But such a system keeps the borrower in perpetual bondage to the supplier.

Another reason the rates are high is the high cost of operations. Microlending takes the banking to the people, literally-- a loan officer traveling from village to village on a dirt bike to handle colllections or disbursment on 50 dollar or 100 dollar loans. It is a time consuming, staff intensive operation and extremely costly in terms of cost per transaction or per dollar lent.

In regards to the usury, my understanding is that Yunus was able to get around the Islamic prohibition of usury by selling the 'interest' as a kind of communal sharing cost so that the program could be extended to their fellow countryme. And considering it is a social venture and all profits are retained I don't think selling it in those terms is necessarily misleading.

I also think you will see more involvement of the capital markets and various bidding systems, maybe something like prosper.com, that will drive the interest rates down.

[ralph]

Interest rates charged by micro-credit institutions reflect the high transaction costs often involved in such activities. To service clients are that are rural, credit officers need to traverse large areas, and collect payments on a daily, weekly or monthly basis. All transactions are in cash and conducted face to face. Institutions looking to be involved in the economic development of a country need to achieve financial sustainability to access commercial credit, freeing them from donor dependency. Compared to other possible lenders for this type of client, rates are very good; moneylenders can charge interest rates that make repayment of the capital impossible.

Part of the problem (IMO) of the ‘microfinance movement’ is its stated aim of targeting the “poorest of the poor” - those with access to sub-US$1 a day. These individuals are the most susceptible to economic upheaval, and who find a change in living circumstances (illness; death; loss of a job) the most detrimental. Loan repayments can here become crippling. Further, in areas without a minimal level of money already circulating in a community, clients find no buyers for their products. No use making sugar cane juice if no one has the money to purchase it.

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