A Market Proposal: Microfinance Pitfalls and Solutions

Graphic Design by Ming Dong

The BRB Bottomline: “Freedom from poverty is not free. The poor are willing and capable to pay the cost,” concluded a 1999 Reserve Bank of India taskforce on finance reforms. While that analysis might seem more at home in a Gilded Age drawing room than a modern boardroom, it reflects the core theory behind international economic development’s golden child: microfinance.

The worldwide craze for providing microloans to poor entrepreneurs began in the 1970s in Bangladesh when academic-turned-entrepreneur Muhammed Yunus came up with a simple idea: why not extend small loans to traditionally credit-unworthy individuals? The idea has since been adopted by the World Bank and United Nations to be rebranded as a singular solution for lifting rural communities out of poverty. 

Yet this optimistic view of microfinance as giving communities a rope to climb their way into the worldwide market has recently come under severe criticism, especially due to the theory’s ambiguous results. Microfinance, critics argue, encourages subsistence development over large-scale entrepreneurship, represents a potential debt trap for poor lendees, and introduces damaging neoliberal ideologies in vulnerable communities. 

I will argue that the criticisms levied against microfinance are broadly true and impede using microfinance as a reliable form of international humanitarian development. Within this context, however, I also suggest improvements in microfinance’s structural systems and how they can be coupled with large-scale welfare programs to create a truly formidable launch pad for impoverished individuals in developing nations. 

The Silver Bullet

In 1976 Nobel Laureate Muhammed Yunus founded the Grameen Bank in his native Bangladesh and began extending loans to female entrepreneurs too poor to provide credit-worthy collateral. Yunus’s idea, in effect, was to stimulate the economy through bottom-up financing that embraced a self-identified ideology policy of “distinct financial benefit for both borrower and lender through intensifying and expanding the market.” It seemed like the perfect solution: the poor would have access to credit, occasionally insured by community joint-liability and financial literacy programs, and the state would no longer need to provide a vast social safety net to encourage development. 

Microfinance was so perfect, it seemed, that by the 1990s it was the most financially supported poverty reduction instrument used by the World Bank, and it continues to be hailed as a kind of silver bullet solution to development problems in poor rural regions. For his part, Yunus received the Nobel Prize in 2005 and went on to declare, “Bangladesh will be free from poverty in 2030,” an ambitious claim given that the Asian Development Bank states 24.3 percent of Bangladeshis continue to live under the poverty line. 

Nevertheless, with cash flowing in, whether from a 500 million USD pledge from the Gates Foundation or from the estimated 30 billion USD in microfinance grants that were extended between 2000 and 2007, microfinance became the natural answer for proponents of community-based development. A 2015 Report by the United Nations cited independent analysis that the microfinance industry had grown by 1,300 percent between 2002 and 2012, with an increase in gross portfolios from 600 million USD to 8.4 billion USD. Microfinance, it seemed, had struck a chord with wealthy investors, national governments, and multilateral financial institutions (MFIs) alike, and underrepresented laborers in developing nations stood to collect the windfall.

Promises Unfulfilled

 Stop the story there, and microfinance sounds like the singular success in a long history of politically-motivated and economically-disastrous development projects. The reality, however, is that while microfinance has enjoyed good PR and financial support, its results are mixed, and it comes with collateral issues that are often left unaddressed. One internal report commissioned by the British Department for International Development (DFID) in 2011 went so far as to say, “the current enthusiasm for microfinance is built on… foundations of sand.”

Foundations of Sand: Perhaps the most damaging criticism of recent microfinance policy is that its lending practices target the wrong type of rural development. As Milford Bateman, perhaps microfinance’s most outspoken critic, put it succinctly, “microfinance is entirely geared up to supporting the wrong type of farming activities and units.” His claims are based agricultural research suggesting medium-size farms produce less economic waste than subsistence farms and provide higher wages than the profits reaped by subsistence farmers. The fact that small farms receive the majority of microcredit but have insufficient scale to maximize benefits is what Dr. Thomas Dichter called in a 2007 report the microfinance paradox: “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 instead need larger amounts with different (often longer) credit terms.”

In a 2007 paper Dr. Aneel Karnani cited similar concerns over microcredit’s economic structure, stating, “Microloans are more beneficial to borrowers living above the poverty line than to borrowers living below the poverty line.” Karnani’s argument rests on basic financial principle: wealthier investors with more collateral are more willing to take risks that yield higher benefits. A middle class investor is more likely to be able to afford the education and technology needed for competitive entrepreneurship, and most micro-creditors “would gladly take a factory job at reasonable wages if it were available.” Without the extra capital needed to make full use of microloans, many borrowers use loans to fulfill more immediate needs.

Giving Just Enough Rope: A system whose design supports subsistence borrowing rather than development naturally results in disillusioned and debt-burdened lendees who find in microfinance a replacement for, not a solution to, predatory lending. The left-wing writer Alexander Cockburn put it more bluntly: “No one was ever liberated by being placed in debt.”

In a 2006 investigation sponsored by the government of Andhra Pradesh, India, the state charged microfinance lending institutions with “behaving worse than moneylenders” by actively using predatory practices and inflated loan rates to reduce default in communities. Unfortunately, the money was being used by lendees in much the same way as predatory loans had been previously. Cockburn notes that in Andhra Pradesh, the average microloan amounts to 130 USD, while even the smallest plot of farmland sells for 2,000 USD. So if the loans aren’t being used to fund land acquisition or other large capital investments, what are they being used for?

Enter consumption smoothing: a little known but deeply damaging aspect of institutional microfinance. A 2007 article on the pitfalls of microdevelopment describes consumption smoothing as a state in which credit is used for sustaining basic livelihood: food security, clothing, rent, and education. Loans are often repaid through triangulated borrowing and “overlapping,” a process that can quickly devolve into self-inflating debt and inevitable loan default. 

Default doesn’t just mean large creditors don’t get their payouts. An alarming number of suicides and deaths amongst borrowers have been attributed to the stress microlan debt imposes on families and individuals. In a stunningly horrific example, “Mylaram Kallava, 45, hanged herself from the ceiling of her mud hut in the village of Ghanapur after she defaulted on four micro-loans amounting to $840.” Default can also mean an inability to participate in community life and a loss of status: the equivalent of social suicide in many tight-knit, rural communities.

Dollar Diplomacy Returns: If a faulty economic model and potentially fatal poverty trap weren’t enough, critics argue microfinance is also a fundamental instrument of insidious neoliberal policies designed to open underdeveloped rural markets to the global economic system. 

Bateman, unsurprisingly the strongest proponent of this view, argues that the World Bank and other MFIs encouraged the profitization of microfinance institutions until, “by the early 1990s, the commercialized microfinance model was firmly established as ‘best practice’ and the only acceptable definition of microfinance.” The conclusion: microfinance has been reimagined from its altruistic roots in the 1970s to become a full-scale “cost-recovery model”: a system that seeks to reap economic profits and that often quantifies poverty as a commodifiable good for sale on the market, an argument famously made by Dr. Ananya Roy’s Poverty Capital.

According to this view of microfinance Western lending banks picked up microlending as a development alternative to state-sponsored social initiatives and slowly discredited other social programs in developing nations. Microfinance then filled the poverty-reduction vacuum while conveniently expounding Western liberal ideals of personal ambition and faith in capitalist markets. The poor would get financial support, but it would come at the cost of adhering to the liberal, profit-maximizing model of investment Western democracies needed to hear before they would invest.

The problem is most rural and impoverished local economies are not prepared to transition to the type of market-based economic models neo-liberalism requires to operate effectively. One of the primary reasons for this is the issue of “saturation:” flooding the economy with low-yield capital enterprises that minimize profits at all levels. According to Bateman, the end result of saturation in small communities is not the predominance of the market, but rather “the growth of unregulated informal sector competition has inevitably ended up being regulated instead by those with power, connections and muscle.” Unfortunately, but not unsurprisingly, rural economies in India cannot sustain the same market-structuring models of, say, the modern British economy.

Escaping Microfinance’s Whited Sepulcher

After such a long diatribe against microfinance, it might seem hard to find any benefits in the system. But the reality is that microfinance, despite all its flaws, shows promise as a development strategy. The greatest shortcoming of modern credit is its inability to extend loans to ambitious individuals lacking the necessary collateral. Microfinance fixes that problem. But, while microfinance fills a gap in the international financial system, it is not a “silver bullet” for poverty reduction. For that, state-sponsored social initiatives must return to the forefront.

In a comparative analysis of microfinance and a universal basic income as poverty reduction models, Dr. Ayten Davutoğlu noted, “Unlike microfinance, a basic income suggestion centralizes and priorities social rights in poverty combat.” State initiatives, by virtue of being publicly funded and directed, tend to come with fewer strings attached and provide a broader range of support mechanisms than microfinance. A basic income, for example, helps to eliminate crediting for consumption smoothing while still providing capital that can be used at individual discretion.

Unfortunately, the neoliberal draw of microfinance as a market solution to capital has rolled back many state initiatives in rural areas. Beginning in the 1990s, India aggressively scaled back state lending practices, purposefully creating a credit extension vacuum filled by microfinance.  Dr. Stephen Young argues the scale back encouraged a cultural paradigm shift in which “The failings of development banking were implicitly attributed not to the absence of broader socio-economic reforms… but to the moral irresponsibility of poor people who chose to default.” 

Undermining state lending institutions,  Bateman claims, was part of a long-term initiative by the US Agency for Development (USAID) and its allies at the World Bank to “neo-liberalize” poverty development by replacing state-initiated development and lending programs with market based and, sometimes, for-profit alternatives, as advocated by a group of American scholars in the 1970s-80s known as the Ohio School. The result: a disintegrating state system, which had effectively supported rural poverty reduction in many developing countries since the 1950s, replaced by a small-scale, experimental development strategy.

The answer to current issues of microfinance seems relatively straightforward then: balance. Scaling back the scope of microfinance by restoring state lending’s preeminence will reduce the corrosive role of neoliberalism, minimize cyclical debt, and direct development in the direction of broad-based economic growth. A realistic understanding of microcredit’s limits and an appreciation for state intervention can, in tandem, correct some of the myopia associated with poverty reduction strategies.

Take Home Points

It’s difficult to find fault with a program designed to help the most overlooked and disadvantaged members of the worldwide economy. And it’s easy to sit and despair over the long-term economic frailty or ideologically-loaded perspective of microfinance when a one week $100 loan at 26 percent interest may be all that stands between a mother putting food on the table and watching her children starve.

The reality is, microfinance is not an inherently bad idea. In fact, it’s an inherently good one. The history of finance has been a history of the wealthy extending loans to the wealthy for the purpose of expanding their wealth. Microfinance’s imaginative approach to inventing good credit through social collateral and debt pooling is a consequential step toward prosperity and access for the world’s poorest people. 

But where microfinance has lost its way is in defining its role in poverty alleviation. Neoliberal advocates and MFIs in the 1990s took up the mantle of a good idea and decided to encourage replacing state safety nets and social programs with a “pull yourself up by the bootstraps” mentality of the struggling entrepreneur. But economies are not made of entrepreneurs; they are made of workers, and poverty is not alleviated through credit alone but through the combination of access and policy.

To right this miscalculation, microfinance needs to be situated into its proper place within the international development system: as a lender of last resort, a symbol of opportunity, and a launching pad for ambition. Let the state handle the rest.


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