The Maturation of Microfinance

By David Lepeska

Sudden, awkward growth spurts, new and unpredictable forms of self-expression, and acts of rebellion against authority figures? It can only mean one thing: microfinance has hit puberty.

Under attack from analysts, academics and policymakers who argue that microloans rarely help alleviate poverty, the industry is redefining itself in myriad ways - going corporate, moving upmarket and broadening the very meaning of the term.

"Ten years from now the sector will be considerably less recognizable," said Jonathan Morduch, professor of public policy and economics at New York University's Wagner School of Graduate Studies.

A Poverty Killer Is Born

Modern-day microcredit began in 1976 when Muhammad Yunus - then an economics professor at Bangladesh's Chittagong University - left academia, went to the village of Jobra and lent $27 to a group of 42 villagers. They used the money to start soap-making and basket-weaving businesses and repaid their loans without default. Yunus then founded Grameen Bank, which grew exponentially and, as of April 2008, had lent over $6.5 billion to more than 5 million borrowers, with a loan repayment rate of 98 percent.

Then came the deluge. The United Nations declared 2005 the "International Year of Microfinance." Yunus won the Nobel Peace Prize the following year for his work with Grameen. Philanthropic moguls like Bill Gates and Pierre Omidyar, of Microsoft and eBay, respectively, pledged hundreds of millions of dollars and celebrity supporters appeared as if out of thin air. The global microfinance market doubled between 2004 and 2006, when more than 3,100 microfinance institutions lent nearly $4.5 billion to over 130 million borrowers.

But what do microloans accomplish? Within academic and economics circles, an anti-microfinance movement, building for years, came to the fore in early 2008.

"Microcredit is making people's lives better around the world," George Mason University Economics Professor Tyler Cowen argued in the Winter 2008 Wilson Quarterly, in an essay written with Karol Boudreaux, a senior research fellow at George Mason University's Mercatus Center. "But for the most part, it is not pulling them out of poverty."

What Microloans Can Do

Microloans typically range from $50 to $500 in developing countries, with no collateral. Relying instead on peer pressure to ensure weekly repayment, microfinance institutions lend to groups of borrowers. Women make up over three-fourths of microcredit customers worldwide, the United Nations estimates, because most MFIs see them as more reliable and more focused on responsible family financing. And 70 percent of microlending is in Asia, although the share of Africa and Latin America is on the rise.

Several studies from the past decade have concluded that microloans improve lives: Barbara MkNelly and Chris Dunford report that two in three Bolivian borrowers saw their incomes increase after joining the lending program. An Indonesian study found microloan borrowers' incomes increased more than four times those of a control group that received no loan. Three-fourths of the clients of SHARE, a major Indian microfinancer, reported significant improvements in well-being and half graduated out of poverty.

Yet the exact impact of microloans on the lives of borrowers is extremely hard to determine. External factors such as a country's overall economic growth, an alteration in national policies, and the impact of other development projects in that region as well as shifts in a group or family's income-generating abilities are nearly impossible to quantify.

The problems with microfinance don't end there. Most MFIs charge monthly interest rates of 5-8 percent (or 60-100 percent annually) on loans that are paid off within weeks or months. This interest rate cuts into the profits an entrepreneur might re-invest. But even if they were to reinvest, several studies, including that of Cowen and Boudreaux, have found that the businesses microloans fund are almost always owner-run and unlikely to expand beyond the family.

"From a tiny, owner-run business to having and paying employees, that's a big jump," said Morduch.

Further, many MFI's will only fund an existing business, as opposed to a start-up, which suggests the business may have been sustainable without a microloan, and undercuts Yunus' argument that microloans create entrepreneurs.

Microloans are often used to finance consumption and domestic expenses. Cowen and Boudreaux found that many borrowers use the money on personal expenses - fixing their roof, sending kids to school, purchasing a mobile phone - rather than on a small business. A Tanzanian microlender told them that 60 percent of his loans were used to send kids to school and a study of microcredit in Indonesia found that 30 percent of loans were spent on food and other consumer goods.

"For better or worse, microborrowing often entails a kind of bait and switch," Cowen and Boudreaux wrote. "The borrower claims that the money is for a business, but uses it for other purposes."

The duo called it "a sad reality that many microcredit loans help borrowers to survive or tread water more than they help them get ahead."

Survival is better than the alternative. Most of the developing world's poor have for decades borrowed from unlicensed moneylenders. These profiteers charge annual interest rates of up to 300 percent. Many demand collateral and, if repayment is not made on time, reputedly resort to intimidation and violence. Monstrous moneylender debt has played a key role in thousands of farmer suicides across India. In comparison, microcredit seems a pot a gold.

But when it comes to creating jobs and broader economic growth, microloans fall short.

"If it's employment generation you're after, microfinance isn't going to give you a big kick," said Morduch, the New York University professor. He remains a supporter of micronfinance, but acknowledged, "these businesses really aren't growing."

An Upmarket Shift

In developing countries, large corporations receive investment funding from major banks while poorer borrowers have access to microcredit. Long left out of the action are the small and medium enterprises (SMEs) that create more than 60 percent of all jobs in the developed world, according to James Suroweicki, who writes the New Yorker's financial page. Analysts are increasingly pointing to this "missing middle" to jumpstart growth and many donors and banking institutions have started to move upmarket.

"Businesses that can generate jobs for others are the best hope of any country trying to put a serious dent in its poverty rate," Suroweicki wrote in a March column. "Sustained economic growth requires companies that can make big investments - building a factory, say - and that can exploit the economies of scale that make workers more productive and, ultimately, richer."

Aliya Khawari, a researcher at Germany's Hamburg Institute of International Economics, reviewed several microloan impact studies in 2004 and found that higher-income borrowers experience a greater income boost from the loans.

"This is because clients above the poverty line are more willing to take risks and invest in technology for the efficiency or advancement of their activities that would in turn most probably increase income flows," she reasoned.

Many have concluded that as loan size increases reinvestment and company growth will do the same.

"A good question is how far upmarket do you need to go to have business that are creating a lot of jobs," Morduch said. "I think you have to go pretty far upmarket."

The U.S. Agency for International Development, one of the first to lend to SMEs, didn't go very far. The agency established an SME program in Pakistan in 2003 and added a second a couple years later. Called Widening Harmonized Access to Microfinance (WHAM), the latter initiative provided consulting, training, and technology to commercial banks and MFIs and helped disburse nearly 40,000 loans and $16 million in three years. The loans ranged from PRs 40,000 to 1.8 million (approximately US$650 to US$32,000), with annual interest around 17 percent.

Shorebank International, which implemented the USAID program, vetted, selected, and then helped nine Pakistani lenders identify borrower businesses with the best potential.

"Do each of these small enterprises grow and start to build factories and become multinationals?" Gregory Chen, director of Shorebank International's Pakistan operations, asked during an interview with Devex. "Definitely not - most small businesses stay small businesses."

The loans are not necessarily intended to help the businesses build factories or create jobs by the hundreds.

"The goal is to make them more profitable, more efficient, it's sort of an intermediate goal, and that might lead to the next stage," said Chen, who has been studying the impact of microcredit for more than a decade.

The idea is that every borrower has an optimal loan size, which would improve operations and possibly lead to job creation.

"The goal of Shorebank and USAID at the end of the day is to help build sustainable economies and a big part of that is poverty alleviation and improving people's standard of living," he said. "Finding the right loan size is just a means to an end."

One group argues the right loan size is rather large, and is in fact not a loan at all. The Omidyar Network has teamed with the Soros Economic Development Fund and Google.org to create a $17 million firm that will invest in small and medium enterprises. The company, to be based in Hyderabad, India, will invest between $500,000 and $3.5 million in SMEs and work closely with the Base of the Pyramid Lab at the Indian School of Business, which has considerable experience with SMEs.

"We want to show that SMEs can be profitable investments," says the firm's Web site. "We will do this by focusing on lowering transaction costs, deepening capital markets to increase liquidity, and catalyzing capital for investment."

This description omits two traditional goals of microfinance: poverty reduction and job creation. Omidyar has long advocated microfinance as a profit-making commercial sector, butting heads with idealistic first movers like Yunus as a result. In 2006 he donated $100 million in eBay stock to Tufts University, his alma mater, for efforts to promote the commercialization of microfinance.

At least one observer questions the planned SME fund.

"I think they're ahead of the evidence on this one," Morduch said. "I'm happy to see the money coming in to the market, but we don't have the evidence to make an informed choice regarding loans of that size."

Microfinance Changes Its Stripes

With the impact of SME loans uncertain, many are working to making microfinance better.

"Microcredit is not a miracle cure that can eliminate poverty in one fell swoop," Yunus wrote in "Banker to the Poor," his bestselling 2003 book. "Combined with other innovative programs that unleash people's potential, microcredit is an essential tool in our search for a poverty-free world."

Some lenders have broadened the microfinance umbrella to include health care, education and other social services while financial services firms invested an estimated $4 billion in 2007, tilting the microfinance field towards commercialization.

Hussain Tejany, the president of Pakistan's First Microfinance Bank, the country's first bank geared towards microlending, applauds this development.

"Poverty alleviation involves a series of tools - microfinance is just one," he said. "Education and health are others; we try to get involved in all."

First Microfinance was one of the nine lending institutions in USAID's WHAM program. Yet despite moving temporarily upmarket, the company continues to grant mostly smaller loans: The firm's average loan size remains around PRs 16,000 (about US$250), according to Tejany.

"Yes, it is good to build businesses and create jobs," he said, explaining that First Microfinance subsidizes health care offers financial education to poorer borrowers. "But our goal is to strengthen those people involved in small businesses, so they become capable of taking care of their family first, then we look on to the wider community."

Tejany is particularly pleased with one recent statistic: the percentage of women in micro-borrower families that are involved in some sort of business has increased fivefold in the past two years.

"There's no doubt about it," he said. "The smaller loans are better."

Reducing poverty is not only about money; it is also about, as Nobel Prize-winning economist Amartya Sen put it, "expanding the real freedoms that people enjoy." Social and political freedoms, certainly, but more importantly the things many in the developed world take for granted - public safety, basic education, public health and infrastructure. Dubbed "microfinance plus," these more holistic initiatives are making considerable headway with South Asia MFI's.

One pioneer is Vijay Mahajan, who in 1996 founded Basix India to improve livelihoods of the rural poor.

"Mahajan started with something very simple," Morduch said. "Creating this holding company that has a microfinance element alongside a livelihood strategy, drinking water linkages, technical services - it's seeing microfinance much more broadly."

Mahajan and Basix are now held up as models of industry innovation.

A program in Orangi, Karachi's sprawling squatter settlement, has been setting an example for much longer. Begun in 1986, the Orangi Pilot Project's microfinance program has handed out 21,000 loans, averaging around PRs 12,000 (about US$90, at PRs 65 to the dollar) each.

"We've supported a wide variety of businesses and created hundreds of jobs," said Nylah Ghias, the program's co-director.

Today, the dirt lanes of Orangi - Asia's largest slum in terms of population and geographic size - are filled with wallet-making, flower-stringing, and embroidery businesses. Women and young men spend long days sewing sequins and bold designs into silk shawls. Twelve-year-old boys work four to five hours after school to supplement their family income. And the microfinance program is just a small part of the Orangi Pilot Project's broader mission, which includes sanitation, sewage disposal, education, and housing construction.

Ujjivan, another "microfinance plus" lender, is indicative of the booming and innovative microfinance market in India. The firm, which was launched with seed funding from the Michael & Susan Dell Foundation and Bellwether Microfinance Fund and lends to small groups of women in poor urban areas, opened its first branch office in Bangalore in September 2005. Less than three years on Ujjivan has 47 branches and 67,000 clients across the Bangalore, Calcutta and Delhi metropolitan areas.

"We realize that their needs can be unpredictable, so we offer alternatives," said Manoj Dwivedi, chief operating officer of Ujjivan's Delhi offices.

Ujjivan offers loans for businesses, emergencies, and A combination of business and family expenses. The firm also educates women on financial services and, with backing from Viacom, the entertainment conglomerate, has opened dispensaries and clinics in borrowers' neighborhoods. Further, Ujjivan is adding technical and vocational education programs across its markets.

"We insist our customers go to these dispensaries, where for prescriptions and check-ups doctors will not charge any fee," Dwivedi said.

Tip of the Iceberg

Many financial services and venture capital firms have stayed out of microfinance, primarily because it takes thousands of $75 loans to make the sort of profit a single $40 million investment might provide. But an unexpected nugget of data has emerged in recent years to change that dynamic: Small loans to the poor are generally more profitable for lenders than larger loans to businesses and wealthier clients.

"The return on investment for [investing in] smaller firms tends to be considerably higher," Chen said.

Higher interest rates and fewer defaults are partly responsible for profits nearly double those of loans to large businesses.

Chen added another reason: "Because they're poor these borrowers don't have an office - they're in their living rooms."

Commercial investment has come to the fore in recent years, as donors such as the World Bank and USAID are replaced by the likes of Citigroup, Deutsche Bank, and Morgan Stanley. And for good reason: Consulting firm McKinsey & Co. estimates that half of the world's 3 billion poor people still lack access to institutional lending and credit. Financial ratings firm Standard & Poor's says the market could expand 10-fold, to $150 billion in microloans.

Already, nearly 100 investment funds are buying equity in microfinance institutions, according to the World Bank-managed Consultative Group to Assist the Poor, a microfinance industry association. CGAP estimates that these firms invested $4 billion in the sector in 2007. Morduch has been told this number may be as high as $7 billion. Either way, the corporate dollars bode well for the industry's future.

"I think successful microfinance has to be commercial," Cowen said in an e-mail. "There just aren't enough charitable dollars to go around; there will always be hard cases but overall commercialization is the way to go."

Critics worry about the hefty profits some MFIs take from the poor. Mexico's Banco Compartamos, for instance, charges interest rates of up to 100 percent annually. A June 2007 report from CGAP faulted the bank's rates as well as profits of more than 50 percent.

Meanwhile, other initiatives have found ways to lower interest rates. India's Women's Initiative for Self-Employment is a social business that strives to break even by offering microloans at the shockingly low rate of one percent monthly interest. It has no office and maintains no automatic teller machines. Still, since Kiran Rawat founded the firm in September 2006, loans of IRs 4,000 to IRs 5,000 (US$100-125) have helped dozens of rural women run bakeries, dairies, and toy-making businesses.

"There's so much money going into microfinance," said Morduch. "The sector just doesn't have the absorbent capacity, so there's pressure to move the money somewhere."

Thus the rise of SME loans, social businesses and various versions of "microfinance plus," not to mention insurance and savings programs, technology initiatives that provide access to smart cards and banking via mobile phone. Morduch said much of the flood of cash was a result of Yunus' Nobel Prize.

"Ironically, it was meant to go into microfinance initiatives, but now it's going far beyond that," Morduch said.

With microfinance now backed by the deep pockets of corporate finance, such innovations and permutations will continue for the foreseeable future. Chen is all for such diversification.

"All these market segments are equally important in different kinds of ways," he said.

Chen remains focused on the boom in Pakistani microfinance. With the number of loans expected to double in the next two years, the sector is going to need qualified staff, and quick.

"We have 5,000 employees in the microfinance sector," he said, noting that Shorebank International is helping to establish training centers and assisting Pakistani institutions with recruitment. "We need 20,000 three years from now."

Who says microfinance doesn't create jobs?

-- posted on devex.com on 16 July 2008