Note: Just as I have been recovering from old age and wondering what I would do next for TQE, a marvelous manuscript that I had asked for ages ago came in. This manuscript is from my close friend, J.D. von Pischke, who is the world expert on microfinance. I first met J.D. many years ago when he worked for the World Bank and invited me to speak at a Quaker luncheon there. (I'll bet you didn't know there were Quakers in the Bank.) Later, he left them for KPMG, a prominent consulting body, and now well, I'll let him tell you. Jack
P.S. Here's a quote from Friedrich Hayek, who told it to Kenneth Boulding, who told it to me: "I tried old age but I didn't like it, so I quit."
by J. D. von Pischke
Microfinance is currently a popular means of helping the poor in poor countries and in the former planned economies. I have been involved in microfinance for many years, and currently serve as the Washington representative of a German group that sets up and manages microfinance banks and finance companies that serve microentrepreneurs and small businesses in 18 countries. (See ipcgmbh.com and imi-ag.com.) Several TQE readers have expressed curiosity about this field. This letter provides an overview, indulging in broad generalizations.
1. Microcredit means loans, which is how the business began around 1980, while microfinance means loans, savings facilities, money transfer (remittances), insurance, and other financial services used by the working poor. Microfinance institutions (MFIs) using the newer formula are now favored: the working poor need savings as much as they need credit.
2. There is no hard and fast definition of microfinance, other than that it is used by the working poor. The poorest of the poor are not the working poor, who usually have lots of other issues to contend with that loans will hardly alleviate. Many fear going into debt, knowing that their ability to repay is doubtful. Most MFIs avoid lending for start-ups, which are riskier than existing businesses. A microloan may mean $50 in Ethiopia or Sierra Leone, and $10,000 in Russia, because of differences in levels of development.
3. Microfinance is virtually always subsidized. Without subsidies, the only licensed, regulated MFIs would probably be credit unions. There are two approaches to subsidy: NGOs making tiny loans may be perpetually dependent on continuing injections of subsidy because they cannot or do not price their services to cover their costs. To them, microfinance is charity. In contrast, commercial MFIs making somewhat larger loans use subsidies for a few years to get underway, but then expect to cover their costs out of interest and fees paid by their clients. Official aid agencies (USAID, World Bank, etc.) have provided billions of dollars in subsidy for microfinance, have made many loans to MFIs and even invested in MFIs’ equity capital.
4. There are thousands of MFIs around the world. Excluding credit unions, fewer than 100 are commercially sustainable, not requiring continued subsidy. Possibly another 100 might become sustainable at some point. Sustainable MFIs account for a disproportionately large share of the industry’s total assets and loans made. The portfolio quality of the best commercial MFIs and some NGOs is better than most North American credit card portfolios, with arrears rates of less than 2% (calculated as the entire amount of outstanding loans on which one or more installments are overdue for 30 days or more, divided by the entire loan portfolio). About a half-dozen MFIs have more than a million clients, with those in Bangladesh and Indonesia leading the pack. Estimates of the size of the microfinance loan market vary widely, from $3 billion to possibly $12 billion.
5. It is difficult to get commercial banks to go down market into microfinance. Reasons for their reluctance include hierarchical decision structures that are costly and slow and therefore not suited to tiny loans, a preference for lots of collateral, a lack of familiarity with microentrepreneurs, and the impression that they will not use many other banking services. However, some banks and consumer finance companies are increasingly invading the realm of microfinance, using less costly loan analysis techniques that do not evaluate repayment capacity as carefully or precisely as MFIs do. Microlenders fear that this will result in overindebtedness, fuel financial bubbles and crashes (as occurred in Bolivia several years ago), and undercut microlending.
6. Interest rates on loans tend to be high, up to 40% or beyond in real (inflation-adjusted) terms. This reflects MFIs’ efforts to recover costs. It is also generally possible for MFIs to undercut moneylenders and other informal lenders. In Mozambique, for example, rates of 30% per month are charged by beer wholesalers lending to retailers. An MFI that I am associated with there opened its doors with loans priced at about 4% per month. Eager borrowers were not hard to find. High rates decline over time as inefficiencies are driven out of markets by competition. In Mozambique and elsewhere our banks’ activities play a significant role in this transformation, helping our clients and many thousands of others. In the meantime, our borrowers who repay promptly will be favored with lower rates on successively larger loans with longer repayment periods. Their transaction costs also decline. A borrower who has repaid promptly on two loans can usually get her third loan in less than 30 minutes, cash in hand. This is how financial markets are developed to serve those who have not had access to banks before.
7. There are two major lending methodologies, the trade term for how relationships with clients are structured. The first is group lending, involving loans to groups of 5 women as with Grameen Bank in Bangladesh, or groups of 30 as in village banking devised by FINCA, a US NGO active abroad. The feminist agenda and the romance of collective action make group lending attractive to the press and donors such as USAID and its constituents and to its counterparts in other rich countries. The second is individual lending the same sort that readers of TQE obtain from their banks or credit unions. As a very broad generalization, group lending is a subsidy guzzler, while individual lending is much less voracious but some group lenders are commercially sustainable.
8. Getting repaid is increasingly seen as an incentive issue. Group credit is secured by the mutual guarantee of group members, but there are hard and soft versions: the degree to which members are called upon to cover defaults by other members varies. Individual credit is often secured by collateral, but the cash value of the collateral and loan size are not necessarily closely related. Often a bicycle, set of tools, refrigerator, sewing machine or similar items that the borrower would not want to be without are pledged. Some joke that the best collateral for a microloan in Latin America is a TV set on the eve of the World Cup. MFI sustainability is increasingly seen as the best guarantee, because borrowers have incentives not to repay if they believe that they will not be able to obtain further loans.
9. There are two major approaches to the range of services provided. Minimalists offer financial services only, while maximalists also offer business development services and advice, and even maternal health and other rudimentary medical services, literacy, insurance, etc. The minimalists tend to be commercial, concentrating on an exacting agenda that will make them sustainable without subsidy, not wishing to have their energy pulled in different directions. The maximalists tend to be NGOs. By offering more services they can argue for and attract additional subsidies because they want to help their clients and enlarge their client base. The group credit methodology used by many NGOs imposes transaction costs on the borrowers, such as having to leave their places of business to attend group meetings. To maintain a loyal clientele, more services may be offered.
10. Microfinance rarely vaults a poor household into the middle class. Money alone can rarely do this, and at some point most successful microentrepreneurs become fully extended, using their energies to the fullest (and having hired all their trustworthy relatives). In other words, they have realized their capacity. Does this mean that microfinance does not lead to development, which is sometimes viewed as the accumulation of large enterprises and big projects? Microenterprise first of all creates employment, which is the best way to enrich households. The most common use of microcredit is in retail trade, followed by services, with relatively few loans for manufacturing and agriculture. Microfinance also enables tiny enterprises to grow. Loans are usually taken first to increase working capital, often inventory, and only later for investments in fixed assets such as machines, equipment and buildings. In certain cases loans may enable households to weather transitory food insecurity (e.g., going hungry) so that they do not have to sell household assets. Selling household assets may lead to chronic food insecurity.
12. The New Institutional Economics (NIE) emphasizes information and incentives as determinants of human behavior. The NIE has led to certain insights within the MFI group in which I work, which have enabled us to achieve good results. The largest threats are those that are beyond our control: for example, we took some hits in Haiti recently from plunder and weather. Of greater interest is governance of microfinance institutions. Our general conclusion is that ownership in the economic sense, which centers on which parties make the decisions that count, or who have the final say, is the most important element that determines MFI sustainability. Those having the final say should be those who will make the final decisions that add the most value. Our view is that institutions without real owners, such as NGOs (which have members instead of owners), are less likely to perform consistently well over the long run. NGO leaders may not wish to change the structures they control in ways that enhance commercial sustainability, which may ultimately mean the formation of banks that can obtain deposits to fund their lending operations. Likewise, commercial banks often seem to lack the incentives to dig in for the long run, preferring immediate profits. Our owners have to be patient investors who are committed to our target group of micro and small business clients, while also having to be subjected to the discipline of financial markets.
13. Finally, microfinance in the US and other rich countries bears little relation to that in poor countries and ex-socialist economies. The poor in rich countries are truly marginalized, and have a hard time competing in markets that are incredibly efficient. A lady in Bolivia can buy oranges from a stallholder in the morning, sell them on the street throughout the day, and make enough to survive. In the US, Safeway is just around the corner. Heavy subsidies are required for microfinance in the US. Some economists and welfare bureaucrats justify these by comparing these costs to those of keeping a family on welfare. For any given borrower, the cost to the agencies making microloans in the US may be several times the size of the loan that is issued.
Thank you for the very thorough discussion of microcredit. I learned a lot from it.
Janet Minshall, Anneewaukee Creek Friends Worship Group, Douglasville (GA).
Cheers to the two J's for a clear, instructive and dispassionate piece on microfinance!
Chuck Fager, Director, Quaker House, Fayetteville NC
Thanks, J.D., for writing this it has answered many questions that I've had in the past but not known where to go for explanations. What I'm curious about is whether there is an accessible market for individual American Friends to invest in microcredit? Or should we think of this when we're doing our charitable giving?
Ann Dixon, Boulder (CO) Friends Meeting (currently in Philadelphia).
The Author Replies:
Possibly this could be a question that could be posted and that I could answer in a future letter. Lots is going on on this front, and I will be attending two meetings in Germany in October and November that will provide some concrete answers that could be the subject of a future letter.
Steve Williams, a Friend from Washington (DC).
Thank you Jack and J. D. for the enlightening review of microcredit, its benefits and limitations. You have brought the debate of assisting those in developing economies out of the abstract into the arena of the practical and pragmatic.
Norval Reece, Newtown, PA. Meeting
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Publisher: Russ Nelson, St. Lawrence Valley (NY) Friends Meeting
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