Does Microfinance Lead To Economic Growth?

Candace Williams PPE Tutorial Paper: November 5, 2007 Does microfinance lead to economic growth? Poverty and Access to Financial Technologies Lack of access to credit markets is a major reason why many economies cannot develop. In Latin America, over 360 million people lack access to basic financial institutions. Less than 10% of low-income households around the world have savings accounts. Financial technologies like credit, investment, savings accounts, and insurance are important because they are a form of investment or they protect investments by managing risk. Investment plays a key role in development. In the Solow Growth Model, high levels of saving (investment per worker) lead to faster output growth in the short-run (countries diverge over time). Changes in the amount of capital per worker change how productive workers are an in economy. For example, Singapore had a 40% saving rate and 5-6% GDP growth from 1960 – 1996. During this same time period, Kenya had a 15% saving rate and GDP growth of about 1%. Usually, the lesser-developed economies do not have access to financial technologies because perspective borrowers lack collateral; institutions do not want to pay high monitoring, screening, and enforcement costs; and because risks are very high in populations that suffer from severe illness, malnutrition, and low levels of education. Arguments for Microfinance: The Case of the Grameen Bank of Bangladesh Microfinance is a wide variety of economic interventions that aim to improve poor people’s access to financial technologies. The model of the Grameen (Village) Bank of Bangladesh is the most well-known and discussed model in the literature. Muhammad Yunus, a Bangladeshi economist who founded the Grameen Bank in 1976, won the 2006 Nobel Peace Prize. As of 2007, the bank has 7.3 million members in over 74,000 villages. Total assets are nearing $1 billion, the recovery rate is 98.4%, and profits are at $20 million. The distinguishing features of the Grameen model are joint liability, forced savings, and ‘non-financial products’ that aim to change the social and economic infrastructure of Bangladesh. Joint liability turns the access of future access to loans into collateral and creates social capital. Members are placed in groups of 5 – 8. A loan officer meets with the groups weekly and loans are disbursed on a staggered schedule over the course of a few months. Borrowers who have already paid off much of their loans as well as members who have not received loans have a large incentive to make sure that everyone in the group fulfills their obligations. Also, members automatically receive a larger loan upon repayment of old debts. All members must save $0.02 per week – these funds can be borrowed against in emergencies and fund human capital projects like scholarships, school improvement funds, and sanitation projects. Other non-financial products include group education and discipline. For example, all members must learn how to sign their name; memorize resolutions that encourage small families and education, prohibit dowry and child marriage, and praise sanitation and cleanliness; and practice calisthenics. Members have to sit in straight rows, chant, and participate in support networks. Another important element is that 97% of the borrowers are women. Arguments Against Microfinance: A Deeper Look at Grameen Studies show that the Grameen program does not change consumption (Khandker 2004). The same study also found that Grameen was responsible for a 1.6% decrease in moderate poverty and 2.2% decrease in extreme poverty in the 1990s. This means that it is responsible for over 40% of the reduction in poverty

Candace Williams PPE Tutorial Paper: November 5, 2007 during this time period. Other studies say that there are very small (but significant) improvements in health indicators and a slightly larger likelihood that children will attend school. Some studies note that noneconomic benefits, including self-esteem and social mobility for women, may be benefits of the program. Although these gains seem like a clear argument for microfinance, it is important to realize that billions of dollars have been spent on the microfinance in Bangladesh (Grameen Bank has disbursed $4 billion in the last 10 years). There is a very high opportunity cost for these expenditures: It is possible that a focus on water, sanitation, education, and other infrastructure developments may have a larger impact on poverty. Economist Aneel Karnarni argues that group microfinance will not alleviate poverty and that the opportunity costs are indeed too high. His first argument is that microloans decrease cash flows to the poor because of high interest rates (anywhere between 2 and 60%) and the fact that microloans help borrowers above and below the poverty line in different ways. Borrowers who are already above the poverty line are likely to take risks like investing in new technologies. These risks are necessary to increase income and consumption. Borrowers below the poverty line take out conservative loans with the goal of protecting subsistence activities like farming, weaving, and sewing. These enterprises own very few assets, have no paid staff, and cannot achieve economies of scale and are very inefficient because of their small size. Karnarni says that most of these enterprises fail and believes that the development stories of China, India, Vietnam, and South Korea provide the real solution to poverty: more jobs. The International Labour Organization calls micro-borrowers “own-account workers”: people who are not entrepreneurs by choice and work rather have a factory job if wages were available. Employment and increased worker productivity is the way to economic growth and poverty reduction. It seems like microfinance cannot increase worker productivity because borrowers’ businesses cannot achieve economies of scale, they often compete with many similar businesses in a niche market, and borrowers repay high interest loans. Grameen says that a traditional $100,000 loan to one savvy entrepreneur who sets up a garment business that employs 500 people has a higher probability of increasing economic growth than 500 $200 loans for women to set up individual sewing enterprises. Karnal argues that India’s growth rate is actually mediocre when the level of saving and employment is taken into account. He says that the average firm size is too small (less than 1/10 of the size of comparable firms in other emerging economies). Karnal says that markets are not enough and that governments must work harder to fulfill their duties toward people. He says that it is wiser for civil society, businesses, and governments to reallocate their investments to large enterprises in labor-intensive industries. Which has a stronger case: traditional investment or microfinance? Although microfinance projects may have impressive noneconomic gains, including empowering women and changing cultural norms that are destructive to equality, they are a means for subsistence rather than economic growth. I think that the banking and nonprofit industries have a lot to learn from microfinance: the developing world needs mechanisms that change the nature of collateral, decrease loan enforcement costs, and manage risk. That being said, I would rather see entrepreneurial loans go toward larger projects. Instead of funding 5 – 8 small projects in groups, we have to come up with a model that funds large community projects, but still has some form of joint liability or another way to manage risk and decrease the costs of investment. Until someone thinks of that model, I would rather promote loans to middle and upper-income entrepreneurs who start large businesses in labor-intensive sectors.