Is Microfinance the Universal Poverty Reduction Tool?

Written by: Maggie Winding

Microfinance and micro-loans have, since their conception, been hailed as a “miracle tool” for alleviating poverty in developing countries. Many, however, myself included, remain unconvinced that microfinance is necessarily “the solution” to resolving the vast disparity in economic achievement that many nations face. Therefore, as a deeper exploration of this topic, this article seeks to achieve two purposes: define microfinance through an explanation of its origin and context, as well as analyze its global impact as a means of supporting underdeveloped countries’ economic advancement.

Although the idea of microfinance was first introduced in the 1970s, widespread awareness and implementation of the new banking method didn’t really occur until the early 2000s. At the same time that microfinance began gaining global recognition, Thomas Barnett, a planner for the Pentagon, published a book called The Pentagon’s New Map in which he illustrated the staggering economic gap between nations. Barnett’s map divided the world into two clear zones: “The Functioning Core”, and “The Non-Integrating Gap.” He defined “The Core” as the “heartland of successful and peaceful integration into economic globalization,” while “The Gap” was defined as the zone of countries and communities who have failed to integrate. He created the map to raise awareness of the issue, going so far as to argue that “disconnection defines danger.” As such, remedying these ‘disconnections’ should be an absolute priority. As is clear on the map below, nations represented within the bounds of “The Gap,” are also widely considered “third-world,” or underdeveloped by the international community. 

Recognition of this global economic inequality spurred the conversation of how to help assimilate the countries in “The Non-Integrating Gap,” into “The Functioning Core.” Enter microfinance. The ultimate idea behind the concept, as described by Beatriz Armendáriz and Jonathan Morduch in their book The Economics of Microfinance, is increasing “access to small-scale loans, savings accounts, insurance, and broader financial services in poor and low-income communities. Microfinance theorists’ bet is that access to microfinance can offer powerful ways for the poor to unlock their productive potential by growing small businesses.” Thinking more broadly, the more individual citizens become successful, the greater the stimulation of local economies, the larger the nation’s GDP becomes, and the closer it moves into “The Functioning Core.” Success? Not quite. While the idea certainly holds promise, it is by no means a panacea that can be expected to work everywhere, for everyone.

As with any debate, there are, of course, counter-arguments to be made. Microfinance has been presented as somewhat of a win/win scenario in the global landscape. People living in poverty are given access to loans to start a business and increase their personal capital, lenders make a profit from loan interest rates. Unfortunately, most win/win situations do not leave everyone completely satisfied, and the realm of microfinance is no exception. There are several reasons why corporations and investors have chosen not to participate in the phenomenon of microfinance and micro-lending.

Firstly, many perceive the risks of such investments to be too great. Armendáriz and Murdoch explain “the principle of diminishing marginal returns to capital, which says that enterprises with relatively little capital should be able to earn higher returns to their investments than enterprises with a great deal of capital. Poorer enterprises should thus be able to pay banks higher interest rates than richer enterprises. Money should flow from rich depositors to poor entrepreneurs.” By this logic, global investors can expect greater profit returns by investing in countries with less capital, like those within “The Gap,” rather than in places like New York, Beijing, and Tokyo. If this indeed the case, then why aren’t more investors channeling their funds into impoverished countries? The answer is risk. “Investing in Kenya, India, or Bolivia is for many a far riskier prospect than investing in U.S. or European equities, especially for global investors without the time and resources to keep up-to-date on shifting local conditions.” While investing in poorer countries does hold potential for a greater profit return than an investment in a developed country, many investors still choose not to, because doing so requires not only a financial commitment but a large time commitment as well. Being that the political and economic atmosphere in these low-capital countries is exceptionally volatile, ensuring a good profit return requires extreme vigilance in monitoring any and all hazards to the financial climate. As such, many companies, unwilling to make such a large temporal and monetary commitment, forego the risky investment and opt instead for a “surer” bet in a larger city.

Secondly, lack of information on the credibility of borrowers, and their inability to produce collateral significantly reduces a bank’s willingness to serve poor communities. The problem occurs “when banks cannot easily determine which customers are likely to be riskier than others. Banks would like to charge riskier customers more than safer customers in order to compensate for the added probability of default. But the bank does not know who is who and raising average interest rates for everyone often drives safer customers out of the credit market.” If there existed a low-cost way that banks could elicit information on their clients to identify which customers are secure and most-likely to repay their loans, then that would greatly reduce the uncertainty banks feel in lending to people in low-capital markets, allowing them to be more participatory in microfinance practices. Congruously, if borrowers had marketable assets they could offer as collateral, “banks could lend without risk, knowing that problem loans were covered by assets.” As it stands, however, being that it is incredibly challenging for banks to find and evaluate information on potential borrowers and that citizens of these countries are not typically in possession of any assets of market value, most banks are unwilling to lend to poor borrowers. So the question arises: If banks would not lend to people living within the bounds of “The Gap,” how did microfinance gain traction?

When one thinks of microfinance, it is difficult not to associate the term with Muhammad Yunus, founder of the Grameen Bank, one of the most well-known micro-lending institutions in the world. In his book, Creating a World Without Poverty: Social Business and the Future of Capitalism, Yunus illustrates how the idea for the Grameen Bank was conceptualized. He says, “The first thing I did was try to persuade the bank to lend money to the poor. But the bank said the poor were not credit-worthy. They had no credit histories and no collateral to offer, and because they were illiterate they couldn’t even fill out the necessary paperwork. The idea of lending to such people flew in the face of every rule the bankers lived by.” In an effort to prove to financial institutions that investing in the poor was not radical or illogical, Yunus became a guarantor for loans to the poor. The bank would lend him money, and, in turn, he would lend it to the poor. Should there be any loan defaults, Yunus was responsible to pay them. During his period as a guarantor, not a single person was unable to pay back their loan in full. Despite these exceptionally promising results, banks remained unconvinced, still believing the plan to be fallible and illogical. Realizing that his persuasion attempts were futile, Muhammad Yunus “decided to create a separate bank for the poor, one that would give loans without collateral, without requiring a credit history, without any legal instruments” and in 1983, Grameen Bank was born. 

The introduction of the Grameen Bank into the financial sector had a dramatic effect on the investment industry, while simultaneously increasing impoverished women’s potential for upward socioeconomic mobility. One might ask, how are the two related? I’ll explain. When Muhammad Yunus began lending, he quickly discovered that women were more likely to pay back their loans, and were far less likely to abscond with money than male borrowers because of their familial duties and responsibilities. By loaning to women, Yunus could reduce lending risk while at the same time affording women the chance to expand beyond a simple domestic life and elevate their status in society. For women who live in places like rural Bangladesh, micro-loans offered an exceptionally attractive alternative to a strictly domiciliary life. 

To this day, the efficacy of microfinance as a poverty alleviation tool is intensely disputed; some people believe it has the capacity to dramatically alter the financial status of communities, while others think microfinance lacks the profit potential for investors, and therefore will not succeed. As with most ideas, no one method is a panacea that will work everywhere, with no negative repercussions. That being said, however, microfinance appears to be one of the best tools of our day to combat global poverty, and help assimilate countries from the “Non-Integrating Gap” into “The Functioning Core.”