Economics for Beginners: A Critique of Microloans

In this article we will examine whether microloans can simultaneously alleviate poverty and provide sustainable financial gains for MFIs (micro financial institutions) in developing markets.

More specifically we will focus on microloans which are small loans given to low-income individuals in developing markets to encourage self-employment and enterprise (Investopedia, 2016). These individuals would otherwise not have access to traditional financing. The motivation behind micro-financing is that entrepreneurship needs capital. Therefore, investment into individuals’ small businesses is necessary to achieve a profitable turnover (for example via the purchase of machinery or labour). Because the credit ratings of these borrowers tend to be low, microloans demand above market interest rates, making them appealing to investors.

There is a lack of credible academic evidence proving any poverty alleviating effects of microcredit financing (Walt, 2012). This isn’t to say that microfinancing has failed, it undoubtedly can help and has helped many individuals. Nonetheless, with £62 billion in current loans outstanding, microfinancing is not always what it is made out to be.

Microloans are provided predominantly by micro financial institutions (MFIs). Many entities including commercial banks and NGOs are regarded as MFIs as they provide microcredit services (Microfinance Info, 2016). A topic of much debate, this article will critically evaluate several aspects of microloans in their mission to simultaneously alleviate poverty and provide sustainable financial gains for MFIs.
 

Current Flaws of Microloans

Usage of loans

Firstly, borrowers living below the poverty line are less likely to invest in fixed capital such as manufacturing equipment or land rights. Instead, conservative microloans are often taken out to cover subsistence in the short-term and not to increase long-term wealth which means lower likelihoods of lenders receiving a positive ROI and borrowers becoming vulnerable to perpetual over-indebtedness and further poverty (Karnani, 2007). An estimated 90% of microloans are used for personal consumption rather than enterprise. As a result, microcredit has little impact on an economy’s relative development performance (Steve Beck, 2007).

Furthermore, microloans generally don’t reach the poorest segments of the population as MFIs are not willing to bear the costs and risks associated with such small loans. Studies also suggest that these segments are not even willing to participate in microcredit schemes as there is a fear of the formal institution and the consequences that can erupt from defaulting (Rodrigo Canales, 2013).

The audiences that microloans target also tend to be financially illiterate. With the opportunity to ‘get money now’ and pay later, these individuals tend not to have a plan with which to handle the money to generate wealth (Kazmin, 2010). Later, when borrowers cannot pay back their debts, their lending MFI can take legal action against them. Those in poverty simply can’t afford to legally fight back and consequently are subject to legal oppression. This emphasises the issues that accompany the demographic that microloans target.

Interest Rates

Another major flaw is the abuse of usury: lending money at unreasonably high rates of interest. For instance, private banks in Mexico provide microloans for low-income individuals at an APR of 50% - 200% (Hickel, 2015), these figures are a stark contrast to traditional, larger loans from commercial banks which generally charge an APR of below 20% (Keith Epstein, 2007). In this context, MFIs can be likened to loan sharks whom prey on desperate people to extortion significant profit, all under the guise of ‘economic development’ and ‘positive social change’. Borrowers may fall into a cycle of perpetual debt as they borrow more to cover previous loans, with the accumulating interest eroding their net worth. This is exacerbated when paired with the usage of microloans for consumption rather than enterprise as mentioned above.

In order to payback microloans at their often astronomical interest rates, borrowers often make compromises. In a survey of borrowers in Ghana, 54% postponed important expenses such as vaccinations, 18% reduced their food consumption and 5% had taken their children out of school in order to repay microloans (Center for Financial Inclusion, 2011). This implies that microloans can exacerbate rather than alleviate poverty. Some may argue that governmental bodies must impose interest rate caps in favour of social development. Several issues related to this decreasing of interest rates and their effects on both MFIs and borrowers will be discussed in the next section.

Auditing

On a national scale, it can be argued that many regulatory institutions operating in developing countries don’t have the capacity or resources to oversee and enforce regulation on all micro lending activity in an economy. Furthermore, external auditors often do not understand what auditing can and is supposed to achieve and leaves MFIs with plenty of space to manipulate accounts and lobby when corruption is rife (CGAP, 1998). This means less transparency and hence less scrutiny from auditing which leaves gaps in the market for inefficiencies and unfair exploitation.

Political Crises

Bolivia suffered from political turmoil between 2000 and 2005. As a result, MFIs such as CRECER and Promujer found it difficult to maintain stable connections with their markets and repayment of loans was difficult for borrowers (Practical Action, 2014) within the institutional voids that were created as a result of the crisis. Microloans are subject to large delays and unrecoverable defaults in developing markets which tend to be less politically stable than developed markets and thus regulation, auditing and legal systems are not as effective or efficient.

Other issues

Other issues associated with microloans include exchange rate risk, insolvency related to rapid expansion, abusive collection practices by some MFIs, ever-changing reporting standards which incurs additional costs for MFIs and political conditions, as seen in India by negative public opinion towards microcredit allegedly triggered by corporate greed, the neglect of social development and general bureaucracy involving lengthy legislation (Biswas, 2010).

Recommendations and Further Evaluations

Firstly, it can be assumed that increased regulation on MFIs leads to fairer terms and increased confidence in them by borrowers and thus has the potential to increase demand for microloans.

Interest rate ceilings are limits placed on the interest rates of microloans. At first this may appear to be the best imposition to help microcredit alleviate poverty as borrowers will be required to pay back less interest and thus have more money for themselves. However, interest rate ceilings will frequently lead MFIs to retreat from the market, or at least segments of the market, due to inability to cover operating costs (Brigit Helms, 2014) as their revenues are reduced.

In 2001, the Nicaraguan government imposed such a ceiling on NGO-MFIs who subsequently saw their growth fall from 30% to 2%, many of which left rural areas where risk and operational costs are higher. Similarly, the BCEAO in West Africa enforces a ceiling of 27%, which has led investigations to discover that most microfinance institutions are not financially sustainable due to the low interest rates they must charge. For example, of the 24 registered MFIs in Mali, 22 are not sustainable and are due to shut down in the foreseeable future (Brigit Helms, 2014).

Furthermore, interest rate ceilings often force MFIs to cover costs by introducing new types of fees (Brigit Helms, 2014), subsequently eroding the original mission of the caps and creating more and costlier needs for regulation of such fees.
We can thus deduce that interest rate ceilings do not always allow MFIs to continue sustainable operations or protect low-income customers and can reduce borrowers’ access to financial capital and services.

On the other hand, as successfully demonstrated in Ecuador, proactive national regulation can propagate development and remain profitable. This has been done my imposing an interest-rate ceiling of 30.5%, compulsory usage of a centralised credit bureau and deposit protection schemes to name a few (Sinclair, 2014).

Microloans summing to $50 million, which target micro-entrepreneurs, were provided by the Inter-American Development Bank (IDB) in 2011. The IDB estimates that this has fuelled the creation of 5000 jobs in the country while seeing no significantly negative effects on other MFIs or poverty. Ecuador has seen a 60% increase in credit availability to poverty stricken regions, with the total microloan portfolio increasing by over 405% since 2003 (IDB, 2011). Ecuador is more of an exception however, which is due to the resources at the disposal of regulatory bodies as well as socio-cultural aspects of borrowers who tend to be more educated than those in, for instance, sub-Saharan markets. Hence Ecuadorians may make better use of their credit via enterprise (Central Intelligence Agency, 2016) to generate wealth, payback lenders and therefore fulfil the microloan system which is in place.

An alternative solution involves no interest rate limitations and allowing markets to operate freely, leading to high competition and hence improved efficiency. Bolivia, Nicaragua, Cambodia and Bosnia have no interest rate caps, yet saw a decrease from an average of 57% in 1997 to 31% in 2002 in microfinance portfolio yield while MFI operating efficiency simultaneously increased by 50% over the same period. These are attributed to increased competition in the respective markets (Brigit Helms, 2014).

Some critics believe the answer is placing a focus on providing microloans solely to SMEs which are more capable than individuals of creating employment, paying taxes and operating in formal markets (Sinclair, 2014). This may provide MFIs with less risk, poverty-stricken demographics with more stable jobs and the national economy with more, auditable growth. Additionally, as part of the lending process, MFIs should insist on a set of clearly defined success measures (Steve Beck, 2007) via business plans such as income growth, payback periods and forecasted cash flows.

As technology increasingly penetrates developing markets and access to mobile phones, computers and the internet expands, the costs of monitoring, accessing and transacting microloans are likely to decrease. Furthermore via information and communication technologies, local intermediaries may be cut out of the lending process (Pm Rivière, 2013), allowing for direct, cheaper communications between tier 1 lenders and borrowers. This means that, alongside aforementioned factors, technology will aid the reduction of costs and may help in perpetually lessening poverty through microcredit.

Conclusion

To conclude, we can gather that micro-lending, although at times beneficial for both lenders and borrowers, suffers from numerous flaws. Primarily those concerned with the usage of microloans, the interest rates associated with them and their lack of regulation.

To combat aforementioned flaws, numerous suggestions have been discussed and critically evaluated. Interest rate caps have been more successful in some regions (e.g. Ecuador) than others (e.g. Mali) with their imposition changing market conditions for lenders which may lead to loss of financial sustainability, leading to the shutting down of MFIs and a subsequent loss of access to capital for low-income borrowers. What is essential for overall success is more regulation at a national level and more resources given to institutions that aid lending, auditing and mentoring in the microcredit process to transition the micro-lending economy to a more formal one. However, there are of course hefty costs associated with these resources and thus the financial sustainability of executing such practices is debatable.

As mentioned, an alternative course of action is to leave the markets to act freely. However, this is perhaps a long-term strategy aided by improvements in technology and technology access. In the short-term, this could lead to social detriment for borrowers living in poverty.

No consensus exists on the best way for microloans to be delivered and managed in order to both alleviate poverty and provide sustainable financial returns for MFIs. Nonetheless, development banks in some countries such as Ecuador are building an increasingly improved framework within which to operate. Ultimately, we can conclude that there are two major factors that will determine the future of microloans: borrower education and lender efficiency, both of which are expected to be ameliorated through the globalization and advancement of universal education and digital technologies.
 

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