Microcredit is the newest silver bullet foralleviating poverty. Wealthy philanthropists such asfinancier George Soros and eBay co-founder Pierre Omidyarare pledging hundreds of millions of dollars to themicrocredit movement. Global commercial banks, suchas Citigroup Inc. and Deutsche Bank AG, are establishingmicrofinance funds. Even people with just a few dollarsto spare are going to microcredit Web sites and, with a clickof the mouse, lending money to rice farmers in Ecuadorand auto mechanics in Togo.
Wealthy philanthropists, banks, and online donorsaren’t the only ones fascinated with microcredit. TheUnited Nations designated 2005 as the International Yearof Microcredit, explaining on its Web site that microentrepreneurscan use their small loans to“grow thriving business and, in turn, providefor their families, leading to strong and flourishinglocal economies.” The Nobel Committee awarded the2006 Nobel Peace Prize to Muhammad Yunus andGrameen Bank, declaring that microcredit is “an evermore important instrument in the fight against poverty.”
All this enthusiasm for microcredit has attracted untoldbillions of dollars.1 Grameen Bank alone disbursed $4 billionin microloans over the last 10 years, and it now has 7million borrowers in Bangladesh. In India, about 1,000microcredit organizations and 300 commercial banks lent$1.3 billion to 17.5 million people in 2006, says Sanjay Sinha,managing director of Micro-Credit Ratings International in India.2 Worldwide, 3,133 microcredit institutions providedloans to 113.3 million clients, finds the State of the Microcredit SummitCampaign Report 2006.3
This fervor suggests that microcredit really must help thepoor. And many have made grand claims to this effect, includingYunus, who said, “We will make Bangladesh free frompoverty by 2030.”4 Somewhat less ambitiously, the State of theMicrocredit Summit Campaign Report 2006 states that “microcreditis one of the most powerful tools to address global poverty.”
Yet my analysis of the macroeconomic data suggests thatalthough microcredit yields some noneconomic benefits, itdoes not significantly alleviate poverty. Indeed, in some instancesmicrocredit makes life at the bottom of the pyramid worse. Contraryto the hype about microcredit, the best way to eradicatepoverty is to create jobs and to increase worker productivity.
To understand why creating jobs, not offering microcredit,is the better solution to alleviating poverty, consider these twoalternative scenarios: (1) A microfinancier lends $200 to each of500 women so that each can buy a sewing machine and set upher own sewing microenterprise, or (2) a traditional financierlends $100,000 to one savvy entrepreneur and helps her set upa garment manufacturing business that employs 500 people. Inthe first case, the women must make enough money to pay offtheir usually high-interest loans while competing with eachother in exactly the same market niche. Meanwhile the garmentmanufacturing business can exploit economies of scale anduse modern manufacturing processes and organizational techniquesto enrich not only its owners, but also its workers.
As these scenarios illustrate, a surer way to ending povertyis to create jobs and to increase worker productivity, ratherthan investing in microfinance. But before going into detailabout why it is better for an underdeveloped country to promotelarge enterprises, not microenterprises, let’s examine the theorybehind microcredit.
Microcredit 101
The microfinance movement addresses a basic yet devastatingglitch in the formal banking system: Poor households cannotget capital from traditional banks because they do not have collateralto secure loans, and traditional banks do not want to takeon the risks and costs of making small, uncollateralized loans.Without this capital, impoverished people cannot rise above subsistence.For example, a seamstress cannot buy the sewingmachine that would allow her to sew more clothes than shecould by hand, and thereby pull herself out of poverty.
Microfinanciers use innovative contractual practices andorganizational forms to reduce the risks and costs of makingloans, such as lending to groups, rather than just to one person.Some microcredit organizations give their clients more thanloans, offering education, training, healthcare, and other socialservices. Typically, these organizations are not-for-profit or areowned by customers or investors who are more concernedabout the economic and social development of the poor thanthey are with profits. The largest of these social purpose microfinanciersinclude Opportunity International, Finca International,Accion International, Oikocredit, and Grameen Bank.
In contrast to nonprofit organizations, commercial banks thatmake microloans typically provide only financial services.Indonesia’s Bank Rakyat, Ecuador’s Bank Pichincha, and Brazil’sUnibanco all directly target poor customers. Some large commercialbanks, such as the Indian bank ICICI, do not lenddirectly to individual microcredit clients, but instead workthrough small microfinance organizations.
Another innovation that many nonprofit microfinance organizationshave adopted is targeting women. At Grameen Bank,for example, 97 percent of clients are women because “womenhave longer vision [and] want to change their lives much moreintensively,” says Yunus.5 On the other hand, “men are more callouswith money.”6 Evidence indeed suggests that when womenretain control of microloans, they spend more on the health,security, and welfare of their families.7
A major selling point of microfinance is its alleged ability toempower women. Research shows that microcredit increaseswomen’s bargaining power within the home, centrality to thecommunity, awareness of social and political issues, and mobility.It also increases their self-esteem and self-worth.8 Yet microcreditalone cannot overcome ingrained patriarchal systems ofcontrol. In spite of having access to credit, some female microcreditclients do not have control over the loans contracted or theincome generated by the microenterprises.9 Overall, microcreditdoes empower women, but only in noneconomic ways.
Failures of Microfinance
Despite the hoopla surrounding microcredit, few have studiedits impact.10 One of the most comprehensive studies reaches asurprising conclusion: Microloans are more beneficial to borrowersliving above the poverty line than to borrowers livingbelow the poverty line.11 This is because clients with moreincome are willing to take the risks, such as investing in new technologies,that will most likely increase income flows. Poor borrowers,on the other hand, tend to take out conservative loansthat protect their subsistence, and rarely invest in new technology,fixed capital, or the hiring of labor.
Microloans sometimes even reduce cash flow to the poorestof the poor, observes Vijay Mahajan, the chief executive ofBasix, an Indian rural finance institution. He concludes thatmicrocredit “seems to do more harm than good to the poorest.”12One reason could be the high interest rates charged by microcreditorganizations. Acleda, a Cambodian commercial bank specializingin microcredit, charges interest rates of about 2 percentto 4.5 percent each month. Some other microlenders chargemore, pushing most annual rates to between 30 percent and 60percent.13 Microcredit proponents argue that these rates,although high, are still well below those charged by informalmoneylenders. But if poor clients cannot earn a greater returnon their investment than the interest they must pay, they willbecome poorer as a result of microcredit, not wealthier.
Another problem with microcredit is the businesses it isintended to fund. A microcredit client is an entrepreneur in theliteral sense: She raises the capital, manages the business, andtakes home the earnings. But the “entrepreneurs” who havebecome heroes in the developed world are usually visionarieswho convert new ideas into successful business models. Althoughsome microcredit clients have created visionary businesses, thevast majority are caught in subsistence activities. They usuallyhave no specialized skills, and so must compete with all the otherself-employed poor people in entry-level trades.14 Most have nopaid staff, own few assets, and operate at too small a scale toachieve efficiencies, and so make very meager earnings. Inother words, most microenterprises are small and many fail – contrary to the United Nations’ hype that microentrepreneurswill grow thriving businesses that lead to flourishing economies.
This should not be too surprising. Most people do not havethe skills, vision, creativity, and persistence to be entrepreneurial.Even in developed countries with high levels of educationand access to financial services, about 90 percent of the laborforce is employees, not entrepreneurs.15
The reality of microcredit is less attractive than the promise.16Even a stalwart proponent of neoliberal policies like The Economistis beginning to conclude that “the few studies that havebeen done suggest that small loans are beneficial, but not dramaticallyso.”17
Jobs, Not Microcredit
Microcredit is certainly a noble idea and a genuine innovationthat has provided some positive impact to its clients, particularlyto women’s noneconomic empowerment. It also helps thepoor during cyclical or unexpected crises, and thus reducestheir vulnerability.18 But the critical issue is whether microcredithelps eradicate poverty. And on that front, it falls short.
China, Vietnam, and South Korea have significantly reducedpoverty in recent years with little microfinance activity. On theother hand, Bangladesh, Bolivia, and Indonesia haven’t been assuccessful at reducing poverty despite the influx of microcredit.
The fact is, most microcredit clients are not microentrepreneursby choice. They would gladly take a factory job at reasonablewages if it were available. We should not romanticizethe idea of the “poor as entrepreneurs.” The InternationalLabour Organization (ILO) uses a more appropriate term forthese people: “own-account workers.”
Creating opportunities for steady employment at reasonablewages is the best way to take people out of poverty. “Nothingis more fundamental to poverty reduction than employment,”states the ILO. And the United Nations Development Programmeagrees: “Employment is a key link between economicgrowth and poverty reduction. Productive and remunerativeemployment can help ensure that poor people share in thebenefits of economic growth.”
Consider the patterns of poverty and employment overtime in China, India, and Africa, whose populations make upabout three-quarters of the world’s poor (see graphs on p. 39).Each region has pursued a different path to economic development,and the results so far have been markedly different.
In China, a large and growing percentage of the populationis employed in a job. At the same time, the percentage of peopleliving in poverty has declined significantly in recent decades.In Africa, a small and shrinking fraction of the population isemployed, and the incidence of poverty has remained unchangedduring the same period. India’s performance lies somewherebetween the two: The number of people in jobs has grownsome, and the number of people in poverty has shrunk a little.
Many people who have jobs in these regions are still stuckbelow the poverty line – the working poor. Whether anemployee is “poor” depends on her wages, the size of herhousehold, and the income of other household members.Increased productivity leads to higher wages, which in turn leadto employees earning enough to rise above poverty. That is whyit is not enough to create jobs; regions must also increase labor productivity through the use of new technology, managementtechniques, specialization, and the like.
When it comes to increasing labor productivity, India’s performanceis mediocre and the situation in Africa is dismal. Onereason for India’s poor productivity growth is that its enterprisesare often too small. The average firm size in India is less thanone-tenth the size of comparable firms in other emergingeconomies.19 The emphasis on microcredit and the creation ofmicroenterprises will only make this problem worse.20
It is possible for an economy to invest in both microenterprisesand larger enterprises. But governments need to prioritizedevelopment approaches that have a higher payoff. AsAmar Bhide and Carl Schramm wrote in The Wall Street Journal:“Governments in fragile states have only so much political capitaland capacity. So it is crucial to proceed in a disciplinedsequence.”21
The State’s Responsibilities
Poverty alleviation cannot be defined only in economic terms;it is also about addressing a much broader set of needs. AmartyaSen, the Nobel Prize-winning economist, eloquently arguesthat development can be seen as a “process of expanding thereal freedoms that people enjoy.”22 Social, cultural, and politicalfreedoms are desirable in and of themselves, and they alsoenable individual income growth. Services such as public safety,basic education, public health, and infrastructure nurture thesefreedoms and increase the productivity and employability of thepoor, and thus their income and well-being.
The governments of all developing countries claim to acceptresponsibility for these functions. Yet they have failed dismallyto deliver on their promises. Consider the case of India: Theeconomy is growing rapidly, the stock market is at an all-timehigh, Indian companies are expanding abroad, and a large middleclass is emerging. It is, for many, the best of times.
Contrast this image with that of another India, where 79 percentof the population still lives on less than $2 per day, 39 percentof adults are illiterate, 31 percent of rural households and9 percent of urban households do not have safe drinking water,81 percent of rural households and 19 percent of urban householdsdo not have a toilet, 10 percent of boys and 25 percent ofgirls do not attend primary school, 49 percent of children areunderweight, 9 percent of children die in the first five years oftheir lives, and 400,000 children die of diarrhea every year.
The boom in India’s private sector has been accompaniedby an outright failure of the state, and the poor have borne thebrunt of this failure. The rich can purchase services from privateenterprises, and the middle class are the main beneficiariesof limited public services. But the poor have little or no accessto public services and cannot pay the high prices for private services.For instance, children of the rich go to exclusive privateschools, children of the middle class use a mix of private andpublic schools, and children of the poor often do not go to schoolat all or go to low-quality public schools.
Markets Aren’t Enough
India isn’t the only country whose government is failing tomeet its responsibilities. Much of the developing world is likewisemissing a vibrant public sector. In response to these shortcomings,a growing number of people believe that marketswould do a better job of providing these same services. Thatis one of the reasons why microcredit has such widespreadappeal: It’s a market-based approach to eliminating poverty.23
Even those who advocate a market-based approach to providingbasic services don’t argue that the state can totally abdicateits responsibilities. The late economist Milton Friedman,who advocated a school voucher system, did not want thestate to withdraw totally from the field of education. Thestate must provide basic education for the sake of intergenerationalequity. The state must also be responsible for providingservices when there is a market failure. Free markets do notwork well when economies of scale are very large and thereis a natural monopoly, as in the case of piped water, and whenthe commodity is a “common good,” as in the case of publichealth. In such cases, the market might be a partial complementto the state, but it cannot be a total substitute. For example, ifa region has a private water supply, the government must stillregulate rates and ensure that the poor have enough purchasingpower to buy water.
The business guru C.K. Prahalad says, “If people have nosewage and drinking water, should we also deny them televisionsand cell phones?”24 Writing about the slums of Mumbai,he argues that the poor accept that access to running water isnot a “realistic option” and therefore spend their income onthings that they can get now and that will improve the qualityof their lives.25 This opens up a market, and he urges private companiesto make significant profits by selling to the “bottom ofthe pyramid” (BOP).
Yet the BOP proposition glosses over the real issue: Why dopoor people accept that they cannot expect running water?Even if they do accept this bleak view, why should we? Instead,we should emphasize the failure of government and attemptto correct it. Giving a voice to the poor is a central aspect of thedevelopment process.
The business community, bureaucrats, politicians, and themedia are very busy congratulating themselves on the boomingprivate sector in India. Sure, more Indians have cell phones.But what many remember about India is not all the people usingcell phones. It’s all the people defecating in public because theydo not have toilets. Even in Mumbai, the business capital of India,about 50 percent of the people defecate outside. The currentcelebration of private sector successes should be met, and perhapschastened, with anger at the failure of the state to providebasic services.
Overall, governments, businesses, and civil society would bewell advised to reallocate their resources and energies away frommicrofinance and into supporting larger enterprises in labor-intensiveindustries. This is what is alleviating poverty in China,Korea, Taiwan, and other developing countries. At the sametime, they should also provide basic services that improve theemployability and productivity of the poor. Otherwise, they willmiss the mark of lifting people out of poverty.
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Read more stories by Aneel Karnani.
