By Joshua Kenyon
Microfinance is a financial service that provides loans for microenterprises in developing countries. It is often argued to be a panacea for economic development as it provides capital to poor citizens who, in theory, are then able to grow their own businesses. Besides creating new opportunities, microfinance is argued to empower women by giving them greater financial autonomy, leading to better health and educational outcomes for their children. These claims, however, have been strongly disputed and many believe that microfinance is not only ineffective but damaging to the development of these countries. Though its efficacy as a tool for development is debated, microfinance has given rise to greater financial freedom for many of its recipients and should continue to be developed as an essential service in developing countries.
The perceived benefits of microfinance
In developing countries, many citizens are self-employed microentrepreneurs, selling fruit, vegetables, or other low-cost goods. Sub-Saharan Africa and South Asia, two of the poorest regions in the world, both have a self-employment rate of 72.1%, much higher than in many developed countries. In the absence of microfinance, these entrepreneurs often seek loans from informal lenders who charge extortionately high-interest rates, commonly known as ‘moneylenders’. One study finds that the mean annual interest rate charged by moneylenders in Bangladesh is 103%, with the highest being 240%. High interest rates can leave lenders in perpetual debt and therefore unable to escape poverty. In contrast, microfinance institutions (MFI) typically charge between 10-40% annual interest rates, making debt repayments more affordable. MFIs are NGOs that provide microfinance loans to small business owners in developing countries. The typical MFI contract involves a group loan system where borrowers in the group are liable for each other’s loans, incentivizing them to ensure all members of the group repay. Moneylenders, on the other hand, usually give out individual loans, and sometimes even use threats of violence as a method of ensuring repayment.
Microfinance has become increasingly popular as more people have started to view it as a tool for economic development. In Africa, for example, the industry expanded by over 1300% between 2002 and 2012. Many in the development sector believe it allows borrowers, a large number of whom are living on less than $2 a day, to grow their business and escape poverty. The UN Secretary-General from 1997 to 2006, Kofi Annan, argued that microfinance is a “weapon against poverty and hunger”. Furthermore, many citizens in developing countries are without basic financial services. In Myanmar, for example, only 21% of adults had a formal bank account in 2014, making it harder to save and borrow. Successfully providing microfinance loans to those in developing countries, who would otherwise struggle in times of low cash flow, has increased their ability to both spend and invest.
The success stories of microfinance are often championed as proof that microfinance is beneficial, especially for women. One Zambian woman, for example, took out a microfinance loan to grow her cosmetics business and claims that her life was changed as a result, stating “I am financially independent and able to pay for my children’s education”. As 80% of borrowers are women, microfinance is argued to be bringing about greater gender equality in developing countries. Not only does this give women more autonomy in household decisions but also to an improvement in the quality of life for their children. According to studies, giving money to women in developing countries significantly improves the health and nutrition of their children, compared to no significant increase when money is in the hands of men. This suggests that microfinance can help bring about long-term development in these countries.
Microfinance is not a panacea for development goals
Though many believe microfinance to be a way for countries to achieve economic development, other studies have found that the benefits of microfinance are marginal. Before this, there was little evidence to support the claims that microfinance was a panacea for development. This gave rise to an influx of studies that set out to determine the benefits of microfinance. One paper, for example, looking at 6 studies across 4 different continents, found only a marginal benefit on business activity. None found a significant increase in household income, which is a strong indicator for poverty reduction. Besides that, it found no evidence of an increase in household consumption, a measure of the standard of living. And the study found no overall effect on women’s empowerment. Moreover, in many developing countries, it is common for men to control all household financial decisions, leading to occasions where men spend the microfinance loan, leaving women to sell assets or go hungry to pay it off.
Besides reports of suicides among some microfinance borrowers, one of microfinance’s biggest limitations is that it is diverting funding away from small and medium-sized enterprises (SMEs). According to the OECD, SMEs are businesses that employ less than 250 employees, whereas microenterprises, a subset of SMEs, employ less than 10 employees. Studies show that the upsurge of MFIs has reduced support for SMEs, which has negative impacts on the economy. Microfinance supports microenterprises, which generally have limited growth potential and are unlikely to make significant profits. On the other hand, SMEs have the potential to grow into bigger businesses, hire more employees, and pay more in taxes. The growth of SMEs ultimately leads to growth of the economy and therefore more tax revenue for government expenditure. Though providing cash to the most vulnerable in society can lead to positive outcomes, it is crucial not to damage the productive potential of the country’s economy.
Despite the benefits of microfinance, it has limitations as a development policy and is not a silver bullet in achieving development goals. It does, however, provide liquidity to the world’s poor, giving them more options to achieve stability in their lives. In his book Development as Freedom, Amartya Sen argues that poor citizens having the freedom to make their own choices is crucial for development. Microfinance provides the freedom to take out loans to smooth consumption, manage risk, or make household investments. Reliable financial services are crucial in ensuring citizens in developing countries have more stability and opportunities. Microfinance must evolve to fit these goals, with the understanding that it can provide an essential service without being a tool for significant economic development.
Joshua is an undergraduate at the University of Sheffield studying Economics, and has interests in economic development.
The views expressed in this article are those of the author and do not necessarily represent the views of Development in Action.
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