Student No: 1059936

Development and Transition Project

University of Warwick MSc Economics and International Financial Economics

Development and Transition Project

Student No: 1059936

MICROFINANCE INSTITUTIONS IN PRATICE To what extent does Microfinance work? Does it fulfil its primary goal?

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Student No: 1059936

Development and Transition Project

Introduction
Poverty alleviate in the Developing World has become a priority with the need to provide sustainable income, and the fulfilment of basic social, health and literacy needs amongst the poorest of the world. To help fulfil this need microcredit has spread rapidly since its inception in the 1970s, however, the extent to which it helps the poor is a subject of intense debate. Microfinance Institutions (MFIs), offers poor and vulnerable people access to basic financial services such as loans, savings, micro-insurance, training, and peer support. These loans although provided with high interest, MFI programs have shown that poor people achieve strong repayment records - often higher than conventional borrowers. Consultative Group to Assist the Poor (CPAG) lists some of MFI goals as - poverty eradication, education, gender equality, women empowerment and health improvement. With Poverty Alleviation as the primary goal, this project focuses on analysing the impact of MFIs in achieving this. A wide range of research has been conducted on developing countries in order to assess the effectiveness of these institutions on this topic. The critical analyses of this project will aim to answer the following questions: To what extent does Microfinance work? Does it fulfil its primary Goal?

First, I will assess the empirical work of Banerjee.A, Duflo.E, Glennerster.R and Kinnan.C (2009). Other literature will be used to discuss and limitations.

Empirical Research
Banerjee et al (2009) discussed on The miracle of Microfinance based on randomized evaluation assessing the effect of canonical group-lending micro-credit model. In 2005, 52 of 104 neighborhoods in Hyderabad were randomly selected for the opening of an MFI, while the remainder of the sample was left out. This paper considered the effect of MFI on potential new and old business owners, and people with a low propensity to start business. The aim was to examine the effect on outcomes that directly related to poverty such as consumption, new business creation, income, education, health and womens empowerment. The results suggest that access to microfinance contributes to overall poverty reduction in the sample areas, with no improvement in health and education These conclusions raised questions on the evidence of microfinances impact in alleviating poverty.

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Student No: 1059936

Development and Transition Project

The Poverty Trap

The paper raises a question on the sustainability of microfinance resulting from the criteria for loan selection. The analysis showed that potential non-business borrowers spent a significant proportion of the loan received on non-durables, temptation goods and other loan repayments. The criteria of giving out MFI loans for non- business purposes raises questions on how these loans aim to alleviate poverty in the long run. When such loans are issued, doesnt this alleviate poverty only in the short run? How are these loans expected to be financed with interest in the long run? With such loans given out often, isnt there a question of keeping the borrower in a Poverty Trap, hence only limiting the impact of MFI to the short-term. CPAG stated that, While many poor people can benefit from a microloan, not everyone should receive or can use credit. Providing credit to those not able to use it productively could push already-vulnerable people into debt. This argument may also be valid in assessing these loans further. Evidence provided these loan expenditure patterns with no expected return / business investment explains that prolonged lending by MFI of such loans may only lead to a poverty trap from debt in the long-run. Furthermore, this is also supported by evidence from other loan categories. Loans given to potential new and old business owners, gave evidence of better results on non-durables, durables and temptation goods, compare to non-business loans. Consequently, if business investment loans achieved better results, then this poses a question of the effect on poverty alleviate from MFI nonbusiness related loans. With evidence from Nepal, Sharma.P.R (2004) in explaining the effect of MFI on poverty transformation, discussed the numerous programs implemented for poverty alleviation with only MFIs seen as a poor targeted rural based program. However, the provision of these loans is not fully covering the poorest of the poor and vulnerable. This shows that popularity of MFIs has increased greatly, however, with questions on its impact for alleviating poverty. Loan repayments Borrowers There is also a question of the effect of loans on the borrowers. MIFs operate a system of dynamic incentives when they increase the amounts lent to a specific borrower as credit is renewed, and condition the allocation of new loans on previous repayment behavior. Evidence shows that as loans are renewed to previous borrowers there is a higher probability of default in the long run. In a study on the Grameen Bank, Khandker, Khalily, and Khan (1995) found that the longer the MIFs operate in an area, the higher the loan default rate. They explain this feature by the possible decreasing marginal profitability of new projects. This could also be due to a deceasing power of Page 3 of 7

Student No: 1059936

Development and Transition Project

dynamic incentives as credit is renewed over time especially if borrowers observe that credit is not systematically denied to defaulting or late borrowers. Khandker (1995) however, found that membership training, which relates to nonfinancial services, had a positive influence on repayment. Where there are problems with these loan repayments in the long run, there is a reason of concern for MIFs only providing short-term relief from poverty, leaving the poor in a poverty trap in the long run. M.Godquin (2004) also deducts questions on loan repayment based on individual versus group loans. With evidence from Zimbabwe, Bratton (1986) states that group loans perform better than individual loans in years of good harvest and worse in drought years when peers are expected to default. Temptation Goods Banerjee et al explained that MFIs sometimes claim that that access to microcredit may reduce consumption of temptation goods such as such as alcohol, tobacco and lottery tickets. However, old business owners do not reduce their consumption of these goods as much as new business owners. Doesnt this suggest that this low consumption of these goods by new entrepreneurs is only temporary due to fixed-cost investment? The slightly higher expenditure by old entrepreneur may suggest that once new businesses owners start to yield returns on investment, patterns of consumption in temptation goods may increase to similar old entrepreneurs level. Hence this argument implies that the reduction in the consumption of temptations good may only be a temporary impact from MFIs and not a permanent impact on poverty.

Sustaining Poverty Alleviation

The Microcredit Campaign Summit (MCSC) explains that in addition to loans, MFIs can also provide nonfinancial services in the form of training and financial education to Borrowers. Banerjee et al (2009) doesnt discuss about such MFI services. However, evidence has shown that in order to provide the efficient and sustainable use of loans to the poorest and vulnerable of the world (particularly women), these nonfinancial services are important. These services may result in better outcomes and a sustainable way to alleviating poverty. M.Godquin (2004) explained that in addition to loans, some microfinance programs are also referred to as credit plus (Edgcomb & Barton, 1998; Zohir et al., 2001). These programs provide services (such as health services, adult literacy and training) which go beyond financial services. This microfinance methodology has little evidence documented.

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Student No: 1059936

Development and Transition Project

In addition, evidence is also needed on the best institutional way of providing these services to improve the effect on borrowers: should they be provided by the MFIs or should the MFI operate in partnership with NGOs providing these services? There is also a question for the sustainability of these businesses set up by MFIs. From Banerjee et al, there is contrasting view between the proportion of new loans invested by new business owners and re-invested in the business by old business owners. The split between current consumption and partly in business varies especially for old business owners, raising a question of the sustainability of MIFs in influencing sustainable poverty alleviation or possibly pushing the poor into a long-run poverty trap. A possible solution may be a review of the structure of MIFs, possibly if stricter regulations were put in place, specifying that a larger percent of loans to existing business owners must be re-invested in business. This then could improve the impact of MFIs in the long run.

Health and education MFIs may succeed in creating and expanding businesses, however, in order to totally eradicate the poverty trap in the long run, it is important that MFIs show evidence of affecting education and health. Banerjee et al explains that MFIs appear to have no apparent effect on education, health, or womens empowerment. However, this does not consider the long-term effect on the sample period, when the loan and investment impacts would have translated into returns for households. It is possible then that impacts on health and education would emerge in the long run. Overall, in the short run, MFIs do not appear to be a formula for education and health improvement. Banerjee et als research conclusion on this area may also be limited by estimate collation method. The figures were averaged across people who patronized MFIs and those who didnt. In the short term, if the figures recorded by those who took loans were considerably low, aggregating these values over other people may only lead to an insignificant value.

Research Considerations
In spite of criticisms and good empirical research in explaining the impact of MFIs in alleviating poverty, each research has its shortcomings in the approach used. Banerjee et al (2009), relies on a small sample, which is the problem of most empirical work. Kaboski and Townsend (2005) consider randomization on a larger scale with varying results that beyond the scope of this project. Most empirical research helps to evaluate the results of instantaneous benefits from MFIs on the lifestyle of borrowers. However, majority omits the effect of MFI study in the long run and on a large scale of observation. MFI is an investment; it is hard to measure the effect of this investment in the poorest society over 1-3 years (scale of most research). To assess the impact of MFIs, better research on larger scale and longer periods should be done. Page 5 of 7

Student No: 1059936

Development and Transition Project

Overall, researches provide evidence of the impact of MFIs in the local economy no matter how small. To the poorest of the world, where credit and finance for business is practically unavailable, without the presence of MFI many will live in a poverty trap eternally. MFIs may be argued then as a starting point for poverty alleviation and not a Get-Rich-Quick Scheme. Where MFIs support poverty alleviate, the question then is the longevity of the impact: will it be short-lived or sustainable in these communities. As explained by M.Godquin (2004) microfinance programs are now a key element of poverty alleviation strategies. The financial innovations of their lending methodologies such as the use of group lending, nonfinancial services and dynamic incentives have indeed raised the interest of policy makers and researchers as means to alleviate poverty in a self-sustainable way. P.R.Sharma (2004) explained that in Nepal, the poverty reduction rate is slower. If the proper model is used in the region, poor peoples life standard could be raised very fast. In Nepal, the experience shows that MFIs managed by private sector are better performed than the government owned MFIs. Hence Nepal shows evidence of the impact of MFIs. However, P.R.Sharma (2004) also explained that microcredit may not always be the answer, explaining that micro credit is not suitable for everyone or every situation. The destitute and hungry that have no income or means of repayment need other forms of support before they can make use of loans. In many cases, small grants, infrastructure improvements, training programs, and other nonfinancial services may be more appropriate tools for poverty alleviation.

Conclusion
Critical analysis has been done on the impact of MFIs in achieving the primary goal of poverty alleviation. Evidence shows that in the short-run, it allows households to borrow, invest and improve on living standards. However, there are questions on its accessibility and lending style, which may live some of the poorest people in a poverty trap. MFIs works in providing credit in communities where no credit or support is available. With the growth of MFIs across developing countries, issues remain on how take microfinance further. To an extent, in the long run MFIs may work better than hangouts or free aid to the poor and vulnerable people, however research provides us with little evidence on the impact of microfinance. Research on long run effects may provide more evidence and spillovers of economic factors maybe the degree to which we will be able to measure and appreciate the impact of MFI on health and education. The real effects may take time to be observed in the long run, regardless MFIs and nonfinancial services could also be combined in order to help attain better poverty alleviation in the long run.

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Student No: 1059936

Development and Transition Project

References
Banerjee, Abhijit, Esther Duflo, Rachel Glennerster and Cynthia Kinnan (2009). The Miracle of Microfinance? Evidence from a Randomized Evaluation. Mimeo MIT. Kassim, Salina and Rahman, Md Mahfuzur (2008) Handling Default Risks in Microfinance: The Case of Bangladesh. MRPA Paper Microcredit Summit Campaign (2009). About Us. Accessed 15/03/2011 (http://www.microcreditsummit.org/about/what_is_microcredit/) Consultative Group to Assist the Poor (2011). About Us. Accessed 16/03/2011 (http://www.cgap.org) Consultative Group to Assist the Poor Key Principles of Microfinance Building Systems of Homes. Accessed 16/03/11. (http://www.cgap.org/gm/document1.9.2747/KeyPrincMicrofinance_CG_eng.pdf ) Opportunity International (2010). What is Microfinance. Accessed 16/03/2011. http://www.opportunity.org/what-is-microfinance/ Morduch, Jonathan (2010) Borrowing to Save, Journal of Globalization and Development: Vol.1: Iss. 2, Article 8. Marie Godquin (2004). Microfinance Repayment Performance in Bangladesh: How to Improve the Allocation of Loans by MFIs. World Development. Vol. 32, No. 11, pp. 19091926. Puspa Raj Sharma (2004). Microfinance: A Powerful Tool for Social Transformation, Its Challenges, and Principles. The Journal of Nepalese Business Studies. Vol. I No. 1. Shahidur R.Khandker (2005). Microfinance and Poverty: Evidence Using Panel Data from Bangladesh. World Bank Econ Rev 19 (2): 263-286 Shahidur R. Khandker, Baqui Khalily, Zahed Khan. (1995) Grameen Bank: performance and sustainability. World Bank, Washington D.C.

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