Can microfinance help end poverty?

The inventor of microfinance giving small, cheap loans to the poor won a Nobel Prize. Now, the idea's gone global. But is it just a new debt bubble in the making? Simon Wilson reports.

What is microfinance?

It's a way of lending tiny amounts typically up to a few hundred dollars, but often far less to poor people in developing countries. In its modern form microfinance, also known as microcredit, dates from the 1970s. The most celebrated institution is still the Grameen Bank ('Bank of the Villages'), which began in Bangladesh in 1976. Muhammad Yunus, a young economics professor, realised that local craftswomen were crippled by extortionate borrowing costs (of up to 10% a day) to fund the purchase of raw materials. He began by lending just $27 each to a group of 42 families (most borrowers are still women) to help them grow their businesses, and found that the poor were perfectly capable of looking after the money and paying it back with near-perfect reliability. Since then, Yunus has won the Nobel Peace Prize, and the movement has gone global, supported by the UN and the World Bank.

All good then?

No. Microfinance, say critics, is simply not an effective or efficient way to lift large numbers of people out of poverty. In reality, not all poor people are plucky would-be entrepreneurs with the ability or desire to start their own businesses. So giving them a loan is no long-term answer to poverty. US academic Aneel Karnani, for example, says microfinance has been romanticised: "Countries that have lifted people out of poverty", such as China and Vietnam, have not done it through microfinance, he says, but through the development of larger enterprises which create jobs. The question is, could we not use the resources in a better way, for example, by creating garment factories rather than creating individual entrepreneurs by giving them each a loan to buy a sewing machine?

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So why are big banks getting interested?

Partly because wealthy clients are increasingly interested in socially responsible investment, and partly because they simply see the benefit of lending money with low default risks and good rates of return. In the past few years, the proven ability of microfinance to turn a profit has attracted private-equity funds and other foreign investors. Most notably, Sequoia Capital, the venture capital firm that backed Google, Apple and Cisco, took an $11m stake in SKS Microfinance, a large Indian lender. And Pierre Omidyar, the founder of eBay, is a big investor. In 2005 he gave $100m to Tufts University to create a microfinance-only investment fund.

Sounds good what's not to like?

As the microfinance sector has expanded out of the not-for-profit sector into the commercial sector, some have argued that some lenders are now indistinguishable from the loan sharks they were supposed to replace. For example, Mexican microfinance firm Compartamos Banco ('Let's Share'), which floated on the stockmarket in 2007, has been denounced by Yunus and others for charging interest rates close to 100% a year. And for the past year or so critics have warned that microcredit lenders risk fuelling a US subprime-style bubble by lending recklessly to people who cannot afford it.

Is there any truth in that?

The Wall Street Journal seems to think so. A recent report on Indian microfinance paints a disturbing picture. India recently overtook Latin America as the world's most dynamic microfinance market, especially commercial microfinance; some 22 million Indians have microcredit borrowings. The article describes how the poor people of Ramanagaram, a shanty town in the southwestern state of Karnataka, are being "carpet-bombed" with offers of credit. Reportedly, many loans are made with no proof of income by agents working on commission. And (contrary to the spirit of microfinance) loans are made not to fund the growth of small businesses, but simply to pay for consumer spending or to refinance existing loans more cheaply.

What's the case for the defence?

Vikram Akula, founder of India's largest microfinance lender SKS, made a furious but cogent response to the Journal piece accusing it of making generalisations based on anecdotal evidence. Akula points out that Indian microfinance institutions still boast repayment rates of over 95%. He points to local factors in terms of specific repayment problems in Karnataka, and rejects the idea that microfinance lenders encourage their staff to let people borrow more than they can afford. It's a convincing defence, but that doesn't mean the possibility of a microfinance bubble can be ruled out. The Economist quotes academic Jonathan Morduch as predicting that there may well be localised failures among microcredit firms as a result of overheating. But "I don't see any evidence at all for something like a global bubble".

Can smaller investors join in?

Citigroup, Standard Chartered, Crdit Agricole, Barclays and BNP Paribas all offer clients opportunities to get involved in microfinance. Some use investors' funds to provide credit to individual entrepreneurs, and some buy shares in microfinance lenders themselves. For retail investors, a good place to start researching opportunities is the MIX market, an online microfinance information platform run by the World Bank. According to its website, the microcredit providers it covers have a total of 80 million clients worldwide, with an average loan per borrower of $508.