Please note the bibliography and referencing are not yet done, so please ignore

any relevant brackets and/or footnotes.

What are the problems of using microfinance to end

world poverty, and how could they be solved? (Topic of
my choice)
It has oft been mentioned by numerous economists, such as by Thomas Piketty
in The Economics of Inequality, that efficient credit markets are extremely
important in alleviating world poverty. Whereas most entrepreneurs and
borrowers would usually require collateral and a good credit history to borrow
money (thus meaning only the rich can afford to borrow), the rise of
microfinancing from the 1970s onwards as a means of providing credit for poor
people without sufficient collateral has helped to revolutionise the way we look at
eradicating poverty, even resulting in Muhammad Yunus winning the 2006 Nobel
Peace Prize for his work developing micro-credit markets in poverty-stricken
areas. However, although the rise of microfinancing has doubtlessly aided
millions of people and destroyed the belief that such a system (operating without
collateral as it inevitably does) could never work, there are numerous littleexplored downsides to it, and hence I shall first identify the associated problems,
and then discuss how they may be solved.
Many borrowers from microfinance firms use loans for reasons such as
purchasing stock for their business or purchasing work-related equipment, all of
which in most cases have some harmful unintended consequences. For instance,
a loan request from a Kosovan named Dobrivoje on kiva.org makes clear that he
wants a motor cultivator for his farm so as to avoid having to pay others to do
the work. Such a loan would thus reduce the GDP and employment level of
Kosovo compared to if hed paid others to do the work, as well as reduce
aggregate demand in Kosovo due to his spending $2,175 on an import (plus the
cost of the debt interest payments). Given that peoples marginal propensity to
consume tends to decrease the richer they are, and its a fair presumption that
those he hires are poorer than him and perhaps in poverty, it can thus be
concluded that aggregate demand would rise and both poverty and income
inequality would fall were he to hire others to work on his land rather than get a
loan for a cultivator. Dobrivojes is merely a case in point, but there are many
millions of borrowers using microfinancing around the world for similar reasons,
and in doing so may be increasing their nations trade deficits (the problems of
which Ill come onto later), the unemployment rate etc.
The reduction in demand for unskilled labour by small businesses (and people
like Dobrivoje) due to the replacement of labour with capital (which is
increasingly possible as a result of microloans) will reduce the price of unskilled
labour, harming those in poverty. This will potentially allow the exploitation of
these workers by large firms who now have increased monopsony power over
said unskilled workers, as they wouldnt be able to find employment elsewhere.
Whilst these other workers may also be able to take out loans to begin their own
entrepreneurial ventures rather than be exploited, microloans tend to only aid

the middle and upper poor (see analysis on page 2), and the poorest of the poor
may not have the education and knowledge to start up a successful business, or
sufficient assets to be able to risk spending their loans on risky ventures (which
may be necessary to yield returns high enough to pay off the loans interest).
The end result may therefore be a wider gap between the poorest of the poor
and the middle and upper poor (who may be able to earn more and escape
poverty), this being made worse by the potential for debt traps amongst those
whose ventures fail and are unable to pay back the loan and the interest on it.
A trade deficit may increase due to microfinancing on a large scale, both due to
interest payments paid to the lender (which are often around 35% per annum but
reach beyond 80% in some countries) and the fact that many loans are spent on
imports (usually for consumption or ventures that won't then go on to increase
exports). This will reduce aggregate demand in the borrowers nation by lowering
net exports, and itll depreciate the borrowers currency ceteris paribus. This is
unlikely to be a problem inasmuch as exchange rates are unlikely to ever be
affected significantly in most countries by microfinance. However, many small
economies with floating-rate currencies (especially Pacific islands like Samoa,
Vanuatu and the Solomon Islands) which have relatively few exports and imports
may be affected if the rate of microfinancing reaches its potential.
The ability for currency depreciation in small economies like Samoa due to
microfinance is made more likely by the low per capita incomes in these
countries (and so the large potential market for micro-loans there), as well as the
fact these small economies dont produce much, so a large proportion of loans
will have to be spent on imports. The microfinancing market is growing at a rate
of 15-20% per year worldwide and Microcapital estimate that only 4% of
microfinancing demands are being met worldwide, so with such huge potential
for expansion the idea of the industry becoming large enough in some small
economies to affect exchange rates is entirely possible. Such currency
depreciation would most likely aid net exports in the borrowers country in the
long run, but whilst exporters would benefit, those in poverty would be hit far
harder by the resulting increase in the prices of the imports that they rely on to
survive, thus increasing inequality and poverty.
Other potential issues with microloans include, as I touched on earlier, the
inability of loans to aid the very poorest in the world. Whilst loans may help the
middle and upper poor to escape poverty, the very poorest in many countries
may struggle to repay loans and the large interest payments accompanying
them if their businesses arent profitable enough (which is likely as they may lack
knowledge compared to the upper poor), and they may end up in a debt trap and
become significantly worse off. There is substantial evidence to back up this
assertion, such as data in Andrha Pradesh showing that micro-loans caused debt
traps amongst the very poor (who often werent aware of the high interest rates
or even the problems of using a second loan to pay off the first) 1, and substantial

1 http://archive.indianexpress.com/news/andhra-s-smalldebt-trap/701577/1

lending led to over 80 suicides in the region 2. In fact, according to Vijay Mahajan,
the chief executive of Basix (an Indian micro-finance institution): [micro-loans]
seem[] to do more harm than good to the poorest, as those poor who cannot
afford a greater return on their investment than the interest they must pay, they
will become poorer as a result of microcredit, not richer (Karnani, 2007).
As a result of potential problems with the very poor, micro-finance institutions
often target the upper and middle poor only, and dont lend to the poorest unless
there are specific programmes dedicated to helping them (Hickson, 1999). A
study in Indonesia found that only 40% of the poorest households were deemed
creditworthy (Johnston and Murdoch 2007), and it has been estimated that the
poorest 10% of Bangladeshi households are too poor for microfinance
(Rasmussen et al., 2005). More data from Bangladesh also show that the use of
micro-financing is highest amongst the second-poorest quintile group there, but
lowest amongst the poorest quintile (Zaman, World Bank, 2005). Not only may
this mean that micro-loans are inappropriate for many people, but the proportion
of people who arent able to access microloans grows each year because of the
stricter credit analysis criteria being caused by rising over-indebtedness across
the industry (Hes, 2012). This isnt to say that micro-loans cant alleviate
poverty, but its worth noting that in many cases they could harm the very
poorest and, in the words of Hassan Zaman: microfinancing is not the way out
of poverty for all the poor (Zaman, 1997).
The use of microloans for consumption is often an issue too. Such loans are
hugely popular, but whilst fuelling enterprise might alleviate poverty by raising
the incomes of those involved (though theres evidence to suggest it may not
actually achieve this3), loans for consumption merely result in higher costs to the
borrower from interest payments, as well as the inevitable lowering of aggregate
demand and net exports derived from purchasing imports. In fact, conclusions
derived from 15 studies carried out in sub-Saharan Africa found that microloans
often made borrowers worse off because they tended to be spent on
consumption rather than entrepreneurial ventures (Stewart et al., 2010), and
because any ventures often werent profitable enough to cover the interest
payments. Whilst consumption loans may allow the borrower to increase their
living standards it could be argued that the high interest rates, combined with
the potential for a debt trap make consumption microloans not only irresponsible
but also harmful, potentially increasing the inequality of wealth distribution.
Microloans have many potential problems, but what are the solutions? Most
currency-related problems shouldnt be an issue because the effect of microloans
on exchange rates will usually be negligible. In fact, were the industry large
enough to affect currencies significantly then countless more complex, severe
problems would occur. For instance, microloans would result in the depreciation
of the borrowers currency (due to imports and interest payments reducing the
2 http://www.bbc.co.uk/news/world-south-asia-11997571
3 www.citylab.com/housing/2015/01/do-microloans-really-help-the-poor/384877

demand for said currency), causing real incomes of those in poverty to fall as the
price of the imports they are dependent on rises in their currency terms. This
would entice them to take out microloans to increase their incomes, which would
further depreciate the currency and cause a spiral that would only end once the
problem was addressed by the government or micro-financed ventures began
exporting abroad and stabilised the currency. Numerous other such issues would
come up too, but its a fair assumption that microfinance is unlikely to ever grow
large enough to affect most countries exchange rates. If the industry did grow
large enough then itd almost certainly be counterbalanced by the inevitable
reduction in microfinance interest rates over time (see page 4). If it still wasnt
solved by this, then tariffs could be imposed by the government on imports, or
regulations preventing loans for purchasing imports could be introduced.
The problems of debt traps, possible currency issues, loans for consumption and
some people being too poor for microfinance can all be alleviated to an extent by
a reduction in microfinance interest rates. These could occur as a result of
government intervention (for instance Muhammad Yunus believes that a
maximum interest rate of 15% plus the cost to the lender of obtaining the funds
should be imposed by governments) or by governments encouraging competition
in the sector. Many institutions offering microloans (such as Compartamos) have
begun to go public, and satisfying shareholder demands for increased profits
often results in increased interest rates for borrowers. Therefore increased
competition would lower the market rate, as would the installation of a
microfinance regulator in all countries that MFIs operate in.
Whilst there are steps that could be taken to reduce high interest rates, in the
future it seems inevitable that rates will fall of their own accord and that most
latent demand for loans will most likely be satisfied as microfinance markets get
more efficient. Whilst this sounds so vague as to be devoid of much meaning,
there is much evidence to suggest that as time goes on this does occur. For
instance, many microfinance institutions were operating in Guatemala in the
early 2000s, and hence (other than morality) there was little incentive to repay
loans, because one could possibly default on a loan then get another from a
different institution.
A credit bureau was established to enable lenders to check borrowers past credit
histories, and the behaviour of borrowers who were aware of the bureaus
existence versus those who werent was recorded. Research published by Janvry,
McIntosh and Sadoulet in 2010 showed the effects of the bureau on the industry
there, and found that borrowers who were aware of the bureau took out 27%
more loans overall (resulting in far more credit being received), and the
delinquent repayment rate fell 6 percentage points. Lenders also had an
increased base of potential clients, enabling them the ability to provide more
loans to those they deem suitable. This increased market efficiency reduced the
uncertainty to lenders, which will most likely eventually have resulted in lower
market interest rates, and it resulted in more credit being lent, thus increasing
microfinancings ability to alleviate poverty. On the flipside lenders became more
picky choosing their borrowers, leading to more borrowers that were perceived

as weaker (which in many cases were women) being denied funds. In this way
efficiency increased, lowering the interest rate, but it resulted in an efficiencyequity problem that could reduce microfinancings ability to end poverty.
Many of the problems associated with consumption loans and debt traps caused
by businesses failing could be addressed by training and educating borrowers on
ways in which they could use their loans sustainably. However, this may not
occur if lenders go public and become public enterprises rather than non-profits,
as they will have little incentive to expend resources helping their borrowers
except for the sake of increasing their repayment rates. However, even this
incentive is minor because in many cases borrowers often borrow from multiple
lenders, all of whom may not co-operate and will not want to take responsibility
for providing the education. Given many lenders profit more from delinquent
payers than those who pay on time due to added interest, such education must
therefore be provided by a government or other institution with little profit
incentive.
Even with education there will inevitably be a number of failing businesses and
businesses whose profits do not exceed their loan interest payments. In these
cases most possible solutions are inherently flawed. Government intervention to
compensate failed businesses would create a moral hazard and encourage fraud
amongst borrowers; government regulation allowing borrowers to default without
losing many assets would again provide a moral hazard and encourage fraud,
and just allowing borrowers to declare bankruptcy would be devastating for
those already in poverty. The least flawed solution in my opinion would be a
ceiling on the value of interest, such that the borrowers debt may increase over
time (providing an incentive to repay), but will cease increasing beyond a certain
level (say 50% of the debt).
Microfinancing has been instrumental in alleviating poverty and the industrys
growth has shown little size of stopping. Estimates for industry potential are
huge, with Deutsche Bank estimating the size of the funding gap the industry
aims to fill at $250 billion, and a 2013 paper by Hes and Polednakova estimating
the number of people who could use microloans at 975.4 million people (though
the general consensus is around 1.5 billion people). Micro-credit is (quite rightly
in my opinion) seen as a revolutionary and important way of ending world
poverty, but there are many problems related to it (primarily due to loans being
used unsustainably) that need to be recognised, and here Ive attempted to
highlight some of them.