Micronance

Its growth, change and role in poverty reduction

Emma Engstrm

GNOSIE

Micronance is the notion of providing nancial services to (a before discarded) group of low-income households, meaning providing savings and credit to people that have small or no assets or collateral. These people would otherwise be left to the informal sector. Micronance has existed for thousands of years but during the last two decades its devel- opment has been phenomenal; this has been called: The democratization of nance. This paper will investigate the history and evolution of micronance and what predictions has been made for the coming decades. It will also clarify the role of micronance in the nancial system and why the de- velopment of a nancial system in a less developed country is important. The different perspectives of micronance: the clients and the donors will be studied. Finally, the advantages and shortcomings of micronance compared to other poverty reduction tools will be discussed.

c Emma Engstrm Gnosie, Stockholm 2006

Contents

1 2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Micronance evolution and revolution . . . . . . . . . . . . . . . . . . . . . . .

2.1 The past . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 The present . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Positive trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 The future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 4

4 5 6 7 7
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3 Client perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1 Micronance services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Microcredit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.2 Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.3 Micro-insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.4 Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Client characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 Women . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Groups and individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 8 8 8 8 9 9 9
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4 Donor perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1 Millennium goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Actors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Paradigms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 The importance of nancial systems . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Developing a micronance organization . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.1 Donor traps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10 10 11 11 12 12
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5 A tool among others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5.1 Grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14 14 15
15 16

6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1. Introduction
All people, including the poorest, have dreams about improving their livelihoods. People save to make home and small business repairs, stabilize consumption and pay for lump sums as school fees and celebrations. Due to lack of collateral, people living in poverty do not have access to credit services from banks. Therefore they often borrow from moneylenders that are part of the informal nancial sector. This is often risky, costly and inconvenient and interests rates are very high. Saving money at home does not pay interest and is often hazardous. Here micronance organizations (MFOs) can play an important role: they provide nancial services as credit, savings, pensions, insurance, capital loans, and money transfer services.

2. Micronance evolution and revolution

An important person in micronance is Professor Marguerite Robinson who for many years has served as an adviser to the Indonesian Ministry of Finance and on the largest self-sufcient micronance system in the world: Bank Rakyat Indonesia. She has worked in other countries in Asia, Africa, and Latin America, giving advise on micronance to governments, banks, donors and others. Professor Robinson has claimed that we are living in the era of a micronance revolution and the following section is a summary of how she analyzes its evolution.

2.1

The past

Micronance in one form or another has existed for very long. Already 3000 years ago pawn-broking existed in China, and it has likewise appeared in Greek and Roman texts. Religious groups have dealt with he concept; Old Testament and Franciscan monks handled poverty reduction partly with pawn-broking. Moneylenders, pawnbrokers, religious organizations and traders were the ones administrating micronance. In 1720 the famous author Jonathan Swift introduced the Irish rural funds for poor. Before 1840 these had reached 20 % of the Irish households. After this period charity organizations and commercial credit organizations organized similar activities. In 1890s Dutch colonial authorities created Indonesian
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commercial rural credit. Before the 2nd world war some Non Governmental Organizations (NGOs) provided savings and loan possibilities, but these organizations were often scattered and small; the large group of clients used informal institutions which meant high risks and costs. After the war large rural programs provided credit to farmers, who needed large amount of money to pay for the new, technically advanced machines making farming more productive. Commercial loans were thought to be too high. This unfortunately destroyed the commercial micronance approach; the credit was widespread and paid for by donors providing low-market credit. It reached only the rural elite and not the poorest, they were believed to be unable to save and borrow from nancial institutions. It was a politicized and corrupt process and debts and non-repayment of loans was frequent. This was the general case until the 80s. In the 1970 the nowadays most famous MFO: The Grameen Bank Project (Grameen means "rural" or "village" in Bangla language) was originated by Professor Muhammad Yunus, Head of the Rural Economics Program at the University of Chittagong in Bangladesh. He organized a research in whether banking services would be possible for the most poor in the area, and the following objectives were dened (citat from Grameen bank): Extend banking facilities to poor men and women Eliminate the exploitation of the poor by moneylenders Create opportunities for self-employment for the vast multitude of unemployed people in rural Bangladesh Bring the disadvantaged, mostly the women from the poorest households, within the fold of an organizational format, which they can understand and manage by themselves Reverse the age-old vicious circle of "low income, low saving low investment", into virtuous circle of "low income, injection of credit, investment, more income, more savings, more investment, more income" The project turned out well in Jorba (a village nearby the university) and through nancial aid from the central bank and large commercial banks it was extended to Tangail district (a district north of Dhaka -the capital of Bangladesh) in 1979. This extension was as well successful and the project spread further. In October 1983, the Grameen Bank Project was transformed into an independent bank by government legislation. It is noticeable that Grameen bank is owned mostly by the poor people whom it serves; borrowers of the Bank own 90 %.

2.2

The present

The last two decades micronance has come a long way. An important step was when commercial nance methods in the 80s were applied to the micro5

nance markets. The possibilities of using commercial nance for equity were investigated. Facilitated communication through technical development made it easy to gather and systemize the methods that had been used. This resulted in that some institutions progressed and found their way to large-scale organizations, meaning greater range and protability. These institutions were observed and studied by others which lead to the creation of a commercial micronance industry. It is hard to nd statistics about micronance since the MFOs often are small and have decient records. In 2003 The MicroCredit Summit reported that in total micronance institutions (MFIs) served more than 80 million clients. The growth is estimated to be 15% per year.

2.2.1

Positive trends

Professor Robinson states some positive features of the micronance industry today: Institutional prots are made possible thanks to the spread of interest rates Subsidies for loan proles are abundant; public voluntary savings and access to nancial markets are instead playing the role of providing money to a large amount of low-income clients. Through an enlarged competition, efciency and client service have improved Micronance industry standards are being developed: industry leaders, rating agencies, training programs, investment funds have more contact trough developed technology. Commercial nancial institutions in a competitive environment have been proven to show large-scale, sustainable and continous outreach to lowincome clients. Industry leaders (this often happens in an emerging industry) control large shares of a market. These leaders are often well regulated, have good governance and ownership with transparent organizations, skilled managers, performance-based incentives and a large network. Weaker institutions eventually join the industry leaders, merge, change orientation, develop a specialization or die. Good repayment borrowers can continuously obtain larger and larger loans - there is usually no liquidity constraint. Different savings products are being created to meet with the needs of clients.

2.2.2

Constraints

Micronance is concerned with many set backs, for instance repressive nancial systems and inappropriate regulations hinder every day work and its long-term impact.

When governments regulate interest rates they are often set at very low levels. This leads to that microcredit can neither cover for its costs and risks, nor earn a prot. The costs are much higher when making many small loans compared to a few large ones. If microlenders cannot charge interest rates that are above average bank loan rates, they are not able to cover their costs. Other governments have liberalized interest rates, but are not able to control public supervision of deposit taking institutions that serve nancial clients. The global demand for MFOs is large while good managers are few. The management is sometimes bad and ownership uncertainties are causing an inefcient organization. Managers with experience within the eld are demanded and more nancial managers need to be attracted to micro- nance.

2.3

The future

Professor Robinson makes some predictions about the following two decades:

Finance is not a bottleneck for industry leaders; capital markets, public savings and investment will provide for money. The most important actors on the market are large credits unions and NGOs becoming banks. The client service will be further improved. India and China are the most important markets. The roles of donors will be more focused on industry developments and institutional building in new markets. The World Bank-based Consultative Group to Assist the Poor (CGAP) has concluded that the potential market for micronance has an extent of almost three billion people.

3. Client perspective
In mentioning the micronance client as "poor", one must aware that poverty itself is hard to dene, it is changing from place to place, over time poor people oscillate below and above the poverty line. Poverty has many dimensions, for example levels of income and consumption, social context and vulnerability to risks, social resources and political access.

3.1

Micronance services

The most common micronance products are mentioned below.

3.1.1

Microcredit

Microcredit is a good choice if the client is a person with entrepreneurial capacity and management skills and he/she already has some on-going economic activity; the client has already found an entrepreneurial opportunity and has identied how a loan can increase capacity. If this is not clear in advance, the client will probably not be able to repay the loan.

3.1.2

Savings

The advantages of savings are obviously that there is no risk of getting stuck in debt. It makes it possible to buffer for coming emergencies as natural disasters, crop failures, job loss, illness and death. The saving levels out consumption and provides support during seasons of low income and makes family and business investments possible.

3.1.3

Micro-insurance

Microinsurance addresses specic risks by sharing the cost of unlikely events among many poor households. This is a pressing issue in the areas of life and health insurance. However, if addressing community-wide risks or expected outcomes (for example regions of high-risk for natural disasters or in whole populations risking HIV and AIDS) insurance of this kind can make a very small difference.

3.1.4

Leasing

Leasing an object i.e. an ice-cream machine instead of borrowing money to buy it has some advantages. It means less risk for the lender since it is possible to stop leasing at any moment and there is no debt.

3.2

Client characteristics

The micronance clients vary widely: from beggars borrowing money to sell water and soda instead of begging to fabric producers wanting to buy expensive machines for their factory. However, is has been shown that some characteristics of the clients are more suitable.

3.2.1

Women

If the client is female a larger part of the money goes to the family and the default risk is decreased. Promujer is an American MFO with only female clients in Bolivia, Mexico, Peru, Nicaragua and Argentina. They offer credit and training programs to poor and undereducated women who run a small business or have the urge to open one. They claim that since women often are excluded from educational and economic opportunities that men traditionally enjoy, they have many difculties nding employment in the formal business sector. With a small loan and simple business skills training, women have shown that they can be very successful entrepreneurs who repay their loans on time. Promujer states: "A small amount of money in the hands of a creative, condent, entrepreneurial woman can make a big difference in a familys life." A typical micronance client is Haika Lymo Tanasio, 45 years who lives in Dar Es Salaam in Tanzania and is a client at Pride Tanzania since 2005. She has got credit for development of her enterprise that is sales of fruit and vegetables. Her rst loan is 50000 shilling (35 EUR) for which she will buy vegetables to sell and a better roof for her stand. The loan will be repaid in six months.

3.2.2

Groups and individuals

An individual in a group gets a loan and the other members in the group act as collateral meaning that they have to repay in case the individual doesnt. If the group is a village and an individual gets a loan and doesnt repay it, the village risks that the bank doesnt provide loans to that village again. This puts a lot of social pressure on the individual. Group lending has been very popular among MFOs; one argues that it improves repayment rates and decreases transaction costs by providing incentives for peers to screen, watch over and enforce each others loans. However, some claim that this group liability leads to extreme pressure and discourages good clients from borrowing and that this threatens growth and sustainability. Varying success of individuals in a group and different repayment capabilities lead to that a prosperous entrepreneur has to pay for other loans, leading to a slower growth for the successful enterprise. It remains unclear whether group lending actually improves the poor persons access to nancial markets and the lenders protability.

In the case of microcredit, loans for individuals often is a result of a tight relation between lender and borrower, this trust is established for example with savings. This often means less time demanded from the borrower compared to group lending.

4. Donor perspective
The micronance institution is not an emergency intervention. It is a longterm development tool and demands a long-term plan for its progress. One must be aware that all investments affect the internal market, thus deranging competition. The donor supplies grants, loans, and equity for MFIs and this support is not permanent. Donor funds complement the private capital. Supporting infrastructure like rating agencies, credit bureaus, audit capacity and experimentation assists the MFI.

4.1

Millennium goals

The millennium goal of halving poverty can more easily be reached with the aid of micronance; Professor Robinson states that neither donor nor government money sufces for nance of the enormous (todays unmet) demand for money by millions of underprivileged people. Moving out of poverty demands successive enlargement of loans and only commercial micronance can provide for this. In many cases, the savings in an MFI are the only legally recognized assets a poor person has. To put focus on this way of reducing poverty 2005 was set to be the Year of Microcredit in the UN.

4.2

Actors

Providers of nancial services to the poor are NGOs, co-operatives, communitybased development institutions as self-help groups and credit unions, commercial and state banks, insurance and credit card companies, wire services, post ofces, and other points of sale. Some types of organizations have roots in the rural societies since long back, for example ASCA (accumulated savings and credit association), ROSCA (rotating savings and credit association), SACCO (savings and credit co-operation).

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4.3

Paradigms

There have been two main paradigms concerning the way micronance is to be organized by donors: the rst enhancing the poverty lending, and the other the establishment of sustainable nancial institutions. While The World Bank favors the latter, the former is the main method of donating for the moment. However Professor Robinson remarks that there is a progress towards the establishment of nancial systems which are more autonomous. The Swedish International Development Co-operation Agency (Sida) states that changes in the forms of more competitive markets should be seen in a large context: a nancial system. This includes all nancial institutions such as legislation and regulations governing the functioning of nancial markets and the authorization that look after agreements and regulations.

4.3.1

The importance of nancial systems

Currently the MFOs are mostly separate from the large banks but their longterm goal is to be integrated in the formal nancial system. Sida states in the folder Finansmarknaden och de fattiga that a nancial sector is very important in poverty reduction since it is a conducting factor when creating economical growth, which in turn is the most important factor when decreasing poverty. Increase of the total production in a country leads to more wealth for all groups of society, both poor and rich. Sida continues that a good nancial system controls that the money coming to a country is distributed to where it is the most effective. In poor countries most of the capital are in forms of land and natural resources, whereas in rich in machines and infrastructure, which makes the production more effective. The impact of a bad nancial system is illustrated with Indonesias situation in the 80s and 90s: poor regulations and politicized banks resulted in bad control of where money was placed. The investments went to high-risk projects and when this was discovered during the Asia crisis in the end of the 90s, the foreign investors withdrew their money. The local currency then lost value and this resulted in an increase of Indonesias foreign loans. The enterprises could not pay for the higher interests and went bankrupt, leading to unemployment. Having the goal of an effective market in mind, the main goals of the nancial system are the following:
Aid transfers of capital to where it is most needed; i.e. a surplus of money must be transferred to where it can make the most protable investments. Manage risks, meaning that institutions and market mechanisms are needed to judge controls and xate prices; these institutions are for example banks, insurance companies and risk capital fund companies. payment means, instead of paying in exchange of products or services, cash is used (or credit cards in the most developed coun11

tries). The volatile ways of payment simplify and cheapen the purchasing and selling.

4.4

Developing a micronance organization

The repayment time is longer. The administrative cost is larger for many small loans. It is hard to provide unlimited liquidity.

In administrating an MFI one must be aware of the following difculties:

In most cases the MFIs aim for having the following characteristics:
The most poor must be reached and targeted; the institutions must be close to the customers and the loaning procedures must be close to the local environment. The interests and fees are often higher than in a commercial bank but lower than the interests offered from informal local business men, this means that 40 - 60 The reliability of the institution is dependent upon the repayment of loans, thus this is very important. The repayment is gradual and part repayment regular and recurrent. The sizes of the loans are gradually increasing. In order to make the institution more effective, one introduces training with micronance and incentive to employees to encourage repayment and develop effective methods for credit rating and repayment. Experts with a successful track record are hired when designing and implementing projects. The projects have a plan for reaching a point where the donors support is no longer needed.

4.4.1

Donor traps

Past experience has shown that some project types means higher risk of failure - they can for example damage the long-term development of the nancial sector. Sida has drawn some conclusions in the text Design features to be careful about in the folder Guidelines on Micronance.
Including an MFO in another project often leads to that when seed capital is offered to develop an industry, for example farming, important aspects of the MFO is lost; risk of default and cost for credit are enlarged. The management of the different business parts, screening of the clients as well as project evaluation must be separate. In 1974 The Bangladesh Rural Advancement Committee (BRAC) added micronance to its activities and its founder Fazle Abed comments this 12

as follows: "The working of a microcredit system itself brings new elements. A softhearted patronage approach of welfare organizations must give way to a hardheaded professional approach if the micronance approach is to be sustainable and effective. This transition can generate tension in an organization. The organization, therefore, needs to accept and internalize the change required of it. Leaders of the organization must clearly understand what it entails and prepare their staff accordingly." Multipurpose organizations dealing with micronance often results in erroneous micronance advise given to clients, since expertise is missing. The processing of different services is often hastily done; a problematic situation can occur if fee-based services i.e. credit is mixed with fee-free services as health, the requirement for repayment is loosened. A too narrow target group such as not only poor and with low collateral, but also with other features specied, is often problematic. It frequently leads to that too few clients are found and that administrative costs are too high. Instead market research and creation of specied product shall be developed. The funding of several MFOs in a certain country is believed to be a good solution because of less administrative burden and to reduce market distortion. Commonly, though, the MFO sector in a country is too small and lenders of 2nd class shall not be sustained. Technical assistance should be given to individual organizations and a national funding institution for MFOs is more important to support The donations that go via the governments are often problematic since they include signicant risk of political inuence, ownership obscurity and inefciencies in money transactions. Donations to a region with access to micronance are not efcient, since it results in that people stop using savings and other products. This is not sustainable and Sida has the aim to, instead of supply easily accessible donations, remove obstacles and facilitate access to micronance products. The regional expertise should instead with Sidas aid be linked to international expertise.

5. A tool among others

It must not be assumed that micronance is the general solution that can be applied to all people in all situations. If people are hungry or in emergency
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they dont have energy or possibilities to pay back for a loan och utilize savings opportunities. Since micronance is a very "trendy" development tool, the market has inexperienced actors, which cannot provide the right products or dont have sufcient experience. There role of micronance in long-term development should be viewed with other efcient poverty reduction tools in mind; for each case one must nd out which tool is the most suitable. Other types of aid are for example: grants, health and food subsidies, investment in public infrastructure, community-level investments, employment programs, training, education programs, business development services, legal education and assistance, social empowerment, legal and regulatory frameworks. One must also be aware that no single intervention can defeat poverty; many aspects must be considered in order nd the best strategy. In order to employ and help people many interventions are good, of which three are mentioned below.

5.1

Grants

In a case of urgent post-crisis situations and serving the chronically poor and high-risk low-experience groups, grants are more useful than micronance. Grants are useful to overcome social isolation, lack of productive skills, and low selfcon dence of the extreme poor. This can be a preparation for the eventual use of microcredit. Some suitable grants used as safety nets and to provide help for livelihood improvement have the target group:
People hit by crisis (temporary safety net) People who just moved due to a conict People affected by natural disasters as earthquakes and oods

Grants can also be used to help people recently laid off from government employment to move into self-employment. Microcredit may be risky both for the ex-employees and for the microcredit providers if ex-employees have small entrepreneurial abilities and technical skills. To "create entrepreneurs", is very risky particularly among high-risk, low-experience groups and can burden people with debt.

5.2

Regulations

To assist in legal reform processes can be useful for the poors access to economic opportunities and safe nancial services. This since very bureaucratic procedures for registering and operating a microenterprise can restrict the creation and growth of enterprises. The cost of registering property can result in that the poor has access to only very small loans.
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5.3

Employment

To facilitate life investments in public infrastructure: roads, communications, and education are important and can provide a foundation for self-employment activities. Investments in commercial or productive infrastructure (such as market centers or small-scale irrigation infrastructure) facilitate business activity. Non-nancial services-from literacy and business training to business development services build social capital and basic skills within the community.

6. Summary
The recent explosion of micronance demands an analysis of its capabilities as poverty reduction tool. Micronance is particularly interesting when it comes to sustainable development. External money cannot support its whole potential market. The latest intelligence is that the MFOs are to be integrated in the nancial system of a country in order to make it autonomous. Financial assistance should go to creation of regulations and legislation in a country to facilitate creation of commercial MFOs. The nancial system is substantial for economical growth which is the most important factor for decreased poverty. The prot of micronance products varies: credit can be benetting if clients have an entrepreneurial objective, while savings are useful as a buffer for worse times. Wheather groups or individuals are the most successful clients remains unclear. It has however been shown that females are particularly good clients since then prot goes to the whole family and repayment rates are high. There are many traps for a donor in micronance, one is the integration of MFOs in other types of businesses. One must also remember that micronance is not a general poverty reduction solution. When an emergency has occurred, people rather need an immediate grant to survive and run daily activities. In a later stage, when livelihood is stabilized, micronance can be help full to steadily move out of poverty. The future for micronance seems to be improved with more standardized systems and rened products, more experienced actors and self-sufcient MFOs. This is good news since the World Bank predicts 3 billion potential clients for micronance.

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7. References
Ahlquist, Martin. Finansmarknaden och de fattiga, Sida, Stockholm, 2002, ISBN 91-586-2118-0. Robinson, Marguerite S. Commersial Micronance: Past, Present and Future, The Collegium for Development Studies, Uppsala, 2005, ISBN 91-974705-97. De Vylder, Stefan. Utvecklingens drivkrafter, Forum Syd, 2002, ISBN 9189542-08-8. Sida. Guidelines on Micronance, Sida, Stockholm, 2004. Sida. Sm medel - stora drmmar, En utstllning om nansiella tjnster fr vrldens fattiga. Sida, Stockholm, 2005. http://www.promujer.org, 2006-07-20. http://www.worldbank.org, 2006-07-10. http://www.cgap.org/about/micronance.html, 2006-07-06.
Microcredit: One of many interventions, CGAP, Training Objectives, 2003. http://www.cgap.org/direct/docs/modules/microcredit/MicroSlides.ppt, 200607 - 06.

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