BPP 5 10/2/2010

Critical Research Report

Topic 1: Micro credit is the most effective method of combating poverty in developing countries. To what

extend do you agree?

Introduction

Poverty is one of the biggest obstacles that prevents the development of the world.

Poverty is the cause of inequality, increase of crime rate, and other social evils.

According to the World Bank Report on 26 August 2008, there are approximately

“1.4 billion people in the developing world (one in four) living on less than US$1.25 a

day in 2005, down from 1.9 billion (one in two) in 1981”. This number is much

higher than the previous approximation of 985 million in 2004. The World Bank also

pointed out that the number of poor has decreased 1% per year since 1981. However,

Justin Lin, the economist of the World Bank, argued that poverty seemed to be

spreading over the world in recent years. Therefore, to alleviate poverty, other

effective plans should be made rather than the support of non-government

organizations or governments.

The 2006 Nobel Peace Prize was awarded to Muhammad Yunus for his successful

microcredit program in the form of the Grameen Bank in Bangladesh. Now,

microcredit is regarded as the most effective way of combating poverty in developing

countries. Microcredit or microfinance is a small loaning service that provides a small

amount of money to people who want to develop agricultural plans, or who run their

modest business (Robinson 2001, p. 9); and especially to poor people who live in both

rural and urban areas and have little or no property to access collateral for

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conventional banking. In a recent survey of Grameen Bank, it was discovered that

42% of its clients broke out of poverty by 2001. Thus, microcredit is successful in

combating poverty in developing nations; compared with Foreign Direct Investment

and Official Development Assistance, microloan is considered a more helpful scheme

to improve the standard of life of the poor. This report will analyze the aspects that

lead microfinance to the most efficient method to fight poverty, such as flexible and

smart loan methodology, effective repayment system, and positive impacts in spite of

its current disadvantage of high interest rates, repayment risks and deception

vulnerability.

Flexible and smart loan methodology

The first important argument for microcredit is the dynamic lending and repayment

method that permits loans to be reached effectively. To access microcredit, the poor

do not need to have collateral to prove income capability. Additionally, this flexible

microcredit lending system provides loans based on a group of borrowers or “group

lending”. This system allows members of a group to undertake each other’s loans and

the group will self-divide loans to its members. This method makes use of peer

pressure as replacement for guarantee property (Ledgerwood 1999, p. 68). Grameen

Bank, for example, organise a group of five members to lend to (Mc Donnell 1999 p.7

cited in Khandker, Khalily and Khan 1995) points out that if these people self-select,

they are alike in economic status, and are from the same location, so the ability of

repaying loan will be higher.

Moreover, Microfinance Institutions (MFIs) frequently lend money to help the poor

resolve daily financial necessities of their business. The results of a study by

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Ledgerwood (1999, p. 67 cited in Rhyne and Holt 1994), regular ranges of loan “at

Badan Kredit Kecamatan in Indonesia and Grameen are well under $100 while most

ACCION and Bank Rakyat Indonesia activities feature average loans in $200 to

$800”. These loans are very flexible; they can solve current financial problems of the

poor effectively, because the financial demand on the poor is usually just a small

amount of money.

In addition, MFIs usually apply a progressive lending method for microloans.

Initially, a group of clients will receive a small loan. The next loan will be increased

and take a longer time to be repaid after borrowers pay back full repayment of former

loans. As said by Robinson (2001, p. 37), this method is used to see if borrowers are

eligible for loans. Besides, if borrowers repay regularly, their repayment

documentation will get to the top limit of loans of microfinance banks, this means that

they are qualified for make a loan from a conventional commercial bank. This is

because with the small loans which they have repaid, they may have gained a little

property which is collateral needed for a commercial bank and their repayment

records demonstrate their income capability to the banks (Robison 2001, p38).

Effective repayment system

Microloan is based on lending without collateral. It would appear to be very risky to

lend to poor entrepreneurs. However, the repayment rate of micro borrowers is very

high. From 1987 to 2002, the repayment rate of microloan clients of Grameen Bank is

over 95%, this rate is higher than any records of other monetary supporting

foundations (Mc Donell 1999, p. 9). This shows that repayment system of microcredit

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is very effective. By using short-term loans, micro lenders can measure clients’

repaying ability; and interest is paid by an installment method; so, loans will be paid

weekly over a year. Dividing high interest rate into short-term repayment can make

borrowers feel less pressure on repaying loan.

The case of Grameen Bank can confirm that the poor can be capable of repaying

loans. Microcredit banks focus on motivating repayment. Loans are lent by group;

because the interest is based on a group, if one member of a group tries not to repay

the loan, that group will be responsible for that. Or if one member of a group fails, the

other members can support him/her because of community pressure. Members of a

group, therefore, will look after and help each other to proceed more productively. As

a result, loans appear as social capital in a group; this clarifies the reason why group-

lending repayment is very successful in developing countries where interdependence

is very high. (Mc Donnell 1999, p. 9 cited in Beasley and Coate 1995)

Positive impacts

Microcredit has positive effects on society as governments support is reduced and

people become financially independent.

First direct impact of microfinance is on the poor. With microfinance, individual poor

people have chance to create their own opportunities to break vicious poverty cycle.

In the short term, the poor can become self-employed, run their micro business, and

improve their life standards. Credit for the poor (2007, p. 21) defines that the fastest

and most effective way to solve unemployment problem and to assist the poor break

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the debt and poverty cycle is self-employment. Moreover, micro entrepreneurs can

fund themselves fully or partly and gain their savings, so that they can continue to

invest in future projects (Robinson, 2001, p.263).

In the long term, microenterprises can use their savings as collateral for formal

commercial loans in conventional banks. As said by Robinson (2001, p. 263), savings

account can assist low-income people improve their income. Because micro business

men can have savings account and loans at the same time, savings can be used in

emergency for immediately support of their enterprises. Indeed, many micro

entrepreneurs are both borrowers and savers.

With financial support from MFIs, the poor can earn money by themselves, they can

increase their income and their properties; this has been resulted in increasing their

self-confidence. Thus, the governments no longer need to spend their budgets to

subsidize the poor. National economies also improve because of the increase in the

poor’s assets; and the poor are no longer burdens on society, but also they can

participate in a productive labor force (Robinson, 2001, p. 264-5)

Disadvantages

However, there are still some disagreements that microcredit has disadvantages which

include high interest rates, so that it can not be the most effective way to combat

poverty. Normally, interest rates of microloan are much higher than formal

commercial banks. Following to Fernando (2006, p 6), these rates are caused by

“operating expenses loan losses, and profits needed to expand their capital base and

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fund expected future growth”. However, these rates become the burden of poor

borrowers. Microcredit’s target is alleviating poverty; therefore high interest rate is a

conflict to its aim. Elahi & Danopoulos (2004, p65) theorized that micro lenders

should not make use of difficult situations of the poor to do business.

Another risk of loans is security matter. Conventional banks usually access collateral

to guarantee their loans. However, microloan is collateral-free; therefore, there is

nothing to ensure if the loans will be refunded. In other words, the risk of borrowers

links directly to lenders’ (Robinson 2001, p 195). Moreover, most of borrowers are

from rural areas, their major enterprises are of agriculture; in case of natural disasters,

micro lenders can not gather their loans.

Furthermore, MFIs are very vulnerable to deception. Because of limiting employees

for decreasing cost, “internal procedures” are also weak; this makes deception occur

easily due to lack of inspectors supervise their branches and “less confirm client

balances” (Ledgerwood 1999 cited in Valenzuela 1998).

However, with group loans, the security is in having more than one borrower to repay

and in a society where interdependence is high, the risk is reduced. Also the group

needs to be consulted; the risk of deception is lowered.

Conclusion

In conclusion, the example of the Grameen Bank can prove that microcredit is the

most effective method of combating poverty in developing countries. According to

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Daley-Harris (2007, p. 1), approximately 250,000 borrowers of Grameen Bank along

with more than 1 million family members would be out of poverty every year.

Microloan not only aids the poor eliminate the vicious poverty circle, but also helps

the poor run their own business and improve their life standards. Because of its

benefits, the microcredit program of Grameen Bank has been replicated in many

developing countries such as India, Nepal, Indonesia, and Malaysia. MFIs in these

countries are also successful (Remenyi & Quinones Jr 2000). In future, these

programs should be expanded with the co-operation between the governments and

MFIs. Moreover, this program needs to mobilize financial sources more and create

some training courses to instruct the poor to run their business plans appropriately.

This will improve the effectiveness of microcredit. Income of the poor, therefore, will

increase when they can continue to self-employ and poverty could be eradicated in the

near future.

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References list:

- Adams, J. & Raymond, F., 2008, ‘Did Yunus Deserve the Nobel

Peace Prize: Microfinance or Macrofarce?’, JOURNAL OF

ECONOMIC ISSUES, vol. XLII, no. 2, p. 435-43 retrieved December, 18,

2008, from Macquarie University Database.

- Credit for the Poor 2007, p. 20-4, Harvard International Review. Retrieved

December, 18, 2008, from Macquarie University Database

- De Aghion, B A & Morduch, J 2005, The Economics of Microfinance, The

MIT Press, Cambridge Massachusetts, London, England.

- Elahi, Q. & Danopoulos P., 2004, ‘Microfinance and Third World

Development: A Critical Analysis’, Joumal of Political and Military

Sociology, vol. 32, no. 1, p. 61-77 retrieved December, 14, 2008, from

Macquarie University Database.

- Fernando, A., 2006, Understanding and Dealing with high interest rates on

Microcredit: A note to policy makers in the Asia and Pacific Region, Asian

Development Bank, retrieved January, 16, 2009 from

http://www.adb.org/Documents/Books/interest-rates-microcredit/default.asp

- Harris, S D, 2007, State of Microcredit Campaign Report 2007, retrieved from

http://www.microcreditsummit.org/pubs/reports/socr/EngSOCR2007.pdf

- Ledgewood, J. 1999, MICROFINANCE HANDBOOK: An Institutional and

Financial Perspective, The World Bank, Washington D.C.

- Long-Term Impacts of Microcredit Programs, December 29, 2000, retrieved

from

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http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARC

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- McDonnel, S. 1999, ‘The Grameen Bank microcredit model: lessons for

Australian indigenous economic policy’, Discussion Paper, no. 178,

Australian National University Centre for Aboriginal Economic Policy

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- Microfinance Impact Evaluation, March 2003, retrieved January, 15, 2009

from

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- Remenyi, J. & Quinones B. Jr 2000, Microfinance and Poverty Alleviation:

Case studies from Asia and the Pacific, Pinter, London & New York.

- Robinson, M S 2001, The microfinance revolution: Sustainable finance for the

Poor, The World Bank, Washington D.C., Open Society Institute, New York

- Ryan, F. 2008, ‘Microloans get a boost’, Banking/Finance, 23 October 2008,

p. 11, retrieved December, 18, 2008 from Macquarie University Database.

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