Is Microfinance a Sustainable Solution to Poverty?
Microfinance refers to the provision of financial services, generally microloans, to the poor with the purpose of income generation and poverty reduction. It originated in the 1970s in Bangladesh and by the 1990s it became the world’s most highly funded poverty alleviation policy. Its popularity is based on its intuitive appeal and the success of its business model. Today, microfinance is one of the key tools in the fight against poverty.
But has it really fought poverty? Given the wide international support it has received, it could be assumed that microfinance has worked in poor people’s favor. With the poor now being able to obtain loans in order to set up or expand profit-generating businesses, poverty should have been eradicated around the world. But research has shown otherwise: with the exception of some success stories, economists Bateman and Chan note, the overall effect on the poor has been “nothing short of catastrophic”.
This misconception about the effects of microfinance has taken the focus away from other, more efficient, pro-poor policies. So general awareness of the limitations of microfinance is vital, as it can lead to the implementation of better-performing, more sustainable alternatives. While acknowledging that microfinance can have some moderate benefits, such as providing poor households with a small income helping them meet basic needs, these effects are outweighed by the policy’s adverse impacts, which operate at three levels.
Microfinance works as barrier to sustainable economic and social development because it is focused on short-term gains based on a small income, which is not self-sustaining. Poor people have become worse-off than they were before taking out a loan. Instead of lifting people out of poverty, microfinance has led to deprivation, inequality and backwardness, functioning as an overall “anti-development intervention”.
Microfinance has adverse effects at three levels: individual, local, and national.
At the individual level, microfinance leads to what we call “poverty traps”. While proponents like Dambisa Moyo – global economist and microfinance advocate – argue that microfinance helps the poor by bringing them “into the economy for the first time”, it does so by indebting them. This indebtedness comes as a result of the inability of microfinance customers to repay loans, which is in turn caused by high interest rates. Microcredit interest rates are higher than traditional ones and in some cases interest rates as high as 195% have been reported. For many microfinance customers who work as subsistence farmers, any marginal increase in their output cannot cover the high interest rates. When a person cannot repay one credit, they are required to take out new loans to repay the existing ones. This leaves them unable to move out of a loan-subsistence cycle and stuck in a poverty trap.
Another problem is that many borrowers use microloans for consumption spending and not for the initial purpose of microfinance to help them establish small enterprises. Table 1 shows that the main reason for taking out a loan for 73.4% of debtors in 2001 was to support consumption needs. This practice is highly unsustainable because, as already poor individuals take out a loan in order to fulfill their consumption needs, they are forced to redirect their incomes to microloan repayment, causing further indebtedness.
At the local level, the negative effects of microfinance are twofold. First, it can result in the erosion of solidarity within the local community. With many loans being given as group loans, repayment is guaranteed by social collateral (peer pressure). But in case of one group member’s inability to pay, this can lead to social humiliation and the weakening of the community’s sense of unity.
Second, it can infantilize the local economy and encourage de-industrialization. It does so by preventing the flow of credit to Small and Medium Enterprises (SMEs). For a local economy, these are preferable to microenterprises because they are long-term oriented and use more sophisticated technology, being able to achieve a minimum efficiency of scale. Since microfinance focuses on poverty reduction at the smallest level, it leads to an over-supply of inefficient micro-businesses, eroding the functioning of SMEs and overlooking the crucial role of scale economies.
Microfinance also has negative economic effects at the national level. With the spread of microfinance, small-scale entrepreneurs and microenterprises have proliferated and the informal sector has occupied a growing share of the economy (with values as high as 72% of total GDP in Kenya). The proliferation of microbusinesses has caused already small profit margins to shrink even further, leading to client failure (when the microbusiness fails, resulting in no more income generation). The problem in distressed economies is not a lack of supply but rather demand, and policy-makers’ belief in Say’s Law – the idea that supply creates its own demand – is misguided. Local economies do not have the elasticity to absorb the high number of unemployed persons through expanding the enterprise sector. So the newly created enterprises do not expand the volume of demand, but rather redistribute the existing one. Microfinance creates markets oversaturated by micro-entrepreneurs.
Microfinance has fallen short of reaching out to poor people and lifting them out of poverty. On the contrary, it has contributed to their entrapment in a vicious cycle of loan-dependency. This calls for more attention to be brought to the detrimental effects of microfinance and for a shift of focus towards other poverty alleviation tools.
Table 1. Main reason for obtaining a loan in 2001, per cent.
|Main reason for obtaining a loan||2001|
|Buy inputs/working capital||2.5|
|Investment in equipment/lands/building/animals||5.4|
|Reconstruction of dwelling||13.1|
 Milford Bateman and Ha-Joon Chang, “Microfinance and the Illusion of Development: From Hubris to Nemesis in Thirty Years,” World Economic Review 1 (2012): 13-36.
 Milford Bateman, “The Age of Microfinance: Destroying Latin American Economies from the Bottom Up,” Austrian Research Foundation for International Development/Österreichische Forschungsstiftung für Internationale Entwicklung (ÖFSE) Working Paper 39 (2013), http://www.networkideas.org/focus/sep2013/Microfinance.pdf.
 Investopedia, “Poverty trap”, http://www.investopedia.com/terms/p/poverty-trap.asp.
“What We’re Reading: Dead Aid by Dambisa Moyo”, Opportunity International, November 3, 2010, http://opportunity.org/news/blog/2010/11/what-were-reading-dead-aid-by-dambisa-mo.
 “Does Compartamos Charge 195% Interest?”, Center for Global Development, January 31, 2011, http://www.cgdev.org/blog/does-compartamos-charge-195-interest.
 Milford Bateman and Ha-Joon Chang, “Microfinance and the Illusion of Development.”
 Jami Solli, “What Happens to Microfinance Clients who Default? An Exploratory Study of Microfinance Practices”, The Smart Campaign, January 2015, http://www.smartcampaign.org/storage/documents/what_happens_to_microfinance_clients_who_default_eng.pdf.
 Milford Bateman and Ha-Joon Chang, “The Microfinance Illusion,” Mimeo, University of Juraj Dobrila Pula, Croatia, and University of Cambridge, UK (2009).
 Robert Rolfe, Douglas Woodward, Andre Ligthelm and Paulo Guimaraes, “The Viability of Micro-enterprise in South Africa,” Paper presented at the Conference on Entrepreneurship in Africa, Whitman School of Management, Syracuse University, Syracuse, New York, 1-3 April 2010.
 Milford Bateman, Dean Sinković, and Marinko Škare, “The Contribution of the Microfinance Model to Bosnia’s Post-war Reconstruction and Development: How to Destroy an Economy and Society Without Really Trying,” Austrian Foundation for Development Research (ÖFSE) Working Paper 36 (2012), https://www.econbiz.de/Record/the-contribution-microfinance-model-bosnia-post-reconstruction-development-how-destroy-economy-society-really-trying-bateman-milford/10010369654.
 Ke Chen Chen and Mali Chivakul, “What Drives Household Borrowing and Credit Constraints? Evidence from Bosnia and Herzegovina,” IMF Working Paper (European Department) 8 (2008), https://www.imf.org/external/pubs/ft/wp/2008/wp08202.pdf.
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