Microfinance – discrediting the myth

Development Policy06 Oct 2010Bertine Kamphuis

A review by Bertine Kamphuis

Microfinance feels good. It claims to lift the poor out of poverty and increasingly pays for itself. But does it? In his 2010 book, Why Doesn’t Microfinance Work? The Destructive Rise of Local Neoliberalism, Milford Bateman discredits microfinance for doing almost exactly the opposite and blames Wall Street-style practices for amplifying its negative effects.

His book is published at a time when microfinance has re-invented itself. About thirty years after the popular ‘discovery’ of microfinance, even its long-time proponents have to admit that there is still little, if any, evidence that microfinance lifts the poor out of poverty. Another publication, Portfolios of the Poor: How the World’s Poor Live on $2 a Day, by Daryl Collins and colleagues, published in 2009, shows that, rather than reducing poverty, microfinance can help the poor to cope with the unpredictability of their low incomes.

The obstinate optimism surrounding microfinance is largely based on the assumption that if the poor choose to take – and largely repay – microfinance loans, then they must be benefitting from them. Bateman claims that this assumption simply does not hold, and gives three reasons why microfinance does not work.

First, local markets generally cannot absorb the new economic activities of microfinance clients, which push down prices and put entrepreneurs out of business. Increased competition can lead to more business efficiency or to innovation, but nothing is gained when one coffee bar is simply replaced by another.

A second reason is that the poor rarely default on their loans, even if their businesses fail. The widely held assumption that repayment indicates business success misses this point. In fact, it may well hide increasing indebtedness.

Third, microfinance’s preference for individual, ‘survivalist’ micro-enterprises ignores the importance of scale, connectivity, technology and innovation for triggering local economic development. If microfinance crowds out lending to small and medium enterprises (SMEs), as the book claims, then the effects will be negative, resulting in a ‘primitivization’ of agriculture, increased dependence on imports and a weakening of the local economy.

Bateman draws vivid parallels between the commercialization of microfinance and the now infamous Wall Street-style practices. While microfinance managers face few start-up risks, some have awarded themselves exorbitant salaries and bonuses, which have created the first ‘microfinance millionaires’. Perverse incentives for loan officers encourage aggressive strategies that push poor households to borrow more than they can afford – a policy all too reminiscent of sub-prime mortgage lending. Moreover, interest rates have increased in order to improve profit margins, and social capital is increasingly abused to ensure loan repayment.

Experiences in regions that have been oversaturated by microfinance undermine the notion that more microfinance equals more development. Bateman urges governments worried about the build-up of microcredit bubbles and their possible sub-prime-style bursting to rethink microfinance (even if it pays for itself). He suggests looking for better ways of offering money-management opportunities to the poor and stimulating local development.

As an alternative to microfinance, Bateman favours conditional cash transfers that target ‘at-risk’ groups, especially in countries dealing with the aftermath of war, natural disaster or economic collapse, to provide people with cash to pay for urgent needs. Examples, such as Bolsa Familia in Brazil, where cash was provided in return for visiting a health clinic or attending school have shown good results.

Credit unions can also provide these benefits, he argues, but at much lower costs. He refers to experiences in East Asia, Spain’s Basque region, northern Italy, India’s Kerala state and Vietnam to show how alternative models for local business finance can promote socio-economic development through stronger state or community involvement. These cases have shown how finance with longer-term maturities can be directed to promising sectors and can help micro-enterprises to integrate into supply chains as production-based units.

Not only does microfinance not work, in Bateman’s opinion, but it actually ruins more effective opportunities for financing local businesses. His book would have benefitted from more evidence, however, to drive home his claim that microfinance is crowding out SME financing. As the ‘new wave’ microfinance institutions can increasingly pay for themselves, are they really eating up scarce donor money? Do developing countries have the wherewithal to decide against the mainstream microfinance model?

The wide range of case studies of unconventional local finance described by Bateman seems to suggest that they do – even when faced with heavy criticism from ‘new wave’ advocates as in the case of Vietnam. Can the microfinance industry be regulated differently to overcome its negative effects, for example by directing it towards models that resemble the successful heterodox models?

For example, Bateman criticizes multinationals that include micro-enterprises in their distribution chains. The ‘win-win’ effects only start to fade after the market becomes saturated with too many micro-enterprises. Perhaps the solution lies in limited entry, that is guaranteeing each micro-enterprise a big enough sales territory with enough potential clients to maintain a viable business, rather than dismissing this opportunity altogether.

Bateman is too quick to reject microfinance on grounds that are just asdogmatic as those propounded by microfinance enthusiasts – even though he does bring reality back into a debate in which some neoliberal assumptions have been left unquestioned.

Book details

Why Doesn’t Microfinance Work? The Destructive Rise of Local Neoliberalism, by Milford Bateman. Zed Books, 2010, 262 pp.