Microfinance: Indebting the Poorest in the World

In the previous article, we read about the theoretical concept of microfinance. This theoretical concept has been sold to the major financial organizations of the world that have pumped in billions to expand the reach of microfinance. Microfinance is now a major part of the poor economies right from Bolivia to Bosnia to Bangladesh.

However, the reality of microfinance seems to be the exact opposite. Most of the studies that were full of praises for the concept of microfinance were commissioned by the companies that were pursuing the business of microfinance themselves. Needless to say that these studies had vested interests and wanted to make microfinance look better than it is. Therefore, when unbiased studies were conducted, a lot of issues with microfinance were discovered. It seemed like microfinance was, in fact, indebting the poor and making the companies rich and the whole win-win model was a hoax.

In this article, we will consider the criticisms that have been levelled by some of the biggest critics of microfinance:

Not for Productive Purposes

Studies conducted to investigate the real impact of microfinance found out that most of the loans that were being made were not being used for productive purposes. Therefore, even though the intended purpose of the loans was to start micro enterprises, very few individuals that borrowed the money used it for this purpose. Instead, the money was being used to finance consumption expenses like marriage or medical issues. The microfinance companies had not developed a mechanism to ensure that the money being loaned out was being used for the intended purpose. Over and above that microfinance companies were also giving out a lot of consumer loans. A large portion of the loans being made were actually consumer finance loans aiding the purchase of mobile phones and other electronic gadgets.

The microfinance model, therefore, started to look like the subprime model. People below the poverty line were borrowing money for consumption purposes and did not seem to have any source of income to pay it back! The objective of poverty reduction appeared to be replaced by the debt spiral, that many borrowers found themselves in. They were borrowing more money to keep up with the payments of the old loans.

Usurious Interest Rates

Microfinance was called a significant innovation because it had supposedly created a way for the profit motive as well as the social reason to co-exist. However, this did not seem like the case, when studies revealing the true nature of microfinance activities were published.

The microfinance rates were given out at an average interest rate of 23% per annum! This meant that the microfinance companies were simply taking advantage of the lack of interest rate regulations in the developing nations and loaning out money at extremely high-interest rates. Studies revealed that over 50% of the disposable income of the poor households was being used only to service the interest on the debt. The repayment of principal and closing of the loan was, therefore, a farfetched thought!

Demand for Goods and Services Not Increased

The basis of the microfinance model was that micro enterprises would help to alleviate poverty. However, studies have shown that the whole idea of micro enterprises has ended up being a failure. Micro-enterprises have the potential to increase the supply of goods. However, that does not automatically create new demands for the goods or services being produced. In most economies, the demand is fairly stagnant. Hence, when more production takes places, the demand is simply spread out amongst many more enterprises. It bankrupts quite a few of them as oversupply also causes prices to drop and eats into the profit margins of the small businessmen.

Management Incentives

The top management at a lot of these microfinance institutions simply wanted to make the company look bigger and bigger. They had their personal hidden incentives. If they could make the business appear bigger than it was, they could justify the fat pay packages that they were obtaining. Also, they could justify the giving out of employee stock options which they could cash in during the IPO process making millions as a result.

Thus, the management of microfinance companies started pushing credit like never seen before in these markets. Microfinance loans were growing at the rate of 60% per year i.e. they would more than triple every two years! In hindsight most of the new loans were given to the same borrowers i.e. they were loans given to service the previous loans. Therefore, a lot of these loans were likely to end up the nonperforming assets, the moment they were sanctioned. Yet the management gave out these loans, knowing full well, how they were likely to end up.

Political Motives

Many critics allege that the biggest capitalist organizations in the world have been supporting the idea of microfinance for political motives. Microfinance deflects the responsibility from the government. The government is no longer required to provide better education and technology to the poor. Instead, the focus shifts on individual entrepreneurship which is just self-employment in menial tasks. Also, it takes the attention off of labour unions and labour laws allowing the capitalists to conduct their business unobstructed!

Microfinance has therefore proven to be economically unviable. Most of the microfinance institutions that were booming in 2010 are now facing losses. However, only time will tell whether this is the end or whether there is another twist to this microfinance story?

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