The Wall St. Journal recently published an important article on microfinance (http://blogs.wsj.com/indiarealtime/2015/03/18/calls-grow-for-a-new-microloans-model/). The article wasn’t important because what it said was news. The industry has known for years that very few well-designed studies have been able to detect a measurable impact from microfinance on poverty. No, what was important about the article was that if the Wall St Journal has reported it, then it’s certain that the shine the industry got when Mohamed Yunus won the Nobel Peace Prize in 2006 has now completely tarnished.
The problem with that original shine was that it was, well, a bit too bright. The idea that borrowers were investing in their business using microfinance services that were both convenient and affordable became part of the foundational belief system of the industry and its supporters. This belief system held even as the industry shifted from microcredit to microfinance when evidence began to show a limited developmental impact from credit. Under the microfinance model, clients would use credit coupled with savings (or, occasionally, insurance) to raise themselves up out of poverty.
As the Wall St Journal points out, the evidence for this is scant. Demonstrating how the past always finds a way to repeat itself, recently microfinance has morphed into “financial inclusion”, which places heavy emphasis on (mobile) payments to bring those who are neither borrowers or savers into the financial system. How this will lead to socio-economic development is not clear, but it seems that underneath the new paradigm, the old belief that financial access itself confers benefits continues to hold sway.
Financial access is important because financial exclusion is a monumental problem. But financial access is not sufficient. It doesn’t solve problems related to skills and education or household financial management practices. In other words, just because someone has a bank account and access to credit doesn’t make them less poor.
Critics like the Wall St Journal have a field day when the evidence comes to light that finds little correlation between financial access and socio-economic development. And because its attacks the industry’s foundational belief system, this criticism strikes very close to home.
But it’s always been a weak argument. Financial access creates possibilities, not opportunities. Surely, how someone uses financial services matters more than simply having access. But probably not even Warren Buffet would be able to squeeze a lot of additional income from the small farm or retail shop that is the primary livelihood activity for most microfinance clients. As long as the source of income is low-margin and not scalable, even optimum usage of financial services can only have a small impact on income.
Still, there are at least 200 million microfinance clients in the world, and the number keeps growing every year. If the services aren’t “helping”, then why to people keep using them?
The answer is that microfinance services are helping, just not in the way microfinance’s foundational belief system says it does.
A recent CGAP analysis of M-Shwari, a mobile savings and credit provider in Kenya, provides some clues (http://www.cgap.org/sites/default/files/Forum-How-M-Shwari-Works-Apr-2015.pdf). In only two years, M-Shwari has racked up some impressive numbers: 9.2 million deposit accounts, 20.6 million loans, PAR90=2.2%. This is what we’ve been waiting for: massive scale using mobile technology.
But dig a little deeper and you find the following:
- The number of active savings accounts is 4.7 million — half of all accounts. This is an organization that has only been around for 2 years, and already half their savings accounts are dormant. Based on the numbers they give, those dormant accounts have an average of just $0.40 in them.
- There has been a total of $1.5bn deposited since launch. A huge number. But the current amount of deposits is just $45.3mn. Just 3% of the funds that have been deposited have stayed on deposit.
- Why the quick turnover? Because most people make a deposit in order to access the credit service. It seems many borrowers reduced their deposit after they paid off their loan. Many others who didn’t qualify for a loan many also have drawn down their deposit.
- Still, isn’t it great that someone figured out how to make loans using mobile technology? Well….the average loan balance is less than $10. Loans carry a term of 30 days but can be rolled over.
- The interest rate is 7.5%/month … and is charged each month the loan is rolled over. That’s basically 7.5% FLAT (90% APR)! And yet surveyed clients said the interest rate was “cheap”.
So what’s going on here? It turns out that only 14% said they borrowed to invest in their business. Most people use it to cover shortfalls in income vs. expenses––what the authors of Portfolios of the Poor call “consumption smoothing”.
Although perhaps it is more accurate to call it “household liquidity management”.
The problem for most microfinance clients, and perhaps the main reason why they do not have access to the mainstream banking system, is that their income is not just low, it’s unpredictable. In such circumstances, household liquidity management becomes a regular––if not daily––activity. And that makes long-term planning more difficult.
This is important because if Warren Buffet really were a client intending to use microfinance services to build wealth, he would need to think long-term. Delaying current gratification for long-term benefits is the mindset shift that underlies financial literacy.
If few clients actually use microfinance services in the way they original designers of microfinance programs expected them to, that doesn’t mean it is a failure. Microfinance does address the problem of income unpredictability. A stable, reliable source of credit, combined with savings, allows clients to meet their spending needs even as income ebbs and flows.
There is no doubt that this is important. There is no way to get ahead tomorrow if you have to scrounge to find money to eat today. But contributing to better household liquidity management is not, as the Wall St Journal points out, the same as contributing to increased income.
Another reason the Wall St Journal article is important is it because it shines a light on an important issue that the microfinance industry needs to address. A more nuanced analysis of microfinance’s “failure” to deliver the goods might look something like this:
- Microfinance says its loans are being used to “invest” in farms/micro-enterprises. This is wrong. The loans are used partly for working capital (purchases of inputs/inventory) but rarely used to expand production or move up the production chain to higher value-added goods/activities.
- In fact, there is a possibility that less than 50% of loans actually go into the borrower’s enterprise, with a large proportion being used to smooth consumption. Instead of the loans being used for the business, as the foundational belief system says, in reality the cash flow of the business is the underlying collateral for making a loan that partially finances consumption.
- Enabling people with low and unpredictable income to manage household liquidity stop has an enormous positive impact, but it is really only the first step. The next step is to enable people to use the breathing space created by these short-term loans to plan for the long-term. If anything, this is where microfinance has failed. How many MFIs offer long-term savings plans? How many MFIs offer a real investment loan, which would be larger and a longer term than a typical working capital loan?
This is easier said than done. Saving for the long term is not an automatic habit of low-income households, while borrowers as well as lenders may be cautious about taking on the increased risk of larger and longer-term loans. Financial education can address the former, and technical backstopping for farm and enterprise development may address the latter.
This post was contributed by Ron Bevacqua, ACCESS Advisory Managing Director.