Microcredit and Development — a Critique

Following my economic observations and reflections on Development Aid here in Tanzania, I did some reading on microcredit, which seemed to me now maybe one of the most sensible things to do to stimulate development. My first-hand impression of some other obvious choices has not been very good so far — I am quite doubtful of the real-life benefit of the secondary education the students get in the school I am teaching in, for instance.

The articles I found convinced me that I wasn’t wrong entirely thinking microcredit could help. But there’s a big BUT, or a number of them actually. An article in the New Yorker from 2008 titled What Microloans Miss provides a very readable introduction, but my primary source is an article called Microfinance Misses Its Mark from Aneel Karnani, published in the 2007 issue of the Stanford Social Innovation Review. It says that, first of all, microcredits help the not-so-poor better than the poorest:

One of the most comprehensive studies reaches a surprising conclusion: Microloans are more beneficial to borrowers living above the poverty line than to borrowers living below the poverty line.11 This is because clients with more income are willing to take the risks, such as investing in new technologies, that will most likely increase income flows. Poor borrowers, on the other hand, tend to take out conservative loans that protect their subsistence, and rarely invest in new technology, fixed capital, or the hiring of labor.

Now, even though that is already quite a problem (the way the poorest tend to spend microcredit money often brings them into a debt trap not much different from the one created by informal money-lenders, and the interest rates are still high for microcredit, mostly between 30% and 60% p.a.) it is not very surprising, and the fact that it can’t help everybody who needs help does not mean it doesn’t do any good.

So here are other negative aspects that are mentioned, and make a lot of sense from my own observations of business here:

A microcredit client is an entrepreneur in the literal sense: She raises the capital, manages the business, and takes home the earnings. But the “entrepreneurs” who have become heroes in the developed world are usually visionaries who convert new ideas into successful business models. Although some microcredit clients have created visionary businesses, the vast majority are caught in subsistence activities. They usually have no specialized skills, and so must compete with all the other self-employed poor people in entry-level trades.14 Most have no paid staff, own few assets, and operate at too small a scale to achieve efficiencies, and so make very meager earnings. In other words, most microenterprises are small and many fail – contrary to the United Nations’ hype that microentrepreneurs will grow thriving businesses that lead to flourishing economies.

This should not be too surprising. Most people do not have the skills, vision, creativity, and persistence to be entrepreneurial. Even in developed countries with high levels of education and access to financial services, about 90 percent of the labor force is employees, not entrepreneurs.15

It seems very obvious once you read about it, but still I must confess I never drew that simple comparison between the ratio of self-employed versus employees in developed countries and how we imagine to improve the economy of developing countries. And especially the stiff competition on the „entry-level trades“ is very observable — the number of things you can do for business on your own are very limited after all, it’s simple.

The people themselves see that similarly apparently:

The fact is, most microcredit clients are not microentrepreneurs by choice. They would gladly take a factory job at reasonable wages if it were available. We should not romanticize the idea of the “poor as entrepreneurs.” The International Labour Organization (ILO) uses a more appropriate term for these people: “own-account workers.”

Creating opportunities for steady employment at reasonable wages is the best way to take people out of poverty. “Nothing is more fundamental to poverty reduction than employment,” states the ILO. And the United Nations Development Programme agrees: “Employment is a key link between economic growth and poverty reduction. Productive and remunerative employment can help ensure that poor people share in the benefits of economic growth.”

That microcredit-funded businesses don’t usually create employment for others was already mentioned. The New Yorker article has a good summary of what would do that:

What poor countries need most, then, is not more microbusinesses. They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation. In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need. It’s easy for really big companies in poor countries to tap the markets for funding, and now, because of microfinance, it’s possible for really small enterprises to get money, too. But the companies in between find it hard. It’s a phenomenon that has been dubbed the “missing middle.”

The problem is a dearth not just of lenders but also of people willing to buy an ownership stake in companies, like the angel investors and venture capitalists that American entrepreneurs often rely on. Microfinance has led us to focus on lending, but it can be hard for young companies to get big purely on bank loans, which consume cash flow that could be reinvested in the business. Supplying the missing middle will require backers who want to invest in companies rather than just lend to them.

Interesting, especially the aspect of ownership, investing versus lending. Aneel Karnani, again, has a good image to make the advantage of bigger business easier to grasp:

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

Very convincing. And how can we get there? Karnani’s take-home message, together with only some country-comparison examples (that is an interesting bit in the article which I won’t quote more of here, because it basically backs the claims made before) is:

Overall, governments, businesses, and civil society would be well advised to reallocate their resources and energies away from microfinance and into supporting larger enterprises in labor-intensive industries. This is what is alleviating poverty in China, Korea, Taiwan, and other developing countries. At the same time, they should also provide basic services that improve the employability and productivity of the poor. Otherwise, they will miss the mark of lifting people out of poverty.

And how about what I, we (Action 5) can do? Maybe we could indeed help funding businesses that create employment, on the lower end of the „small-to-medium-sized enterprises“ mentioned. I feel that also education would probably improve if teachers and students had more of an idea what they are being educated for, instead of that almost magical thinking that with an education something good will happen in your life. Without jobs, usually, it won’t.

Datum: Donnerstag, 2. Juni 2011 14:05
Trackback: Trackback-URL Themengebiet: English, Weltreise 2011

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2 Kommentare

  1. 1

    The arguments sound plausible, but as this seems to be in defense of top-down-development-policies, I’d be cautious to draw such strong conclusions: The weaknesses of micro-credits might not render them senseless, e.g. giving micro credits in Indian communities seemed to help to some extent. We ourselves have some micro-funding in Tanzania — is it a poverty trap? Creating „Big“ buinesses on our own would lead to a conflict with our self-imposed principle to not impose ideas upon local communities; secondly its a delicate issue to set up businesses without having an idea about the demand-sides. And about unforseen contingencies (as may happen in poultry farming etc.)…?
    Education — always a big issue. Isnt it the same in Germany: If students do not know what they#re learning for, motivation shrinks?
    Combining both: What about business education? Having „entrepreneurs“ teach how to take risks and to manage start-ups? Or integrating a prototype business in school agenda (e.g. school farm, clothing business…)?

  2. 2

    Dear Roberto, thank you for your thoughts! You are right both that microcredit is certainly not useless, and that (at least from an Action5-perspective) top down cannot be the whole answer. This leads to the question: What is the best that we can do, personally and as a group?

    And there I feel we could consider moving into the „bigger“ business direction. We have been asked in the past and we are being asked (even more if we put the possibility out there) to help fund business. And I think it would be in the normal framework of negotiating the conditions for our support with our partners to stress the aspect of job-creation.

    Business eduction certainly won’t hurt, and actually happens at „my“ school, but all in all I am very convinced that having many small-scale „entrepreneurs“ does not move the society forward a lot.