Rural Credit and Microenterprise Development International Rural Development 111.760 Paper Coordinator: Dr. Tanira Kingi Bandeth Ros 06204554 Date of Submission: 31 Agust, 2007 2 Summary The terms “microcredit” and “microfinance” have been used interchangeably by development practitioners as a poverty reduction tool. The two terms are a little different in terms of motives and means of operations, but still share the same operational ideas of lifting the poor out of the poverty cycle through providing small loans for local economic development. Microcredit and microfinance work in three forms: formal, semi-formal and informal. These three forms show different loan operations, loan contracts, and organizational and management features. Microcredit and microfinance came when the poor cannot access finances from commercial banks due to no collateral, lending criteria, and bank locations. The poor find easier to access loans from informal credit providers, but their interest rates are often high and only for a short-term lending purpose and emergency. Moreover, these informal providers still demand collateral and base on informal relationship. Microcredit programs therefore are the best choice, but self-selected group criteria and membership requirements are still constraints hindering the very poor from taking advantages from these programs. From the lenders’ point of view, lending money to the poor at their places without collateral is risky and costs a lot of money. Cost recovery basis in this situation does not work. Some microcredit programs also fail to serve the poor due to institutional problems and financial constraints. State-owned microcredit programs often fail to distribute loans properly due to lack of implementation experiences, political issues, top-down approaches and no policy supports. In overall, microcredit and microfinance is successful in restarting local economies, improving the quality of life, reducing loan shark operations, and building social capital in rural communities. Their successes come from the focuses on the bottom poor, suitable loan operations, group establishment and ownership, cost management and good institutional arrangement. However, microcredit and microfinance are not the only solution for microenterprise development and poverty reduction. They do not always work in every situation. Microcredit and microfinance serve as a complement to other poverty reduction approaches. 3 1. Introduction When talking about rural credit and microenterprise development, we always come across the terms “microcredit” and “microfinance”. The ideas of microcredit and microfinance initially started when policy makers and economists found the truth that personal failings do not cause poverty, but the limited access of the poor to formal financial services and their unrecognized legal status in the market does (Elahi & Danopoulos, 2004). Collateral and high interest rates from informal money lenders are often the problem discouraging the poor from borrowing money. The poor actually possess tremendous local skills, hardworking experience, local business sense and market knowledge but these have been largely ignored (Robinson, 2001). Providing financial resources to local poor with skills is believed to enable them to set up microenterprises for income generation, which as a result enables community development to begin. The purpose of this report is to evaluate the roles of microcredit and microfinance in improving local economies in developing countries. The report addresses three major areas. Firstly, it gives definitions of microcredit and microfinance, and then provides a brief description of their application in the real development world. Secondly, it pinpoints key constraints faced by both borrowers and lenders in accessing and lending finances. Thirdly, it emphasizes the key successes and reasons for their achievements, using the case of Grameen Bank to provide supporting evidence, and their failures and limitations. 2. Definitions and Application of Microcredit and Microfinance in Development 2.1 Definitions Microcredit and microfinance are two terms which have been used interchangeably in development discourses. Microcredit emerged in 1970s (Grameen Bank, 2007a) and became popular in the early 1980s. This term was primarily applied in Bangladesh by Grameen Bank and later spread onto other nations. Grameen Bank defines microcredit as delivery of small loans to the rural poor, especially to women, who have been disqualified by the private money lenders (Grameen Bank, 2007a). Different from conventional banks, microcredit is collateral-free, aiming to increase local income through economic activities. In 2005, microcredit served, in 4 total, 81,949,036 clients who were among the poorest, 68,993,027 (84.2%) of whom were women (Daley-Harris, 2006). Instead of using the term microcredit, the Asian Development Bank prefers the term microfinance, and defines it as “ the provision of a broad range of financial services such as deposit, loans, payment services, money transfers, and insurance to poor and low-income households, and their microenterprises” (2000, p.2). Microfinance has two approaches, the financial systems approach and the poverty lending approach (Robinson, 2001). The financial system approach refers to providing loans to meet the demands of the economically active poor while the poverty lending approach focuses on proving credit and additional services for poverty reduction (Robinson, 2001). So, what is the difference between microcredit and microfinance? Few literature articles differentiate both terms. Robinson (2001) argues that Grameen Bank applies microcredit which in fact is the poverty lending approach of microfinance. Elahi and Danopoulos (2004) distinguish microcredit from microfinance in terms of motives and means of operation. They state that microfinance has a profit motivation for financial independence, while microcredit does not. Although it is still unclear whether microcredit is one component under microfinance or they are two separate terms, both still share similar operational principles and practices of microlending ideas, regarding the provision of small loans to the poor clients in rural communities (Elahi & Danopoulos, 2004). 2. 2 Uses and Applications in Development Microfinance is operated in three different forms1: formal, semiformal and informal (ADB, 2000; Cornford, 2000). Formal sectors deal with high levels of regulation and supervision over the borrowers and savers, and they can be state, non-governmental organization (NGO), or privately owned (Cornford, 2000). State-owned microfinance generally works in the form of a subsidized poverty loan, in which the government channels money to the rural poor through its development 1 However, in some literature, microfinance falls into only two categories, formal and informal because the semiformal sector is cooperated into the formal sector. 5 program. The government, then charges back interest at a lowered rate (Tsai, 2004). Like in China, the interest rate of subsidized poverty loans is only 2.88% compared to 8-10% of official interest rates (Tsai, 2004). According to Conroy (2002), the operation of NGO-owned formal microfinance is often undertaken in the form of a bank model, and usually replicates the Grameen Bank of Bangladesh. This model involves creating groups in the local community; intensive fieldwork by staff to supervise those groups; and the creation of saving accounts (Conroy, 2002). In contrast, the semiformal sector is characterised by not being formally regulated and is less structured. It can be run by NGOs, donors, local people or partly under supervision of government agency (Cornford, 2000; ADB, 2000). This sector may include saving and credit cooperatives, village bank, and registered self-help groups. Village banks are popular in Latin America and Africa, and dealing with a large group of 30-50 people in a village (Conroy, 2002). Registered self-help groups work successfully in India, helping save money among members for emergencies (Conroy, 2002). Like the Village Bank, this group works best with 10-20 members who share socioeconomic and demographic characteristics (Conroy, 2002; Tsai, 2004). Informal sector is a form of loan operation without formal regulation (Cornford, 2000). This form of microfinance deals with individual confrontation and negotiations between borrowers (the poor) and lenders (informal groups of rich people which include commercial money lenders, traders/merchants, shopkeepers, and landlords) (Cornford, 2000; Tsai, 2004). Lending money between friends, relative, neighbors, and colleagues is also categorized into this form (Cornford, 2000). A relationship, obligation, and loyalty are seen to be high between borrowers and lenders in some rural areas and the opportunity to seek rents by these money lenders through high interest rates is evident. 3. Key Constraints in Accessing and Lending Finances 3.1 Why are rural communities unable to access finance? Rural communities need investment capital to set up their enterprises. According to Buckley (1997), the principle source that people think of is their personal savings coming from self generation (selling agricultural products or employment), and gifts from relatives. Pretes (2002) 6 calls this situation “Self-financing”. In Cambodia, remittances from those who work in cities (mostly garment factories) play a key role in supporting their dependent members at home. In addition, the poor often need to borrow money from friends, relatives and neighbors as a supplement; however, this is often impossible because these people may also live in subsistence (Pretes, 2002). Many rural poor also continue to borrow from other formal and informal credit providers within or outside their communities. There are a number of constraints faced by borrowers in accessing finances from private commercial banks, informal money lenders, and microcredit programs. Private Commercial Banks: Many poor people cannot access loans from commercial banks for a number of reasons. Commercial banks only agree to lend money if borrowers have sufficient collateral for loan recovery (Jain & Moor, 2003). Collateral lowers risks and give more security to banks in case the borrowers fail to repay, which generally implies that only the rich and those with collateral are the banks’ target groups (Basu, 1997). This is a barrier to many rural poor who have no tangible assets to prove that they are able to pay the loan back, with only the promise of future cropping products as collateral. In addition, banks still refuse to give loans to farmers who put their lands as collateral if those lands are unrecorded or have traditional titles (Pretes, 2002). Another reason is that banks also have additional criteria that borrowers should meet in order to get loans; for example, the banks want to know why their clients borrow money, what kinds of businesses they want to invest in and the expected returns, and existing income of borrowers (Jain & Moor, 2003). The reason for meeting those criteria is to make sure that the borrowers have enough future earning potential to repay the loans. The poor may also feel reluctant to borrow money from banks which are based in urban areas, because of high transaction costs (opportunity costs and traveling costs). Informal Money Lenders: Low income households are more likely to access loans from informal money lenders than from commercial banks. One reason is due to low transaction costs and quick disbursement (Buckley, 1997). A study by Buckley (1997) undertaken in Africa shows that the average time to access loans from the first contact to receiving the loans takes only about 2.28 days. However, there are some barriers that may prevent even poor households from accessing loans from these providers. First, interest rates charged by these money lenders are 7 often high, making it undesirable for poor borrowers. On some occasions, interest rates can be as high as 20 percent per day (Pretes, 2002). Another constraint is that money lenders may only give short term loans, which could last a week, a month, or a season, and their lending purpose is for consumption or emergencies (e.g. medical expenses or for school fees) (Burckley, 1997). Like commercial banks, informal money lenders still demand collateral or look for clients with permanent jobs or waged incomes (Buckley, 1997; Pretes, 2002). Local money lenders in some conditions will not lend money to borrowers automatically if they don’t have a relationship with the borrowers; for example, landlords prefer to lend money to their tenants because they have a patron-client relationship (Basu, 1997). Microcredit programs: The advantages of these programs are that they give small loans which are repayable by the poor, do not need collateral, and have low interest rates. Still, there are constraints. Evans et al. (1999) found that self-selected credit group is one impeding reason. From their study, group selected members based on social class, literacy, socio-cultural characteristics, and those who do not meet the criteria are excluded. Moreover, membership requirement is another factor; for example, members have to attend credit group meetings regularly, which mean they need to bear transportation costs and opportunity costs, to pay registry fees, to deposit monetary savings, or to meet target repayment (Evans, et al., 1999; Maes & Foose, 2006). 3.2 Why are financial institutions reluctant to lend money to rural communities? Financial institutions hesitate to lend money to the rural poor due to a number of constraints. Commercial banks do not serve the poor because they are unwilling to confront high risk, as most of the very poor do not have physical collateral to guarantee their repayment (ADB, 2000). Another constraint is due to high transaction costs with small profits of return (Basu, 1997; ADB, 2000; Jain & Moor, 2003). It is obvious that the poor live in remote areas where local infrastructure is poor; population density is low. Therefore, approaching those people at their home will cost a lot of money in terms of administrative work, (such as monitoring or loan collection), and cost-recovery basis will not work in this situation (ADB, 2000; Pretes, 2002; Maes & Foose, 2006). Furthermore, the goal of these organizations is not to help the vulnerable and disadvantaged with poverty reduction but to make profits for business success (ADB, 2000). 8 Many studies point out the same issues towards some microcredit programs that fail to reach the poor. These programs are often unable to cope with their institutional problems, such as inadequate networks and mechanisms to expand their services to reach the poor, insufficient capacity to maintain sustainability, financial crisis (depending on donors’ funds), and lack of local situation understanding (ADB, 2000; Tsai, 2004). Some state-owned microfinance programs do not work well in credit distribution due to a lack of implementation experience, political patronage, top-down approach, and lack of policy support (Tsai, 2004). 4. Assessment of Microcredit and Microfinace Initiatives 4.1 What kinds of successes have they achieved? In developing countries, microfinance is an approach to deal with poverty issues through the restarting of local economies for self employment and surplus gain. Evans et al. (1999) believe that people stay in poverty because they are trapped in the poverty cycle. To lift people out of this trap, we need to break this cycle by providing loans for capital (Evans, et al., 1999; Grameen Bank, 2007b). Giving gifts for consumption is not the right way because it will allow people to depend on external support. The best way is to stimulate people’s thinking about their own skills and then to provide them with financial assistance as an input, to make their local economic activities happen (Doyle, 1998; ADB, 2000). By doing so, the rate of employment may increase, so that the poor can generate income, build assets gradually, manage their risks, and improve their quality of life (Doyle, 1998; ADB, 2000; Marino, 2005). Microfinance is also one solution to deal with local loan sharks and to curb illegal market operators, who always try to exploit benefits from the poor through high interest rates and demand for collateral (Gremeen Bank, 2007c). In addition, in the context of post-conflict development, microfinance is viewed as a relief to help the vulnerable survive disasters and as a tool to enhance wellbeing, empowerment, and human capital. For example, Save the Children in Tajikistan uses the lending and saving groups to raise the awareness of people on health and women’s rights (Doyle, 1998); whilst Bangladesh Rural Advancement Committee helps raise awareness of Bangladesh women on contraceptive use, gender, and food nutrition (Goldberg, 2005). More importantly, microfinance mobilizes 9 people to work together as a way of contributing to building peace, trust, and reconciliation in communities (Doyle, 1998; Marino, 2005). Grameen Bank (GB) gives another example of successful microcredit in Bangladesh. By May 2007, GB serves 7.21 million borrowers, the majority of whom are woman including beggars, disabled, blind, and old people (Grameen Bank, 2007d). 64% of the borrowers’ families crossed the poverty line by June 2007 (Grameen Bank, 2007d). GB improves the social and economic conditions of the poor through providing different types of loans such as housing loans (from July 2006 to June 2007, 11,871 houses were built), micro-enterprise loans, education loans (17,201 students got loans), and scholarship awards (up to June 2007, 50,000 children received the awards) (Grameen Bank, 2007d). It also introduced technology (telephone-ladies), and provided training (Grameen Bank, 2007d). GB contributed 1.10 percent to the national GDP of Bangladesh in 1996 (Grameen Bank, 2007e). 4.2 Why are they successful? Morshed (2006) emphasizes three important features that make microcredit programs successful. First, these programs focus on bottom poor, especially women who in fact are very active for loan investment and repayment (Morshed, 2006). Second, their procedures suit the needs of the poor. As an example, the Grameen model applies social collateral (mutual trust and accountability among group members) instead of physical collateral to guarantee loan repayment; provides services at the borrowers’ doorsteps so it saves transaction costs and is suitable for rural women; encourage their clients to use small loans and frequent repayment to avoid loan defaults, and create saving accounts for emergencies (Jain & Moor, 2003; Morshed, 2006). Third, microcredit requires borrowers to establish groups and to select their own members; so that these groups can put pressure on members who fail to repay the loan (Jain & Moor, 2003; Morshed, 2006). Jain and Moor (2003) emphasizes other factors such as the ability to keep minimum transaction costs of lending institutions by reducing routine operational costs and letting the borrower groups work on monitoring and managing their loans, as well as the good institutional management in terms of power delegation to lower level, staff incentives, and merit-based recruitment. 10 4.3 What are their failures and limitations? Although a lot of successes have been highlighted, some studies still argue that microcredit and microfinance programs cannot reach the extremely poor and are unable to maintain sustainable poverty alleviation (Pretes, 2002; Elahi & Danopoulos, 2004). Elahi and Danopoulos (2004) argue that microcredit cannot deal with poverty because “the lack of microcredit has not caused the pervasive poverty” (p.74). Robinson (2001) says that microfinance is not suitable for the very poor who are ill or who have no skills because these people are not able to repay the loans, and are only using them for consumption. Furthermore, according to Pretes (2002), microcredit cannot enable local enterprises to start up without grants and microequity2. He argues that although microcredit programs offer lower interest rates than commercial banks and informal money lenders, they are still working on a loan principle, which causes borrowers to have a feeling of loan obligation. Microcredit, in some circumstances, can make the very poor even worse off when their business fails because they may need to borrow money from private lenders or sell their properties to resume the refinance. Microcredit is suitable only when enterprises have already been run and are profitable (Pretes, 2002). In addition, credit alone does not push local entrepreneurs to reach the expected results if those entrepreneurs do not have or do not improve their techniques, equipment, or technology (Buckley, 1997). Microcredit cannot work well and yield large impacts in societies that have no clear property rights, weak state, poor market, and strong kinship relationship or networks (Buckley, 1997). 5. Conclusion Microcredit and microfinance share the same operational ideas of serving the poor through small loans. They understand that the reasons why the poor cannot access loans are simply because the poor do not have tangible collaterals, do not meet borrowing criteria, unable to meet the expense 2 Microequity refers to “ the provision of grants by external agencies to operational entrepreneurs in developing countries, without any expectation of a share in the ownership or profits of the business” (Pretes, pp 1341-1342) 11 of high interest rates, and cannot afford traveling and opportunity costs. Moreover, financial institutions don’t want to lend money to the poor due to high default risks and high transaction costs. From this understanding, microcredit and microfinance apply a new strategy to deal with these problems, and make loans more accessible to the poor. The success of microcredit and microfinance are realized in a numbers of ways: restarting local economies, improving the quality of life, reducing loan shark operations, and building social capital, peace and collaboration in communities. Their successes are evident in many developing countries. However, the questions, how far microcredit and microfinance help alleviate poverty and develop communities and whether it is sustainable or not, are still hard to answer. Poverty is a combination of many different factors. Robinson (2001) says microfinance is not a panacea for all situations because some countries may need social grants, vocational training or infrastructure improvement for poverty alleviation. So, microcredit and microfinance are still not the ultimate solutions, but rather a complement to other poverty alleviation approaches. 12 References Asian Development Bank. (2000). Finance for the poor: microfinance Development Strategy. 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Paper presented at Global Microcredit Summit held Nov 12-15, 2006 in Halifax, Nova Scotia, Canada. Retrieved 25 July, 2007, from http://www.microcreditsummit.org/papers/Workshops/ 19_Morshed.pdf 14 Marino, P. (2005). Beyond Economic Benefits: the contribution of microfinance to postfinance to postconflict recovery in Asia and the Pacific. Retrieved 26 July, 2007, from http://www.gdrc.org/icm/country/fdc-afgan.pdf Pretes, M. (2002). Microequity and microfinance. World Development, 30(8), 1341-1353. Robinson, M. (2001). The Microfinance Revolution: Sustainable Finance for the Poor. Washington, DC: The World Bank. Tsai, K. S. (2004). Imperfect substitutes: the local political economy of informal finance and microfinance in rural China and India. World Development, 32(9), 1487-1507.
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