Rural Credit and Microenterprise Development
International Rural Development
Paper Coordinator: Dr. Tanira Kingi
Date of Submission: 31 Agust, 2007
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
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.
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
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
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
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 &
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
However, in some literature, microfinance falls into only two categories, formal and informal because the
semiformal sector is cooperated into the formal sector.
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
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)
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
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
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).
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,
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
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.
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,
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
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
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)
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
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.
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