India: What Ails the Existing Microcredit Model

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Aug 2019
India, August, 21 2019 - Microcredit has gained much traction as a tool for ensuring the welfare of the most impoverished in the society but there are certain flaws in the model.

An article published on 21st August in Ideas for India, authored by Mushfiq Mobarak and Vikas Dimble and originally appearing in Yale Insights, suggests that the existing systems of microcredit have a limited impact on the long-term wellbeing of the recipients. Microcredit has gained much traction as a tool for ensuring the welfare of the most impoverished in society, and boosting development alongside. The article, however, claims that certain flaws in how microcredit transactions occur has led to the outcomes having muted benefits in improving the lives of its beneficiaries in a meaningful way. Furthermore, the article suggests a number of methods of utilising microcredit outside the orthodox ones, which can potentially bring benefits to a much larger section of the population, sections that are generally not served by the operations of traditional microcredit.

What is microcredit?

Microcredit refers to the granting of very small loans to impoverished borrowers, with the aim of enabling the borrowers to use that capital to become self-employed and strengthen their businesses. Loans given as microcredit are often given to people who may lack collateral, credit history, or a steady source of income.

The core idea of microcredit is that a small loan will provide access to the larger economy to people who typically live outside the scope of the institutions on which the mainstream economy rests. Such a loan is meant to enable them to commence with productive activities, and will give them the initial boost required to gain entry into an industry, after which production will be able to sustain itself, and the loan will gradually be repaid.

Advertising Microcredit agreements frequently do not require any sort of collateral, and sometimes may not even involve a written agreement, as many recipients of microcredit are often illiterate. When borrowers demonstrate success in paying their loans on time, they become eligible for loans of even larger amounts, allowing them to finance expansion.

Microcredit falls under the larger umbrella of microfinance, financial services for individuals who don’t have access to traditional services of this kind. Microfinance activities usually target low-income individuals, with the goal of helping them to become self-sufficient. In this way, microfinance activities have an aim of poverty alleviation as well. An example of a microcredit institution is the Grameen Bank in Bangladesh, founded in 1976 by Mohammed Yunus. The Grameen Bank offers small loans to the impoverished without asking for collateral, and was the pioneering institution in the realm of microfinance. The bank has 8.4 million followers, 97% of whom are women, and the bank has repayment success rates between 95 to 98 percent.

Why are microcredit institutions failing to deliver long-term benefits?

The article in Ideas for India cites a 2015 study that found “a lack of evidence of transformative effects of microfinance on the average borrower”. Another study found that having access to microcredit made very little difference to changing the lifestyles of borrowers, based on six indicators: household business profits, business expenditures, business revenues, consumption, consumer durables spending, and spending on temptation goods. These indicators only saw a 5% impact when microcredit was available.

The primary reason for the lackadaisical effects of microcredit is the stringent repayment schedule offered by most microcredit institutions. Since most borrowers to whom microcredit is given have little to no credit history as a result of their exclusion from traditional systems of credit, institutions offering microcredit are unable to judge the risk associated with lending to certain borrowers, and cannot be sure what the risk of them defaulting will be. To lower the risk of defaulting, microcredit lenders therefore resort to repayment schedules that demand an initial repayment that is almost immediate, after which borrowers must adhere to an inflexible weekly schedule for repayments. The effect of this is that borrowers are unable to use the loans on investments that will take some time to be fully realised, and instead are forced to use the loans they receive on short term investments that only boost production to an extent, and the overall growth of their incomes remains meager.

How can the microcredit system be reformed to have greater benefits for borrowers?

A study by Erica Field, Rohini Pande, John Papp, and Natalia Rigol, published in American Economic Review assigned groups of borrowers one of two repayment schedules: the traditional one, wherein repayment was to begin two weeks after the loan was given, and a repayment schedule wherein the borrowers received a two month grace period before they were required to begin repayment. Once repayment began, both groups again had the same schedule.

Three years after the initial loans were given out, the study found that borrowers who received the grace period were more likely to have started a new business, and also reported both higher profits and household incomes. However, there was also an increased rate of defaulting in this group.

But another study cited in the article had borrowers switch from a weekly repayment schedule to a monthly one, and saw increased incomes without the increased rate of defaulting that occurred in the other study. Under a monthly repayment schedule, borrowers scored 45% lower on the Financial Stress Index, and had increases in income more than double those of borrowers under a weekly repayment schedule, with those under the monthly system reporting income increases of 84-88 per cent.

As for the barriers to assessing credit risk, these can be mitigated by using community information. One study, published in 2017, found that when local traders or shopkeepers made lending decisions, the recipients of the loans were notably successful in increasing production, and their incomes correspondingly increased. Another 2017 study saw entrepreneurs being asked to rank their peers on the basis of a few metrics, including profitability and entrepreneurial characteristics. Those ranked in the top third of entrepreneurs by the peers exhibited returns of 17% to 27%, while the average return was 8%. Communities can be an accurate source of information about credit risk for microcredit institutions, though the article notes that the implementation of such processes would require the elimination of bias and incentivising accurate information.

What are the other applications of microcredit?

Conventionally, microcredit has been used mainly for entrepreneurs to begin production and attain self-sufficiency. However, the Ideas for India article notes new, mostly unexplored paths for the utilisation of microcredit as a poverty alleviation and productivity-boosting measure.

A study found that small microcredit loans can allow rural labourers –those who are employees, as opposed to entrepreneurs, who are employers– to migrate to urban areas to find work during the lean season, when there is no work to be found on farms. Those who migrated temporarily during this season experienced increased spending in both food and non-food areas, and increased their calories consumed. Studies conducted in Zambia and Kenya found that microcredit can be used in situations where seasonal factors cause drops in income to overcome these “seasonal credit crunches” and avoid taking decisions which cause people long-term negative impacts. Microcredit can also be used to dampen the effects of shocks like floods by providing people with a form of insurance that both increases production before the shock and provides a safety net after.

Microcredit has a vast range of applications for poverty alleviation and general development, but existing systems require reform in multiple areas to allow for unfettered benefits that last. Furthermore, in areas were the application of microcredit is relatively new, microcredit systems must be carefully evaluated before they are put into place, so as to enable the greatest benefit from such institutions.



 

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