Global, January, 15 2019 -
Studies have shown it hasn’t really lifted people out of poverty. But it’s still made a difference in the lives of the poor.
For a period of time from the 1980s to the early 2000s, “microloans” were all the rage in international development.
The idea was simple enough: By giving a very small loan to someone living in a poor country, you could help them expand a small business, which would lift their family out of poverty. When they pay back the loan, the money can be cycled to more borrowers, getting more families out of poverty.
Organizations offering microcredit to poor borrowers — many living on $2 or less per day — took off in those decades. Investors and donors poured money into microcredit, hundreds of organizations offered loans, and the number of borrowers worldwide skyrocketed to 211 million by 2013.
The microcredit movement has been undeniably successful in opening up financial services to poor people across many countries. But what has its track record been when it comes to lifting people out of poverty?
Over the past decade, this question has occupied researchers, who have conducted randomized studies across a variety of countries and settings. The findings have not supported the original hope for microcredit: They can’t find evidence that the loans have been lifting families out of poverty on average. Many concluded that the classic conception of microcredit was based much more on anecdotes than on robust evidence. Those results have in turn cooled the development community’s enthusiasm for microcredit.
But does this mean that microcredit has been a failure? Hardly.
Rather than see microcredit as it was portrayed in its heyday — as a way to get people out of poverty — we should see it through a different lens: as a way to expand options for poor people by offering more reliable financial services. Extremely poor people need these services just like everyone else, and the availability of capital to deal with irregular and at times unpredictable incomes is a huge help to them. This benefit, along with its impressive growth around the world, arguably makes microcredit a success. While earlier claims about microcredit’s benefits were overblown, there is mounting evidence that it nonetheless plays a valuable role in improving the lives of people in need. Financial diaries of people living on $2 or less per day have shown that microcredit helps many families deal with emergencies, make critical purchases that they couldn’t otherwise afford, and put food on the table in times of scarcity. While the new story about microcredit isn’t the one that propelled it to such heights, it’s much more grounded in evidence and, in many ways, it’s still inspiring.
A brief history of microcredit
Lending money to the poor isn’t a new idea. In his book Due Diligence, David Roodman describes the long history of microcredit, going back to Jonathan Swift (yes, the author of Gulliver’s Travels), who began to lend small amounts to poor people in Ireland in the early 1700s.
Even though microcredit isn’t new, it has long faced some core difficulties. One basic issue with lending to extremely poor people is the cost: Because the loans are often small (averaging a few hundred dollars), the overhead costs are higher as a proportion of the loan, and it’s harder to make lending profitable.
Another problem is predicting who will repay a loan. In poor communities, lending has long taken place locally between people who already knew each other (local moneylenders and family/friends), with social ties that could help ensure repayment.
Another extremely common form of lending has been credit cooperatives, in which people — often living in the same region and/or affiliated through a particular trade — could obtain loans. But organizations from outside a given community don’t have access to information that could help them judge who to lend to. On top of that, those living on $2 or less per day often do not have collateral to put up as a guarantee for the loan. In light of these difficulties, lending to the poor wasn’t widely seen as promising.
However, that changed in the late 1970s and early 1980s, with a new vision of how to offer microcredit to the poor, and what it could do for them. Economist Muhammad Yunus played a big role in shaping this new perspective.
In his book Banker to the Poor, Yunus describes meeting a woman in Bangladesh who was making stools out of bamboo and earned only two cents per day, because she had to repay so much money to her bamboo supplier. If she had a dependable source of credit, Yunus thought, she and others in similar situations could make their way out of poverty.
That idea, along with his conviction that “all human beings are born entrepreneurs,” led him to found Grameen (meaning “village”) Bank in 1983. He also took the crucial step of convincing outside funders, such as the Ford Foundation, that it was a good idea to invest in loans for the very poor.
The original Grameen Bank model included a few core elements. The first is that after a loan for a microenterprise is granted, repayment starts immediately, with frequent, regular payments over the course of a year or so. The second is group loans, in which a small group of borrowers from different households receive loans together — which then puts pressure on the members to help each other repay. Finally, the model cuts overhead costs by having loan officers hold weekly meetings in villages to collect and disburse payments, obviating the need for physical bank branches.
Grameen Bank played a big role as a catalyst for microcredit’s huge expansion (which some called a “revolution”). A huge number of organizations all over the world entered the scene over the next two decades (more than 3,000, as reported in 2015), though most borrowers are clustered in a few countries such as India and Bangladesh. Borrowers repay loans to microcredit institutions at very high repayment rates, upward of 96 percent on average.
Grameen Bank wasn’t the first group to take on lending to the poor — the nonprofit Accion, working independently in Latin America in the 1970s, also developed a similar idea, and in Bangladesh, the nonprofit BRAC was an early pioneer — but it played a critical role in creating a powerful example of how microcredit for the extremely poor can work. As Roodman writes, other groups had done similar things, “but had never hit on a formula that combined such high repayment rates, manageable costs, and scalability to millions of people.”
Beyond the model for lending, Yunus also heavily promoted a vision for microcredit’s promise that proved hugely influential. Tim Ogden, managing director of the Financial Access Initiative, says that before Grameen Bank, there was a consensus that it was bad to lend to those living on only a dollar or two per day, because it would only trap them in debt. After Yunus began to talk about loans helping people to exit poverty through micro-enterprises, there was a “huge transformation” in the perception of microcredit.
Ogden describes this transformation: “You’re loaning money to a woman who is earning a dollar a day? How is that not going to trap her in debt? Oh! She’s starting a business and earning more money than I’m charging her.” Without this narrative, microcredit might not have taken off as it did.
Female empowerment also became integral to the story. Many microcredit institutions (including Grameen) made it a priority to lend to groups of women (about 80 percent of microcredit borrowers are now women). Investors and donors poured money into microfinance, and in 2006, Yunus won the Nobel Peace Prize.
The inspiring narrative falters
In the 2000s, skepticism about the promise of microcredit started cropping up. One concern critics raised was the possibility that some microcredit institutions were harming people. In Andhra Pradesh, a state in southeastern India, the government issued an ordinance in 2010 essentially shutting down microcredit institutions, pointing to over-indebtedness, the pressure to repay loans, and widely reported suicides among borrowers.
There’s also been a long-running debate about what level of interest is acceptable versus exploitative. On average, institutions offer loans at annualized interest rates of around 20-30 percent, though some rates are much higher. While some people — including Yunus — have argued interest rates above a certain level means that microcredit firms have turned into predatory loan sharks, others counter that the rates sometimes have to be high to cover costs of sustainably lending to the poor.
Beyond concern about potential harm, researchers started to seriously, and publicly, question the narrative about microcredit allowing millions of people to get out of poverty. From the beginning, that story had rested largely on anecdotes from borrowers, which might not necessarily be representative.
There was some more systematic research to back up the claim: One of the main studies that supporters pointed to was a study published in 1998 by researchers Mark Pitt and Shahid Khandker, which claimed that borrowers — especially women — were getting out of poverty at significant rates in Bangladesh.
However, when Jonathan Morduch and David Roodman reanalyzed the study, they found issues that made them question the reliability of the results. (Morduch first commented on the original study, which led to a series of replies, and replies to the replies, that continued for a period of more than 15 years.) This, along with the lack of other rigorous studies, meant that there was a big evidence gap for the first few decades of microcredit’s expansion.
Over the past decade, there’s been an influx of more systematic evidence on microcredit. Randomized controlled trials (RCTs) are a particularly good method for gauging impact, since they make it easier to distinguish causation from correlation.
The most recent six microcredit studies, published in 2015, were conducted by economists working independently across six countries. The studies found fairly consistent results: None found evidence that income went up on average among those offered credit. A few saw modest positive effects, such as people choosing to spend more time on their small businesses and some changes in spending habits. Abhijit Banerjee, Jonathan Zinman, and Dean Karlan sum up the studies, concluding, “We note a consistent pattern of modestly positive, but not transformative, effects” — not the result that many people had hoped for.
But in some ways the findings were also good news. For one thing, they countered the backlash that had been brewing against microcredit: Some critics argued that microcredit hadn’t just failed to lift people out of poverty, it was in fact even systematically harming people by trapping them in debt. But the RCTs didn’t find systematic evidence of this claim.
For another thing, these results are only a disappointment if one thought that microcredit would get most participants out of poverty. To be sure, this was a common belief, but many researchers say that that hope wasn’t realistic to begin with.
In a recent discussion about the history of microcredit, economist Bruce Wydick compared microcredit in poor countries to introducing credit cards in rich countries, as a way of explaining why we shouldn’t be surprised. “When they introduced credit cards in the US, so that almost everybody had access to a credit line, did that pull millions of people out of poverty? No,” Wydick says.
But just because it doesn’t pull most borrowers out of poverty doesn’t mean microcredit hasn’t helped people.
For evidence of microcredit’s value, look at how it helps the poor live day to day
So how does microcredit help people, if not by raising their incomes on average? Research that looks closely at the financial lives of people living on $2 or less per day, such as the work of researchers Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda Ruthven in Portfolios of the Poor, shows that credit often plays a crucial role in borrowers’ lives.
Part of that story is that people very often use microcredit for their day-to-day needs, rather than for business loans, as Yunus had originally envisioned. They may have a need for cash to meet emergencies, or for a big purchase, or even just to provide an inflow of money to put food on the table when income fluctuates — and microcredit helps to meet that need.
In fact, microcredit organizations are far from the only source of credit — people often take small loans from friends and family, or from local shopkeepers, for example.
But a really valuable aspect of microcredit is its reliability: People can depend on getting a loan at a certain time, then commit to the small, regular repayments so that they can get a further loan.
As Jonathan Morduch writes:
Incomes are seldom steady and predictable; needs vary as well: families need to pay for schools, medicines, and food during slow periods…Evidence that microfinance loans are used to fund non-business needs (even if for education or health) is sometimes used to criticize microfinance, but that misses the point....poor families, like richer families, need broad financial tools. In fact, the poor may need them more urgently.
There are also other potential benefits of increasing access to credit. In Due Diligence, Roodman also points to Nobel Laureate economist Amartya Sen’s view about the value of increased freedom, in the sense of greater agency in one’s life. By giving the poor a greater number of options in how to navigate their financial lives, Roodman suggests, microcredit can increase this kind of freedom.
Roodman emphasizes that the details matter — some ways of offering microcredit might offer more freedom than others. For example, he writes that group microcredit “emerges in a surprisingly negative light” when looking at financial diaries. Groups that are “responsible for each other’s loans can generate ‘peer support’ in times of difficulty — or peer pressure to pay no matter what.”
There’s also some evidence — from a study in the Philippines by economists Xavier Giné and Dean Karlan — that group liability might not be necessary to achieve high repayment rates. Over time, some institutions have moved toward individual loans instead, while still keeping the group meetings.
Finally, there’s evidence that suggests that microcredit may be playing a broader positive role. For example, economists Emily Breza and Cynthia Kinnan studied what happened in Andhra Pradesh, India, when microcredit institutions were shut down in 2010. They found that this was followed by a notable decrease in wages in rural areas. They write that this result “shows that microfinance, despite its small loan sizes, can have meaningful impacts on rural economies.” It also suggests that the full picture of microcredit isn’t captured in studies that only look at individual borrowers.
Now what about cost? Recent research from the World Bank has shown that the vast majority of microfinance is subsidized, in the sense that investors and donors are providing capital at below-market rates. To the extent that the classic story included the claim that a lot of microcredit institutions would eventually sustain themselves without subsidy, it hasn’t turned out to be true in that regard either. However, the subsidy isn’t so expensive, amounting to a median of around $25 per borrower.
So to sum it all up: Microcredit seems to be very important in the lives of the poor, even if it’s not transformative. Given that it comes at a relatively low cost, it may be that microcredit is quite a cost-effective way to help people.
Comparing microcredit to other ways of helping people
All this said, some readers may want practical advice: Should they contribute to microcredit institutions?
This raises its own set of tough questions. What is the relative effectiveness (and cost-effectiveness) of microcredit compared to other potential ways to help extremely poor people, including just giving cash? How much should an investor or donor be worried about harm to some borrowers? How much “room for more funding” do microcredit institutions now have, and which ones are the most cost-effective?
On the one hand, it’s useful to consult a review by nonprofit charity evaluator GiveWell, which does not recommend microfinance institutions as “among the best options for donors looking to accomplish as much good as possible.” GiveWell notes that microfinance is far from a failure, but finds the evidence for the benefits of cash transfers to be clearer, and expresses concern about potential harm to some microcredit borrowers. (Full disclosure: I have worked for GiveWell in the past.)
On the other hand, some researchers who have looked closely at microcredit and who have done work to compare the costs and benefits of microcredit compared to other programs to help the poor, including economists Jonathan Morduch, Asli Demirgüç-Kunt, and Robert Cull, argue that it could very still well be in the running when compared to other programs. A big reason for this is the low cost of subsidies for microcredit, which could make the program cost-effective in spite of modest average benefits. “It’s an open question,” Morduch told me, how microcredit fares when compared to other programs such as cash transfers, adding that, “There should be more serious comparative cost-benefit work.”
It’s also worth making a final point: While RCTs haven’t found that microcredit raises incomes for average borrowers, there is a small group of people who do achieve higher business profitability when they receive loans and sometimes these returns are really impressive, far exceeding interest rates. (In one study, researchers referred to this group as “gung-ho entrepreneurs” as opposed to reluctant ones.) So an ongoing research question would be whether it’s possible to find ways to better target people when offering loans for business, or whether tweaking the terms of the loans might improve business profits.
Whether or not one concludes that microcredit beats cash transfers or other ways to help the poor, there’s still reason to believe that microcredit has done — and continues to do — a lot of good, at fairly low cost. Beyond that, there’s reason to believe that there may be ways to make small loans (as well as broader financial services such as micro-savings and micro-insurance) even more useful to those living on very low incomes.
To some, the new vision of microcredit — helping poor people to better face their financial challenges — may not hold the simple allure of the old one. But the researchers who wrote Portfolios of the Poor and looked closely at the lives of those living on $2 per day find the new narrative inspiring nonetheless: “Whether or not the microfinance movement was right to stress loans for microenterprises, or has been too slow to embrace savings and other services, its greatest contribution is, to us, beyond dispute. It represents a huge step in the process of bringing reliability to the financial lives of poor households.”
The story of microcredit illustrates that even where a program doesn’t live up to the hype, it can still be a success.