Microfinance
Introduction
In Economics, loans are considered a part of the GDP when those loans are used for productive purposes. Therefore, the interest which is accrued to a productive loan is added to the GDP. Loans are like services, say a Person A gives another Person B a sum of money which Person B will pay back in a while. But why should Person A give the money in the first place if he doesn't earn anything from it? That's why Person A places an interest rate on this loan, so when the money comes back, he'll make a profit.
But sometimes, loans can be expensive. Especially for people in poor countries who cannot afford to take a loan at a high interest rate, even when they desperately need it. Therefore, the concept of microfinance was introduced in the economy - so poorer individuals can take a loan and pay it back without falling into a vicious cycle of paying back the loan.
How Microfinance Works
Microfinance, as the name suggests, is small loans given at small interests to poor individuals. These loans are usually given out by formal institutions such as banks and rural development associations. A striking feature of such loans is that they are supplied very quickly, and families don't need to provide any collateral to such loans.
The non-requirement of collateral comes as a relief to many poor families, as these families don't have the assets in the first place to give collateral. Collateral is any asset taken by the bank in exchange for a loan as surety that the loan will be returned. In the case of microcredit banking, the surety is usually provided by the government in the form of subsidies.
Another way microfinance can operate is through self-help groups (SHGs). Basically, this is a group of families who pool together their assets to provide loans to other families at a very low or negligible interest rate. These families work together for the sake of each other's well-being by providing each other with financial and social support. SHGs have been particularly successful in India, Bangladesh, and Mexico.
Does It Reduce Poverty?
Ever since the brilliant success of Muhammed Yunus' Grameen Banks in Bangladesh in reducing poverty and empowering women, a major question on the minds of Economists has been whether microcredits can reduce poverty on an international scale. We also need to remember that poverty doesn't just mean being below an arbitrary income level set by the government. Poverty also includes how much a person consumes, if they have access to education, if they have access to health care, how much debt they are in, and much more.
Keeping all of these factors in mind, we conclude that microcredits do help reduce poverty in some spheres. Microcredits don't really influence income, as income is determined by other factors than credit. However, microcredits can help finance emergency consumption of families, so they don't fall into poverty by using up their savings. Secondly, microcredits can also reduce indebtedness, as families take low-interest debts to pay off their high-interest ones. Families also use microcredit loans to finance their children's education.
Therefore, microcredits don't reduce poverty in the traditional sense, but they do reduce poverty in the multi-dimensional sense.
Advantages of Microfinance
Provides people from the lower sectors to provide better for their families
According to the World Bank, more than 500 million people have benefited from microfinance institutions’ banking services. The extremely poor, who are earning less than 2 dollars per day, are offered financial services to expand their small businesses. Small loans of 100 dollars make a huge difference for them when it comes to food, education, housing, and emergencies.
Promoting women-led businesses
Many microfinance institutions, such as Grameen Bank, target women-led businesses. At present, almost 80% of microcredit borrowers are women. This not only helps the women provide for their families but also helps the community and economy of countries to grow out of poverty.
Lower Interest rates
Many microfinance institutions offer lower interest rates than traditional banks because the main goal isn’t to raise profit, but rather reduce poverty in given areas. This has led to the repayment rate to be extremely high for microcredit, even higher than traditional loans.
Provides educational programs
In some microfinance institutions, to receive a microcredit loan, borrowers must attend a training program that teaches them the basics of money management such as interest rates, the concept of cash flow, how financing agreements and savings accounts work, how to budget, and how to manage debt. Borrowers receive capital for their businesses and essential skills that will help them as an entrepreneur. Because the borrowers of microcredit loans are very poor, they do not have enough collateral, so microfinance institutions focus more on helping entrepreneurs to succeed rather than looking at collateral.
Provides a better chance for future loans
When the borrowers repay their loans, it will help their credit score and help them when they need to take larger loans from traditional banks.
Disadvantages of Microfinance
For-Profit Microfinance
Many microfinance institutions that were once not for profit are now for profit. Some include India’s SKS and Mexico’s Compartamos Banco. Such institutions receive a lot of criticism because they are “making money from the poor”. Instead of using their funds to increase their reach to more people, they distribute them among shareholders. Whether this is a disadvantage or not is quite subjective but it is clear that the main goal is shifting from ending poverty to making profits. The desire to make profits may lead to higher interest rates and create a debt trap for the borrowers.
Small loans are not always sufficient.
100 dollar loans are sufficient for some businesses but not for all. Furthermore, it is difficult to track how borrowers are using the loans for consumption or investment in their businesses.
Famous Microcredit Schemes
Grameen Bank
The most famous and first microfinance institution called “Grameen Bank” was founded by Muhammad Yunus in 1976. Located in Bangladesh, a developing country with widespread poverty, Yunus devised one of the most famous microfinance schemes. In this scheme, groups of 5 borrowers are created under field managers. Out of the 5, 2 borrowers are given their respective loan amounts. If they are successful in their repayments then the others are granted their loans. Because the poor do not have sufficient collateral to be granted loans, peer pressure in this form acts as an effective alternative. The bank is now independent and has over 2,200 branches all over Bangladesh. Moreover, 97% of the loans are provided to women entrepreneurs. In 2006, Grameen and Yunus were awarded the Nobel Prize for their outstanding contributions to microfinance.
Kiva Microfunds
Operating in more than 80 countries, the San Francisco-based microfinance institution has granted more than 1.4 billion dollars in microloans to its 3.5 billion borrowers since 2005. It uses crowdfunding or peer-to-peer network for microlending. It allows individuals to directly provide loans to people in countries that lack financial services. As a non-profit, Kiva provides interest-free loans for small businesses, education, and health services such as clean water.
Conclusion
Microcredits are a great example of how Economics (here, Macroeconomics) can be used to empower women and better the livelihoods of millions of people. But as with any policy, the reciprocating disadvantages should be kept in mind.
Written by Rayandev Sen and Aryan Jain; edited by Alexey Dudarev
