We began the chapter by describing two simple ideas that have inspired the microfinance movement and challenged decades of thinking: first, that poor households can profit from greater access to banks, and, second, that institutions can profit while serving poor customers. Microfinance presents itself as a new market-based strategy for poverty reduction, free of the heavy subsidies that brought down large state banks. In a world in search of easy answers, this "win-win" combination has been a true winner itself. The international Microcredit Summit held in 1997 and its follow-up in 2002 have been graced by heads of state and royalty, and Bill Clinton, former president of the United States, made numerous official visits to microfinance programs while traveling overseas. As foreign aid budgets have been slashed, microfinance so far remains a relatively protected initiative.
Somewhat paradoxically, though, the movement continues to be driven by hundreds of millions of dollars of subsidies, and those subsidies beget many questions. The hope for many is that microfinance programs will use the subsidies in their early start-up phases only, and, as scale economies and experience drive costs down, programs will eventually be able to operate without subsidy. Once free of subsidy, it is argued, the programs can grow without the tether of donor support (be it from governments or donors). To do this, sustainability-minded advocates argue that programs will need to mobilize capital by taking savings deposits or by issuing bonds, or institutions must become so profitable that they can obtain funds from commercial sources, competing in the marketplace with computer makers, auto manufacturers, and large, established banks.
In the latter regard, Latin America's largest microlender, Financiera Compartamos, an affiliate of Boston-based ACCION International, has led the way by issuing a 100-million-peso bond (approximately $10 million) in July 2002. The three-year bond pays purchasers 2.5 percentage points above the Mexican Government ninety-one-day treasury-bill rate (which was 11.17 percent at the time of issue). A second 100-million-peso bond was planned for the end of 2002. ACCION's president, María Otero remarked at the time, "This sale is an exciting first for an ACCION partner and an important benchmark in microfinance. ACCION is committed to the growth of financially self-sufficient microlenders who need not depend on donor funding to fight poverty." Compartamos has grown quickly, serving over 100,000 clients in fifteen Mexican states by 2002, aiding clients in informal businesses like "making tortillas, selling fruit and vegetables, raising chickens."25 But its legacy is mixed. To win the (Mexico) A+ rating that it was granted by Standard and Poor's rating agency, Compartamos had to cover a relatively inefficient administrative structure by charging borrowers an effective interest rate above 110 percent per year, putting its charges well into the range of those of the moneylenders upon which microfinance was meant to improve.26
If, as we saw in figure 1.1, the returns to capital function is steeply concave, typical poor borrowers may be able to routinely pay interest rates above 100 percent and still have surplus left over. The fact that Compartamos does not suffer from a lack of clients suggests that there are low-income customers in Mexico willing and able to pay high fees. Microlenders elsewhere, though, have balked at charging high rates; in Bangladesh and Indonesia the main institutions keep interest rates below 50 percent per year, and typically around 30 percent (in economies with inflation at about 10 percent).
Why balk at high rates? Let us return to the principle of diminishing marginal returns to capital. Can all poorer borrowers really pay higher interest rates than richer households? An unspoken assumption made in figure 1.1 is that everything but capital is held constant; the analysis implicitly assumed that education levels, business savvy, commercial contacts, and access to other inputs are the same for rich and poor. If this is untrue (and it is hard to imagine it would be true), it is easy to see that entrepreneurs with less capital could have lower marginal returns than richer households. We illustrate this point in figure 1.3. In this case, a poor individual would not be able to routinely pay very
Marginal return for richer entrepreneur
Marginal returns to capital for entrepreneurs with differing complementary inputs. Poorer entrepreneurs have lower marginal returns despite having less capital.
high interest rates. Some might, of course, but a considerable group would plausibly be screened out by high rates.
Even if we imagine, though, for the moment that both rich and poor were alike in these noncapital characteristics, the principle of diminishing marginal returns to capital may still not hold; this is because the production function may not be so "conveniently" concave. Figure 1.4, for example, shows a scenario where the production technology exhibits increasing returns to scale over a relevant range. Here, there may be larger profits per dollar invested by the larger-scale entrepreneur relative to the returns generated by the entrepreneur with less capital.
Here, again, poorer households cannot pay for credit at high prices. This case has the feature that, without adequate financing, poorer entrepreneurs may never be able to achieve the required scale to compete with better-endowed entrepreneurs, yielding a credit-related poverty trap.27 The challenge taken up in Bangladesh and Indonesia has been to charge relatively low rates of interest (around 15-25 percent per year after inflation adjustments), while continuing to serve very poor clients and covering costs.28
The programs in Bangladesh and Indonesia have also been strategic in their use of subsidies. Like other microfinance lenders, Compartamos
Marginal return for richer entrepreneur
Marginal return for poorer entrepreneur
Marginal return for poorer entrepreneur
for richer entrepreneur
Marginal returns to capital with a production function that allows for scale economies (while everything else is the same). As in figure 1.3, poorer entrepreneurs have lower marginal returns despite having less capital.
received large start-up subsidies, as have most of the major microfinance institutions. Typical arguments for early subsidization echo "infant industry" arguments for protection found in the international trade literature. And, as found in such writings, there is fear that some of the "infants" will soon be getting a little long in the tooth. The Grameen Bank, for example, still takes advantages of subsidies twenty-five years after its start.
A different question is whether the anti-subsidy position is the right one—or, more precisely, whether it is the right position for all programs. Again, there is a parallel with trade theory. The strongly anti-protectionist sentiments that had characterized trade theory for decades (Bhagwati 1988) are now giving way to more nuanced approaches to globalization, with mainstream economists identifying cases that justify extended protection in the name of economic and social development (e.g., Krugman 1994; Rodrik 1997). So, too, with microfinance: Serious arguments are accumulating that suggest a role for ongoing subsidies if thoughtfully deployed. Of course, that is a big "if," and chapter 9 provides a guide through the thicket.
Sorting out the stories requires taking apart the "win-win" vision put forward by advocates within the donor community, and recognizing the great diversity of programs jostling under the microfinance tent. ASA's story, with which we started with the chapter, provides a pointed contrast to many other programs. In 1978 Shafiqual Choudhury started ASA as a small grassroots organization to provide legal aid and training in villages, with the hope of raising the social consciousness of rural households. But in 1991, Choudhury and ASA took a very different turn. Instead of placing hope in consciousness-raising, the leaders of ASA decided that the way to most quickly raise the well-being of the rural poor was by providing banking services, and banking services only. ASA's stripped-down banking model makes profits in large part because of its self-imposed narrow mandate.
But other institutions started where ASA did and took a broader approach to microfinance. They can also count successes, but their bottom lines include improvements in health and education outcomes in addition to financial metrics. Like ASA, charitable organizations like BRAC, Catholic Relief Services, CARE, and Freedom from Hunger have become major microlenders, with missions that also include working to improve health conditions and to empower women. Latin America's Pro Mujer is a case in point. Pro Mujer adds education sessions on health topics to weekly bank meetings for customers. Freedom from Hunger's affiliates do so as well, and their evaluations show positive impacts (relative to control groups) on breastfeeding practices, treatment of diarrhea in children, and rates of completed immunizations (Dunford 2001). Bangladesh's BRAC is perhaps the most fully realized "integrated" provider, offering financial services along with schools, legal training, productive inputs, and help with marketing and business planning. If you are in Dhaka these days, for example, you can buy Aarong brand chocolate milk, which is produced by a BRAC dairy marketing affiliate. A different BRAC subsidiary produces Aarong brand textiles made by poor weavers, and still another subsidiary runs craft shops that sell the goods of microfinance clients.
The microfinance movement is thus populated by diverse institutions, some large and many small, some urban and some rural, some more focused on social change and others more focused on financial development. If the programs that are focusing on social change are cost-effectively achieving their goals, should we be concerned that part of their operation is subsidized? Should we be concerned that, to achieve financial success, Compartamos has had to charge very high interest rates—and that, while roughly 20 percent of its borrowers are poorer on average then their neighbors, most of its clients are less poor than their neighbors (Zeller, Wollni, and Shaman 2002)?29 It is not clear that there is only one correct answer to each of these questions—and, as we show, answers posed as simple, "universal" truths turn out to rest on strings of assumptions that need disentangling.
We focus on one important strand of these entangled assumptions in chapter 9. There, we describe the possibility for designing "smart subsidies." Doing so will mean making sure that institutions offer quality services that are better than those already available, while also paying close attention to the complicated incentives and constraints of institutions and their staffs. The debate continues as to whether this is possible and, if so, even desirable. Introducing a stronger economic frame will sharpen understandings, and in chapter 9 we analyze concepts behind the trade-offs between lending practices that maximize the depth of outreach (i.e., that serve a greater number of poorer clients) and those that aim to maximize the extent of outreach (those that serve more—but less poor—clients). The book closes by turning to a critical practical issue for microlenders: how to give staff members the appropriate incentives to carry out their economic and social missions. In chapter 10 we draw lessons from agency theory and behavioral economics to describe and challenge conventional wisdom on good management practices.
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