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in my quest to find a noble cause for the proceeds from our Swear Jar challenge, I thought I’d revisit a topic I was pretty excited about back in college; micro-lending. It’s one of these ideas that everyone seems to love, and is a compelling story as one step that could be taken to start eliminating poverty in the third world.
As with a lot of stuff I thought was great in college, after researching with a little bit more of a skeptical mindset, I found that it may not be the silver bullet I used to think it was for ending poverty, but I still think it has its place, despite criticisms, and I still think it’s a great vehicle for the GoodGuys to invest in.
So let’s start out with the broad description of Micro-Finance. Micro-Finance is providing financial services to very low-income individuals or groups that traditionally do not have access to conventional banking services. This is stuff we, in the west take for granted: Having a safe and secure place to hold your money (savings), having a way that you don’t have to pay for everything in cash (checking), paying small regular payments in order to make sure a disaster doesn’t destroy your finances (insurance), and finally, a way to purchase things up front, and pay for them later (credit).
Micro-credit/micro-lending is generally understood as providing small loans to borrowers that live in poverty, and is designed to spur entrepreneurship. The idea is that small amounts of capital can mean big opportunity for the poor to improve their situation. Here is one example of a micro-borrower that couldn’t make a profit with his water-selling business, and $360 microloan allowed him to buy an underground water tank and start turning a profit and growing his business.
So these are borrowers that conventional wisdom would say are horrible credit risks. They generally have no collateral that the bank can go after if they default, their income is shaky at best, and they usually don’t have access to other financial services that we take for granted. Savings accounts, insurance, etc. Also, there’s an economy of scale issue in that there are costs to banks to servicing loans. If you were a bank, would you rather do the paperwork, research, followup on one $5000 loan, or one hundred $500 loans?
So enter micro-lending institutions; banks that specialize in lending to these types of borrowers. There is a lot of literature out there, and many different setups that I don’t really want to get into. Some banks require borrowers to form groups to “keep each other honest,” some banks focus on lending to women because they have been shown to have lower rates of default, etc.
Because these loans are so expensive to service, borrowers are usually expected to pay a higher interest rate that we, in the US, would expect. Shout out to listener Chris, who actually develops web-interface tools to analyze different data from microfinance institutions. Using his dataset, it looks like these banks yield upwards of 30% on their loan portfolios. This may seem a little extreme to charge a borrower 30% APR on a loan, but the alternative sources of credit to these borrowers typically charge even more. There are reports of loan sharks charging upwards of 100%/month.
The final piece of the puzzle is that since it’s hard for banks to make money on these loans, several non-profit groups have cropped up that work to finance these loans through the local banks like Kiva.org. Kiva allows individual lenders from all across the world to “donate” as little as $25 towards a loan to an entrepreneur in another country. Kind of like adopting a foreign child, you are adopting, in this case, a small business. It truly is an investment, so when/if the borrower pays back the loan, you can re-invest, or pull your money out. An important point to remember, though, is that this still costs money, so the borrower themselves is still paying an interest rate that goes towards recouping the bank’s costs associated with servicing the loans.
So now the picture is complete. Charity-minded lenders who want their dollars to last, can invest small amounts in small businesses in third world countries. The local banks lend out the money at a reasonable interest rate, and the borrowers grow their businesses and pull themselves out of poverty. Then we all hold hands and celebrate together;
“Microfinance is not charity; it is just widening opportunity for the people who deserve it…We have the technology and the tools to alleviate poverty on a global scale. All that is standing in our way is education and will,” – Natalie Portman
Bring in the criticisms of micro-credit! So as with anything that everything likes, eventually people are going to poke holes in the logic and find out that things aren’t all they are cracked up to be. I read this very good article by a guy who brings up some good points, and goes through what he believes are the 5 myths of micro-credit. I think they are well argued and valid points, but I want to take them one by one and talk a little bit about why I still think that Kiva is a good place to stash the GG2K cash.
1. The poor should be self-employed rather than work for wages.
Totally agree, that a big problem with microcredit is that people tout it as the one clear solution to poverty in the third world. Not everyone is an entrepreneur, and millions of people in poverty doesn’t mean that we need millions of entrepreneurs starting tiny businesses to pull themselves out of poverty. BUT, it is clear that these loans DO help SOME people. And many of the success stories that you read on all of these websites, end up with the borrowers expanding their business to the point where they need to hire several workers to maintain their business.
2. Loans are the main financial service needed by the poor, whereas they really need savings and insurance.
Again, this makes sense as a myth. Microloans are just one part of the puzzle. We in the West take a bunch of this other stuff for granted. Check out more on this topic at Econtalk where they talk about the concept of “saving down.”
We are used to the concept of saving up for something; we decide we want something, like an Ipad, and save small amounts of money, each month, until we have enough to buy it. This is HARD! As we get closer and closer to the goal, other things seem to magically crop up. We have an emergency car repair we have to pay for, there’s a concert we need to buy $100 tickets to, etc.
This concept of “saving up” for something becomes even more difficult in the developing world where there is intense pressure to share your wealth. Think if you were in a very poor village and you had the idea to save up and buy a cow. Let’s make it even better and say you’re a woman. So you start saving up the capital to do this, but all these other things start to arise. Other people in your village see that you’re saving money (because you don’t have access to a bank with direct deposit), and your neighbor’s kid gets sick and needs medicine. They come to you and ask for a little bit of money, and there is intense social pressure to comply because this person has probably helped you in the past. This is a form of informal insurance. Once again, a financial institution that we take for granted. Or your husband comes home from a hard day of work where he earned $2 and he says, “hey, woman, I see you are saving money, give me $5 so I can go get a beer.” And because of cultural norms, you oblige. This makes it infinitely harder to “save up” for something that could really improve your situation.
If, instead, you decide to join one of these micro-lending groups, and it’s your turn to get the money this month, you get all the money up front, and immediately spend it (buy a cow). Now you have an obligation to pay back this loan so when your neighbor comes needing some money for their kid’s medicine, or your husband wants a drink, you can point to this outside obligation you have to pay back the loan. So it’s basically the same thing as the first scenario, but instead of “saving up,” you are now “saving down.” In the absence of other institutions like insurance and banks, micro-credit lending groups can offer a way for people to do this. Here’s the kicker; EVEN IF THEY ARE NOT STARTING A SMALL BUSINESS! So even if the borrower is just getting that small amount of money and spending it on education, or to get through a tough time, it still improves their quality of life because it’s like a forced savings plan. It also helps to foster the idea of keeping what you earn and saving. So while it might not be exactly what the architects of micro-lending had in mind at the outset, it is still something that can improve the overall situation of a borrower, even if their economic situation doesn’t improve dramatically. Which is why I still think this is a noble thing to spend our swear jar money on.
3. Credit builds enterprise, whereas actually, entrepreneurship and management are more important.
I think this argument is a bit fallacious. (false dilemma?) Just because entrepreneurship and management may be more important, doesn’t mean that access to capital isn’t also essential. Even if it’s not the most important thing, it’s the easiest part of the puzzle for someone sitting in MN to help with.
4. The non-poor don’t need credit
I don’t really understand why this is a myth of micro-credit so I’m not going to respond to it. Clearly not compelling enough to dissuade me from investing.
5. Micro-credit institutions can be self-sustaining, whereas the evidence shows that this is not the case, that most institutions do not make enough money on their own to survive.
‘Who cares if they are self-sustaining or not?’ As long as organizations like Kiva exist, there are investors/donors who are not expecting a return on their investment, and would likely even accept a small loss. So it doesn’t matter if banks can’t get enough interest rate revenue to sustain operations, because they are subsidized by charity
So in conclusion, despite some of the problems, and lack of measurable indicators of the impact of micro-credit on third world communities, I still think that it’s a worthwhile investment. At its worst, it gives the poor an excuse to tell their neighbors “hey, what’s mine is mine,” fostering a culture of self reliance, and making it easier for them to “save.” At its best, it helps individual entrepreneurs gain access to capital, allowing them to enter markets not available to them before, and drastically improving their quality of life.