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The Road to Microfinance

January 6, 2010

The Road to Microfinance In the face of dark economic times domestically, I fear a hitherto united front in favour of the government’s international development programmes is beginning to crack. As we look to cutting our vast budget deficit, people are beginning to ask why we are reducing significantly assistance to British citizens when we continue to channel taxpayers’ money into international development. I have already received several letters from constituents asking why we continue to provide aid to countries such as South Africa (£78.5 million), India (£402 million) and China (£118 million), particularly when the latter two nations run a huge budget surplus.

It is quite appropriate in these times that British taxpayers demand full value from our international development budget. People are also entitled to question whether Britain should continue to have the same duties to the developing world now our own economy is under pressure. Indeed whether in a new global landscape, developing nations’ regional partners should bear more of this brunt.

Politicians from these shores should not shy away from this emerging debate. If we are to make the case that international development remains vital to our national interests, we must show that DfID money is being channelled to effective projects and that our people overseas work vigorously to reduce the flaws in existing programmes rather than hiding behind a shield of goodwill that has until now shamed people into asking no questions. Aside from this, DfID might also consider the expertise it could bring to poverty reduction in this country, where people living in poor communities might benefit from some of the techniques used to help those in the developing world.

A good place to start would be in the field of microfinance. Despite the debilitating effects of the financial crisis on the developed world, broadly I believe the growth of financial institutions has done more than anything to spread wealth across the globe. The most pronounced poverty in fact continues in those communities most excluded – indeed excluded entirely – from the financial system.

Microfinance can help poor people protect themselves from risk, escape debt and live in a sustainable way by creating small enterprises. It is not – and cannot be – a cure all. It has not even proved sustainable or effective in all the communities in which it has been used. However, as a development technique that encourages responsibility and independence, microfinance is a form of assistance that is more likely to garner the support of the British taxpayer – especially if it is put to work in some of the UK’s poorest communities.

Many commercial activities in the developing world are not monetised, with trade conducted through means of exchange such as livestock. Banks are rarely tempted to change that. There is always a breakeven point in providing loans or deposits below which banks lose money on every transaction. With poor people depositing or borrowing only small amounts, banking operations in such areas can quickly become commercially unviable. Poor people also tend to have very few assets that can be secured by a bank as collateral in the event of default.

This can leave the poorest ill prepared for life’s risks. Paying for education, weddings, childbirth, health care and the impact of natural disasters can be an unbearable struggle, particularly in countries where there is no established welfare system. When forced to borrow, they are often left to rely on family members or local money lenders with extortionate interest rates.

In these circumstances, microfinance can help break the downward spiral. While the idea of small-scale credit as a means of poverty alleviation is a relatively old concept, it was properly developed by Bangladeshi economist, Muhammad Yunus, in the 1970s after he discovered that very small loans to poor women in the village of Jobra could make a disproportionate difference to their lives. Yunus found that given the chance, the poor tended to repay borrowed money, often by establishing microenterprises. By 1983, a pilot for a fully-fledged microcredit bank was established and in October 2007 Grameen Bank could claim to have distributed $6.55 billion in loans, boasting a loan recovery rate of 98%.

The microcredit movement has tended to loan mainly to women who are thought to be more likely to use the money to the benefit of their families. Since the concept’s expansion in Bangladesh, microfinance has been used as a tool to reduce poverty in developing countries worldwide, often to great effect. Take Jennifer from Uganda. After years of struggling to support seven children by working as a seamstress, she took a small loan in 1997 to buy her own sewing machine. This enabled her to expand her sewing business which in turn led her to diversify into other areas – first opening a motorcycle taxi business and later purchasing land to build rental properties. Today she employs 57 people and has taken on the care of five AIDS orphans. Meanwhile, her natural leadership skills led to her election to the town council.

I first became interested in the idea of microfinance myself when a constituent contacted me about the concept in 2003, spurring me to write a paper on free trade and aid. Over six years later, it has returned to my consciousness by virtue of the efforts of two local constituents involved in the field – Louise Holly who works for RESULTS UK and the Rev George Bush of St Mary-le-Bow in the City.

RESULTS was started over twenty-five years ago in the United States to empower and encourage ordinary citizens to create the political will for change in international development. Today there are RESULTS organisations in seven countries, with the UK branch coordinating groups across the country from a national office just off Regent Street. Rev. Bush, on the other hand, is involved in the establishment of a microfinance fund in the City called Arcubus. The fund aims to raise £1 million by issuing a five-year Social Investment Bond at 0% interest that will return donors’ money while channelling the interest from the collective pot into four microfinance NGOs. They will look at providing formal banking services and microloans to those unable to access mainstream bank loans, expand and enhance existing microfinance operations by improving efficiency and sustainability and arrange short-term placements for City professionals at microfinance institutions in Africa. Through Arcubus, these projects will eventually create a mixed portfolio of complementary microfinance initiatives that British individuals, companies and churches can support.

As a way of maintaining public support for these initiatives, I believe it would be helpful if we adhered to the old adage, ‘charity begins at home’ by showing that tools such as microfinance can help British people who are unbanked. Thanks to our welfare system, there are very few people living in absolute poverty. When it comes to accessing finance, however, the picture is wholly different. It is estimated that close to eight million people are unable to access mainstream credit and often find themselves turning to informal money lenders who can charge exorbitant rates of interest. Three million people in Britain do not even have a bank account. Our average household debt excluding mortgage stands at £9500 and Citizens Advice Bureaus have been dealing with 7200 new debt problems every day.

While we have more material wealth than ever before, poverty has become more concentrated and inequality more marked with some communities heavily dependent on charitable giving and public money whether in the form of welfare benefits or grants. It is the people in these communities who are also more likely to be preyed upon by doorstep lenders due to financial illiteracy, poor credit ratings, a sense of exclusion from mainstream financial lenders, past family experience and a confusion over the type of financial products available to them.

Microfinance initiatives in these communities challenge the perception of risk about the poor’s ability to repay loans and support entrepreneurs considered unbankable. Community Development Finance Institutions are now a fast growing sector, providing finance and support to new and growing businesses in disadvantaged communities which in turn create jobs and services where they are most needed. These institutions, which combine elements of the private and charitable sectors, promote a culture of self help and combat poverty and social exclusion from the bottom up. Although not conventional sources of finance, CDFIs provide finance to viable enterprises and seek financial as well as social returns on their investments. In 2007/08 CDFI lending totalled £76 million, levering in a further £35 million of additional finance into underserved markets such as BME businesses, females and small start-ups.

In London, a new drive to assist people through microfinance projects is being spurred by Fair Finance, an organisation that offers loans and advice to help those who have been excluded from accessing mainstream services. Launched in 2005, it has grown rapidly to expand from a council estate in Stepney to covering half of London. It has helped hundreds of excluded women create businesses and saved many hundreds more from eviction. Fair Finance’s managing director, Faisel Rahman, has a background in international development, with experience at Grameen Bank and the World Bank, where he focused on the development of microfinance.

A client who borrows from the organisation tends to save £20-£100 per loan per month in reduced interest payments alone compared to doorstep lenders, who have been known to charge interest rates of up to 4000% APR. By opening bank accounts and establishing credit histories for their clients, Fair Finance helps them to access cheaper products and services such as paying utility bills by direct debit and obtaining longer-term contracts for mobile phones. Importantly, they also advise clients on the management of their finances and introduce savings habits.

Unfortunately Mr Rahman believes the biggest barrier to microentrepreneurs who take Fair Finance loans is the structure of the benefits system which makes it unlikely that someone starting a business will be able to make enough money to cover council tax, rent and living costs. Microentrepreneurs also have to fill out regularly a self-certification form every time their income changes, leading to a reassessment of their benefits.

There are many other pitfalls in the application of microfinance both here and abroad. Unfortunately microfinance is not a panacea and as with all development interventions, it is important that we ask questions constantly about its effectiveness.

Access to financial services has undoubtedly improved the lot of some poor people permanently. But is it unclear whether microfinance reduces poverty on average. There are few studies on microfinance’s effectiveness and it has been difficult to use a correlation to prove a causation. For instance, if affluence and microcredit go hand in hand, does that mean the better off borrow more or that borrowing makes people better off?

A recent study in the Philippines, looking at a sample of middle class people taking individual microcredit loans, suggested no changes in household income, spending or diet one to two years later. One of the study’s authors, Dean Karlan, suggested that rather than going towards new businesses, it is more common that people invest in an existing business.

Microfinance does not always work as well in every country and has difficulty in large parts of Africa, for instance, where a lack of basic resources, a dearth of customers or difficulties with health make it hard to be entrepreneurial. A disparate population can also make microfinance unsustainable due to high operational costs and loan books concentrated in a specific geographical area can be vulnerable to natural disasters or downturns in a local economy. Some women have also reported their money being stolen by their husbands and others have lost it to the demands of corrupt officials or village elders. For many, microfinance alone is not an alternative to direct aid.

While critics of microfinance point to high interest rates charged by lenders, equally, interest rates caps can harm the poor as they prevent institutions covering their costs, choking off supply. Furthermore, few institutions are held accountable for their performance, leading to significant inefficiencies and market distortions. At its worst, borrowers have on occasion effectively become wage labourers for a local microfinance bank.

In places where microfinance is in operation, traditional money lenders are often found to flourish too. Such lenders offer quick loan disbursement, confidentiality and flexibility. By contrast the poor do not always find the lower interest rates of microfinance institutions to be adequate compensation for the time it takes to attend meetings and training courses and the financial cost of monthly contributions.

Such criticisms tend only to be valid when microfinance is looked at in isolation. Its proponents have never claimed it to be a cure all and it should be kept in mind that microcredit and training are designed to offer a hand up, not a hand out. It is also about more than just loans. The most successful microfinance institutions are increasingly providing access to other financial tools such as savings, insurance, training and financial education. In the longer term, microfinance can play an integral role in a comprehensive economic development process by generating local economic activity and stimulating demand for goods and services.

Microfinance has dispelled the notion that those on the lowest rungs of the income ladder are worthy only of aid, not the assistance of financial services. It has also helped shoot down the idea that the poor are not able to follow basic rules of commerce. In much of Asia and Africa, the rural poor have proved that they can be entrepreneurial, able to launch a business and earn. Even if these loans fail, the amounts of money involved are so small that this form of support for poverty alleviation may still be more effective than traditional aid.

Donors should now focus on capacity building, particularly when it comes to obtaining strong managers to run microfinance institutions. We should also cast aside prejudice when it comes to traditional money lenders (whilst not supporting lenders charging extortionate rates). The poor have diverse needs and therefore a whole range of lenders can operate in any market – traditional banks, microfinance institutions, credit unions and doorstep lenders.

At a time when government budgets are under strict scrutiny as never before, it will become ever more important for each department to articulate the benefits of its work. If global development budgets are to be ringfenced, the Department for International Development must prepare to explain its work in terms that demonstrate value to the taxpayer and tangible results for the poor communities being served.

In microfinance, the Department for International Development has a form of aid that has more chance than most of becoming self-sustaining and long lasting, echoing the themes of responsibility and independence that will become ever more important as our own nation negotiates some tough times. While insufficient alone to eradicate poverty, implemented alongside complementary policies there is every opportunity for microfinance to promote long term growth in the poor communities being served. This applies equally to the slums of Nairobi, the rural village of Bangladesh or the council estate in Stepney.