Hype and Hope: The Worrisome State of The Microcredit Movement

CGAP- Gateway

March 22, 2006

Microcredit: All Dressed Up and No Place to Go

Thomas W. Dichter

Has the widespread enthusiasm for microfinance transformed a noble idea into a panacea? Thomas Dichter, long-time practitioner in the international development industry and author of "Despite Good Intentions: Why Development Assistance to the Third World Has Failed," takes a critical look at the microcredit movement and argues that it has done more harm than good.

The UN’s 2005 "Year of Microcredit" marked the long journey of microcredit from an obscure experiment in the mid 1970s to the status of a worldwide movement. Microcredit has captivated not just the entire development aid industry, but journalists, editorial writers, policy makers and much of the general public in both the North and the South.1 Virtually every development project I see these days, from maternal and child health, to women's education, to soil conservation, to social forestry, to old fashioned integrated rural development, has a "microcredit component," and everyone from camel herders in Mauritania to peasants in rural China can speak the lingo.

The hope has bred hype. Pro-microcredit editorials abound and scores of books have been published, with titles like the following: The Miracles of Barefoot Capitalism; Pathways Out of Poverty; Hands Around the Globe; Back Alley Banking; Defying the Odds; Give us Credit; The Price of a Dream…

Yet microcredit is an almost perfect case of a phenomenon that has come to characterize much of development assistance - a widening gap between reality and propaganda. For while the promise of microcredit is irresistible - help the poor out of poverty using their own entrepreneurial energies, and in the process get our investment back - the hoped for poverty reduction impact of microcredit remains elusive. While much has been learned about managing microcredit in a sound manner, the number of professionally run MFIs with a realistic understanding of the limits of microcredit, is dwarfed by the growing number of newcomers to the field, many of whom trumpet success prematurely, and may cause as much harm as help.

This dangerous habit is increasingly being displayed not just by naïve celebrities (we all know their names) but by those who ought to know better. In 2004 Kofi Annan stated that "microcredit has been one of the success stories of the last decade," while USAID's microfinance unit claimed that microfinance "has tremendous potential to generate income and expand employment." The website of the "International Year of Microcredit" is even more unequivocal about the development potential of microcredit: "Currently, microentrepreneurs use loans as small as $100 to grow thriving businesses… leading to strong and flourishing local economies."

The Unreasonably High Expectations Surrounding Microcredit

But can microcredit lead to “strong and flourishing local economies,” much less make a real difference in the lives of the poorest?2 We do not have convincing evidence that it can, and in fact the movement engages in little serious impact study. Richard Rosenberg captures the matter of impact succinctly:

"It is notoriously difficult and expensive to quantify household benefits resulting from financial services and to demonstrate causality, so it is not practical for most projects to produce such impact studies."3

The case for microcredit’s impact rests largely on anecdotal evidence that it helps with cash flow smoothing, and can also boost the confidence of women. These are good things, but they are considerably less than the serious long term economic changes that are claimed for the movement. They are not the same as credit used for productivity, job creation and enterprise growth in an increasingly competitive and global economy. If microcredit results only in making the lives of the poor a bit less terrible, or helping just a few real entrepreneurs, is that sufficient reason to laud it? And if borrowers repay microloans does this automatically mean that microcredit is a useful intervention in poverty reduction? And if it is marginally useful, is it cost-effective?

And what about the distinction between informal credit systems (which exist virtually everywhere in the developing world) and the new formalized ones we call microcredit. Why intervene at all if informal systems (like the growing spread of remittance income, or the rotating savings and credit associations run by extended families or groups of friends) already exist?

The Need for Historical Perspective - Are there Antecedents for the Developmental Role of Credit to the Poor?

Simply: No. For most of history, credit has had more detractors than enthusiasts, and the availability of credit to the average person in the "north" hardly figured in its development. As recently as 50 or 60 years ago most people in the "developed" countries had little contact with financial services (banks) or with formal credit. A working class or rural (agrarian) American, Briton, or Frenchman tended to see banks as institutions for businessmen and the rich. But while our historical ambivalence about credit seems to have eroded (U.S. consumer debt levels topped $2 trillion dollars for the first time in 2004, up 33% from four years before4) two important facts remain: The development of the advanced industrial countries did not depend on the average middle class or poor person having access to credit. The relatively recent rise of the middle class depended upon economic growth - the expansion of the economy - which created jobs which led to buying power. Indeed, when we did open up the flood gates for easily accessible credit, the result was a huge increase in leveraged spending for consumption. Finally, by far the large majority of people in the North are not entrepreneurs and never will be.

If the large majority of us in the advanced economies are not entrepreneurs, and have had in our past little sophisticated contact with financial services, and if most of us use credit, when we do, for consumption, why do we make the assumption that in the developing countries, the poor are all budding entrepreneurs; that they will use credit wisely for investment in income production, and are ready for all manner of financial services? And how can we possibly posit (as we have since the 1970s) that credit is a "human right" without recognizing the dangers of debt? These propositions defy both history and common sense.

The Distinction between "Business" and Mere Survival Activity

Much of microcredit use in the poorest countries fits the old saying "all dressed up and no place to go."
If microcredit is to lead to economic opportunity it has to be administered in an economic context that can both foster and absorb it.5 This dilemma of absorptive capacity is not uncommon in the poorest counties. In such infertile economic contexts, the people at the bottom are by definition the ones who "need" credit the most, but can do the least with it. Two examples from Africa:

A lady in rural Malawi, age 35 with 3 children, breaks rocks into smaller pieces using a small hammer. She sets out the piles of small rocks on the roadside hoping to sell to construction crews as aggregate for concrete. She sells a few piles a week to contractors working on a nearby aid agency sponsored road project. Once the road is finished, she will have no more market.

A man who patches bicycle tires in the "mechanics" section of the main Niamey (Niger) market place. He is located in the open, and squats on the ground. He has a hand pump, a small can of rubber cement, some patches, a few wrenches and two screwdrivers.6

There is no question that such a use of credit helps the poor, but this is not what the majority of microcredit enthusiasts claim it can do - function as capital aimed at increasing the returns to a business activity.

These microcredit clients are in a sense "helped" by microcredit. But as one delves into the details of their "business activity," as I have done many times, it emerges that the clients with the most experience got started using their own resources, and though they have not progressed very far - they cannot because the market is just too limited - they have enough turnover to keep buying and selling, and probably would have with or without the microcredit. For them the loans are often diverted to consumption since they can use the relatively large lump sum of the loan, a luxury they do not come by in their daily turnover. Since the mid 1990s research on microcredit use has found that it often goes to "help the poor smooth consumption over periods of cyclical or unexpected crises…"7 Again, there is no question that such a use of credit helps the poor, but this is not what the majority of microcredit enthusiasts claim it can do - function as capital aimed at increasing the returns to a business activity.

Indeed, in part because of what has been aptly called "microfinance evangelism," the prospect of significant returns from microcredit made available to solid enterprises has become less likely.8 This is because those who can really leverage a small loan -somewhere between poor and well-off - who have already got a genuine business going against all odds are often left out of microcredit basically because they are not poor enough. Again the research is clear: "…the better off the borrower the greater the increase in income from a microenterprise loan. Borrowers who already have assets and skills are able to make better use of credit…. Indeed, some of the poorest borrowers …..became worse off as a result of micro-enterprise credit, which exposed these vulnerable people to high risks. .."9

The poorest clients, or those with the least experience, are however the targets of the majority of microcredit practitioners today. Yet most of these borrowers are not going anywhere with their activity except from one day's subsistence to the next. In the informal sector, such borrowers are reduced to "copycat" behavior, everyone selling the same thing, and more sellers saturating the market as more microcredit is made available. They are limited by an inability to add value and low skills, which is why the informal sector is characterized by low "barriers to entry." To be sure microcredit has helped someone here and there to build up a tiny business; enabled someone to buy a bicycle and thus become an owner of a productive asset, but such examples are far fewer than the cases of those who are caught in subsistence activities with no prospect of comparative advantage.

The microcredit paradox is that the poorest people can do little productive with the credit, and the ones who can do the most with it are those who don't really need microcredit, but larger amounts with different (often longer) credit terms. They began their businesses the way most people in the history of the world have, by borrowing informally from friends, relatives, other traders, or using own savings.

The informal sector in most places is in fact a default mode, a function of failing economies. It is not the incubator of economic growth but a holding action where everyone (including government employees) is forced to go since little else is available to them. These markets are not the way out of poverty; they are driven by it.

The Rhetoric of Microcredit Does Not Match the Reality, and Is Counterproductive

Nearly every microcredit organization wants to convey an impression of economic effectiveness. Just look at the websites of virtually any MFI and the stories are the same. Here’s one:

"A Powerful Anti-Poverty Tool… a lasting solution by providing the poor with the means to increase their incomes….long-term solution to some of poverty’s worst suffering…by helping the poor create their own solutions with dignity and self-reliance."10

We are meant to pick up on the phrases "powerful," "anti poverty tool," "lasting solution," "long term solution," etc. And the stories of individual clients all have happy endings. If these tactics are not quite smoke and mirrors, it is still the case that there is considerable exaggeration, and it runs pretty much throughout the microcredit movement. After years of official development effort and billions spent on microcredit this kind of imagery has become pretty much the sole face of the microcredit movement; the one thing a great many organizations have to put forward as a justification to continue to do what they do.

It is a stretch to go from the modest microcredit impacts that emerge from the little serious research we do have. The truth is that microcredit changes poor people's lives marginally. It is a stretch to go from the modest microcredit impacts that emerge from the little serious research we do have11 to suggesting as the UN's International Year of Microcredit website does, that road side sellers of a few bananas, used clothes, a few tea bags, or even 50 kilos of rice, are budding entrepreneurs standing at the threshold of participation in the wider economy, and who play a key role in wealth creation. It’s just not so.

What would permanently help these poor people, and if not them, their children, are governments that get their acts together and provide structures, laws, and institutions under which people's evident interest in getting ahead in the world could be transformed into reality. Microcredit is not just a stopgap while we wait for that to happen. To the extent it is hyped as a genuine solution to poverty, it is a diversion.

The Rising Hype Has Negatively Affected Even the Modest Gains of Microcredit

Microcredit hype has bred demand to have more donors focus on the field and that has created more microcredit projects and components of projects, to the point where an aid donor and a development program are not perceived as legitimate if they do not have microcredit as part of their portfolio of interventions. As more and more operators have got involved, the quality of microcredit operations has deteriorated just as the serious veteran players have reached the point of perfecting their lending techniques. Microcredit is on the verge of becoming a self-polluting industry.

Microcredit evangelism is a familiar story for our industry: An idea that, after all, can produce some modest changes in the life of poor people (cash flow smoothing, confidence building, etc.) but that really works well only in some circumstances, is carried off by hype and urgency, offered as much more than it really is, and applied everywhere. As it grows it is inevitably caught up in the decades-old incentive structure of the development aid industry - people and institutions are rewarded for mobilizing and moving money, and for acting on the mistaken notion that the way to solve poverty is to go directly to the poor themselves. Since the 1970s, time and again our industry trades- in complex and contextual approaches to development (institutional, legal, governance, and other reforms) for bandaid solutions that produce at best marginal changes, but satisfy the need to be perceived as "doing something for the poor." Again, the question needs to be asked: Is the goal to ease the pain or to cure the disease?

Economic Development is the current frontier of the microcredit movement, and a much tougher challenge. It is easy to give out microcredit, and using best practices developed over the years, even relatively easy to get the money repaid. But the marginal developmental returns from microcredit simply don't warrant the enthusiasm nor the money spent so far. To fulfill the promise of long-term change, much harder things need to be undertaken and these cannot be undertaken everywhere, nor by every player in the development aid business who comes along, because they require sophisticated skills, vision, research, and risky experimentation. To move forward the best operators of microcredit need to become banks, move more seriously into savings mobilization, and learn to deal with banking policy and other (institutional) aspects of the enabling environment. And they need to come to terms with the constraints imposed by political correctness - by being unafraid of lending to real businesses, and unafraid of abandoning the subsistence activities in the informal sector.

Questions or comments? Please contact the author Thomas Dichter.


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1 During the 1990s the term "microfinance" began to replace "microcredit" to encompass other financial services as well, including savings mobilization and insurance. But to date, the vast majority of projects still concentrate on credit only.
2 It is significant that CGAP rather quietly dropped the “est” from its former title making “poorest” into just plain “poor.”
3 Rosenberg, Rich, "Review of UNDP Microfinance Portfolio," CGAP, January, 2006, p. 8.
4 Consumer debt defined as credit card and car loan debt, not including mortgages.
5 The World Bank's "Microfinance Handbook" points out the uselessness of targeting "…a segment of the population that has no access to business opportunities because of lack of markets, inputs, and demand. Productive credit is of no use to such people…" See Joanna Ledgerwood, Microfinance Handbook, An Institutional and Financial Perspective, The World Bank, Washington, D.C. 1999, p. 4. In addition, from the lender's point of view, the impracticality of small scale lending under unstable economic conditions has been amply demonstrated, e.g., Jacob Yaron, "Successful Rural Finance Institutions," World Bank Discussion paper 150, The World Bank, Washington, D.C., 1992, p 47.
6 These examples are taken from the author's own field notes during evaluations of microcredit programs over the last two decades.
7 Bennett, Lynn and Cuevas, Carlos, Journal of International Development, Special Issue: Sustainable Banking with the Poor, 8 (2), 1996.
8 Rogaly, Ben, "Microfinance evangelism, 'destitute women' and the hard selling of a new anti-poverty formula', Development in Practice, (Journal) 6 (2), 1996.
9 Johnson, Susan and Rogaly, Ben, Microfinance and Poverty Reduction, Oxfam and ActionAid, Oxford and London, U.K., 1997, p. 11.
10 www.Finca.org
11 see for example, Littlefield, Morduch and Hashemi, "Is Microfinance an Effective Strategy to Reach the Millenium Development Goals?," CGAP Focus Note No. 24, January, 2003, www.cgap.org/docs/FocusNote_24.pdf