Microcredit for small business start-ups – a miracle cure for poverty?

Every revolutionary idea needs a founding legend to explain it. For microcredits, it is this: 35 years ago, Bangladeshi economist Muhammad Yunus met a woman basket-weaver. The academic wanted to know what the woman needed in order to earn enough money to live on.

As little as EUR 30 would enable her to set up her own business, she told him, but because she was poor she had no prospect of getting a loan. He lent her the money, she used it to buy bamboo to weave her own baskets, and she then repaid the microloan on time and with interest.

Nobel peace prize for the ‘microloan’ model of success

This experience prompted Yunus to set up the Grameen Bank. The idea was to provide loans averaging around EUR 100 to help people in developing countries who had no financial security but who did have ideas for starting their own businesses. Unlike traditional development aid the recipients pay annual interest on their loans, because microcredits are not about donations or grants, they are essentially a tool of market economics.

Yunus was proved right. By giving people intensive support and advice when they took out a loan, his bank achieved a repayment rate of 98 %. Hundreds of thousands of poor people in Bangladesh alone were now able to earn an independent living. In 2006, Muhammad Yunus and his bank won the Nobel Peace Prize for their idea. Microloans were hailed worldwide as a miracle cure for poverty, and new microfinance institutions were being set up all the time; the statistics vary, but anywhere between 10,000 and 70,000 such institutions were launched, many of them as profit-making businesses. One large Indian microfinance bank floated on the stock exchange last year, attracting investors by promising high rates of return on their investments.

Interest rate traps and loan-shark behaviour

Microcredits have become caught up in the crisis of capitalism and have been criticised for allegedly driving borrowers into a debt trap. In 2010, several Indian farmers killed themselves because they could no longer pay the high rate of interest on their loans. Grameen Bank charges 20 % interest a year because, it argues, it needs to supervise the loans closely. Meanwhile, a number of disreputable microfinance institutions in the region have borrowed money at standard rates of interest and then lent it out at much higher rates of up to 60 %.

In India, hardly any checks are made on whether the money a customer borrows is actually used as start-up capital for a business. Research shows that, in fact, many borrowers use the money to survive, spending it on food or on medical bills. And then, when the lender demands repayment, they simply take out another loan from one of the vast number of other lenders.

Since then, much of the magic has gone out of microloans. Economists are now debating whether Muhammad Yunus’s idea carried the seeds of its own downfall – or whether what was actually a good idea has fallen victim to inadequate regulation in the financial sector.

Author: Maren Bekker

December 2011

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Richard Baah
10 September 2012

Some parts of Ghana have reported similar cases of farmers and SMEs borrowing money from a microcredit institution to settle debts owe to other microcredit institutions which have also lead to the demise (committing suicides) of some defaulters.

I think that microcredit institutions have lost the philosophy underpinning microcredit which is socially responsible investment and like any investment, it should be profitable but also sustainable. The principal customers of microcredit institutions are farmers, SMEs, etc. who operate at the local level and are underserved by mainstream financial markets. For microcredit institutions to be profitable and sustainable, they should thrive to operate locally meaning understanding the local cultures (clients’ behaviour and customs), diverse local business activities and providing investment packages that meet local business needs thereby curbing the rate of defaulting. To ensure a more efficient microcredit system in an area, microcredit institutions should also be equipped to check the credit performance of their clients (among the institutions).

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Fitsum Tarekegn
1 February 2012

I have worked as team leader of impact assessment of micro and small enterprises in Addis Ababa Ethiopia. During 2004/05 to 2009/10 MSEs have not reported to take loans from micro finance institutions. The procedures are not clear and were found very risky for these households with members of MSES. In the short term, the Government has planned to establish the micro credit services with the saving facilities to enhance the capacity of the MSE.

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