24 Nov 2015

India’s Microcredit System: A Failed Experiment?

Robin writes*

Microcredit, or the practice of extending small loans to the worlds poorest, has long been hailed as a powerful tool in the fight against poverty, even earning its founder Mohammed Yunus a Nobel Prize in 2006. Although when done right, this business model can indeed be implemented successfully, microcredit has become the subject of much criticism lately. Some of India’s microcredit providers, for example, have been behaving like loan sharks, providing loans regardless of what people plan to do with them, charging exorbitant interest rates, and using increasingly coercive tactics to collect loan payments. As a result, many of India’s poorest citizens are left with debt they will most likely never be able to pay off. There are even accounts of suicide linked to the vicious cycle of debt that microcredit schemes have incited. The entire system almost collapsed in 2010, when growing dissatisfaction led borrowers to collectively default on their loan payments. Microcredits were meant to eliminate scenarios like this one, leaving us with the question: ‘What went wrong?’

Yunus himself attributes some of the issues to a ‘mission drift’ Microcredit organizations were originally envisioned to be small, non-profit and community based, but are increasingly becoming large, for-profit companies. For-profit microcredit companies are problematic in many ways, not the least of which is that they raise their funds in international markets that are often volatile and then transfer the risks to the poor in the form of high interest rates. With this profit-maximizing strategy comes a lack of interest in the educational aspect of microcredit schemes that has made them so successful in many instances. Entrepreneurial education is a vital part of ensuring that loans generate viable livelihoods for their borrowers. The original group lending method used by Grameen Bank in Bangladesh, for example, put lenders into small groups, gave them training and encouraged peer-monitoring to help ensure that the loans were being used responsibly. This created ‘social capital’ (as well as physical capital) that India’s current predatory lenders do not (Halder and Stieglitz [pdf]).

Government regulations may provide a solution. At least one Indian state has implemented legislation that restricts the number of lenders that borrowers can lend from and recommendations have been made to put a cap on interest rates and regulate what kinds of companies can call themselves microfinance organizations. While these measures may be helpful to reduce predatory lending disguised as microfinancing, there is also a risk that restricting the activities of legal companies will drive borrowers into the hands of the very loan sharks that microcredits were supposed to displace. This is, arguably, even more problematic because loan sharks are infinitely harder to control.

Bottom Line: Cleaning up the microfinance industry must, therefore, be accompanied by a strategy to combat harmful unofficial lending practices, or ideally eliminate the need for them. There is a delicate balancing act to be observed.

* Please comment on these posts from my growth & development economics students, to help them with unclear analysis, other perspectives, data sources, etc.


Yeming said...

Hi Robin, interesting topic and I think this problem is indeed a pervasive one. However, I do not understand your 'counter-argument' against government regulation. You say that this can be "even more problematic because loan sharks are infinitely harder to control." But on the one hand you say that these 'bad' microcredits are loan sharks themselves, and on the other hand you say that trying to regulate 'bad' microcredits will give rise to (other?) loan sharks. So first, I do not really understand your definition of loan sharks and what they constitute of. Secondly, I do not see how regulating (micro) loans / credit extensions will give rise to other providers of credit (loan sharks as you call them?). I can only see this happening when the loan sharks you are referring to are illegal ones and hence regulating legal companies that extend credit are indeed likely to give rise to illegal forms of credit extension. Maybe you can clarify?

Melissa Leong said...

Hi Robin, I like your blog post and presentation. Microcredit is such a key part of the development realm that I really appreciate that you decided to research and enlighten the class about it.

I agree with your policy suggestions, particularly about how education needs to accompany microcredit loans. I lived in Maharashtra, India for a couple of years before university and personally know some families who have been affected by the “microcredit crisis” and seen its effects on livelihood decisions (closing of farms and migration to Mumbai) and how it breaks up communities in certain cases.

Microcredit is often being talked about in the news, in India and internationally, and what is striking is that none of the articles seem to agree with each other. Some say that microcredit is useless or worse: creates dependency. Some say that it is the key to poverty. The World Bank I think blows the horn for the latter party ( Link: http://www.economist.com/blogs/freeexchange/2014/06/microcredit-and-poverty-alleviation?zid=300&ah=e7b9370e170850b88ef129fa625b13c4 ). Perhaps a way of centering yourself between these voices of debate is to decide if it is the theory or the implementation that is the problem.

It seems like microcredit’s theory sets a clear path to improved wellbeing for its participants. The points you made in your blog post and presentation (about loan shark-like MFIs and inflated interest rates) suggest that it is the implementation that is the problem, not the system and theory. Yunus’s “mission drift” comment seems to hint at this too. I wonder if you could clarify if it is the microcredit theory and structure that you find problematic or if it is implementation issues? Perhaps this might help clarifying Yeming’s point as well.

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