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Microfinance is a term for the practice of providing financial services, such as microcredit, microsavings or microinsurance to poor people. By helping them to accumulate usably large sums of money, this expands their choices and reduces the risks they face. Suggested by the name, most transactions involve small amounts of money, frequently less than US$100.
Microfinance - includes savings accounts, and other functions beyond just credit
microcredit - only credit
For investors in emerging markets:
The two distinct fields of microcredit and Microfinance are hot right now, as investors seek ways to not only find attractive returns, but to also invest in projects with unique social appeal. Seeking economic development of some of the poorest regions on earth, this movement was initially brought to the world stage by the incredible efforts of such groups as the Grameen Bank of Bangladesh and Professor Prahalad of the University of Michigan. Since then, there has been a boom in the credit markets to service the bottom of the pyramid marketing, as banks, individuals and commercial stores have collectively realized the value that can be obtained by extending credit to the emerging consumer classes. In response, we are seeing how the new opportunities with consumers of low income is transforming commodity markets around the world, as projects such as the Bolsa Familia in Brazil spur a whole generation of buyers to seek new automobiles, washing machines, etc. See our discussion on the Rise of purchasing power in emerging markets
History
The origin of microfinance is often dated as late as the 1970s. Only then, it is often argued, did any programs pass two key tests:
show that poor people can be relied on to repay their loans, and
show that it's possible to provide financial services to poor people through market-based enterprises without subsidy.
Recent evidence gathered by Timothy Guinnane, an economic historian at Yale, raises questions about this view. Guinnane demonstrates that the success of Friedrich Wilhelm Raiffeisen's village banking movement in Germany, which began in 1864 and reached 2 million rural farmers by 1901, resulted in large part from its ability to pass both these tests.
Guinnane shows how the village-based bonds of association of these early credit unions gave them both the information and enforcement advantages needed to make loans to people who were both too poor and too remote to access bank loans. Raiffeisen was moved to action by the poverty of the recently freed serfs, and by the degree of exploitation they faced from local moneylenders.
In the 1970s, a new wave of microfinance initiatives introduced many new innovations into the sector. Solidarity lending emerged as a distinctive new methodology, made famous by Dr. Muhammad Yunus at Grameen Bank.
The first fully-incorporated microfinance and community development bank was ShoreBank, founded in 1973 in Chicago.
Microfinance and development
Today, microfinance plays a major role in the development of many African, Asian, and Latin American nations. Its impact is substantial enough to have warranted acknowledgment by the United Nations who declared 2005 The international year of microfinance, reminding people that millions worldwide benefit from microfinance activities.
Criticism
There is, however, criticism towards microfinance institutions. In 2001, a Wall Street Journal article raised questions about the Grameen Bank, including repayment rate, collection methods and questionable accounting practices.
On a larger scale, some argue that an overemphasis on microfinance to combat poverty will lead to a reduction of other assistance to the poor, such as government welfare.
Research on the actual effectiveness of microfinance as a tool for economic development remains slim, in part owing to the difficulty in monitoring and measuring this impact. Questions have arisen regarding whether microfinance can ever be as important a tool for poverty alleviation as its proponents and practitioners would submit
Risk: inflation can ruin the microcredit business model
There is a risk that inflation can ruin the microcredit business model. Read more in our discussion on microcredit and inflation
The current global inflationary spiral has prompted the IMF chief to alert about the consequences it has for the poorest of the population. In his latest statements, Mr. Strauss-Kahn follows classical western economics thought: the poorest fifth of the world population make wages in the local currency, and in inflationary environments their wages are adjusted at a slower pace than price rises, eroding their purchase power over time. The higher the inflation rate, the slower is the wage adjustment. On top of that, the classical economic thinking goes, the poorest segments of the population don’t have the inflationary hedges richer people have like moving their assets to gold or other less inflation-sensible assets class.
This line of thinking has two central assumptions: First, there is an asset the owner cannot dispose immediately (e.g. “frozen” savings in the bank, wages to be paid at the end of the week and/or other accounts receivables); second the asset is denominated in the national currency being devaluated due to inflation.
This set of ideas are extremely compelling in the developed economies where most of the population is wage-earning employees (unemployment rates have been around the 8% average the last 50 years) and poverty is a marginal concern (“endemic” poverty in the G7 countries is less than 1% of the population, mainly as a consequences of other concomitant factors –e.g. mental health, physical handicap, substance abuse )
The contrasting situation in emerging economies
Emerging economies offer a sharp contrast, characterized by unemployment and sub employment rates of above 70%; poverty levels above 40%; a significant portion of the economic activity being informal outside of any state monitoring and taxing. In these latitudes, the poorest fifth of the population likely do not earn regular wages, and live mostly out of locally transacted goods and services. Three salient characteristics of this markets can be pointed: (a) a significant part of the transactions are barter or cuasi-barter transactions: agents tend to operate through simple “mental accounting” in two “ledgers”: accounts receivable from their neighbors and accounts payable to their neighbors. Minimal or no cash is involved and the transaction is denominated in terms of the goods to be exchanged: (e.g. one pound of rice for two pounds of coal). Since there is no cash involved, and their transaction is not indexed to any currency, the accounts payable/receivable act as a natural hedge against inflation (b) these tend to be rural settings without much connection with the global economy. (Furthermore, Development economists tend to agree that it is the lack of trade and linkages with other economies what keeps these regions poor). As a consequence, a global inflationary spiral is irrelevant, since the linkages with the global economies are not there. Whatever happens in the world, for good (development) or bad (inflation), is not necessarily happening there. For instance, while a country can import inflation trough their need to import increasingly expensive oil, this small village’s dramatic isolation isolates them from development and inflation. Finally, (c) Transactions are remarkably small, as the market agents have not savings capability being theirs a subsistence economy (single serving soups are a best seller in Mexico and India, based on the consumers’ ability to pay for one at a time, and their inability to purchase and store large packages). This lack of assets implies that the poorest of the poor don’t have anything to get depreciated trough inflation! Inflation is a concern of those that do have something to be depreciated, like the blue collar’s worker savings in the U.S. bank or his devalued paycheck at the end of the month. In the absence of assets, paradoxically, the concerns on inflation also disappear.
The significant contribution of Microfinance
Microfinance has played an important role in the poverty alleviation efforts the last there decades. Capital fuels the machines of economic growth: As the micro entrepreneurs increases its productivity thanks to micro credits, the local economies grow and trade with other geographies become real. These improved economic conditions lift micro-entrepreneurs while making them more vulnerable to inflation. The micro-entrepreneur’s illness of the childhood are gone, but now they are exposed to the illnesses of the grown up’s. How? (a) Barter transactions recede and the influx of capital increases the amount of economic activity being transacted in the local currency, witch is loosing purchasing power as time passes by. The micro-entrepreneur “cash cycle” becomes a significant hurdle. The cash he gets from sales after his economic activity is performed might not be enough to pay for supplies for the new cycle of economic activity, a couple of days or weeks after (b) Linkages with the global economies make them prone to inflation import by the way of an increase price of supplies now imported from other villages at the national or even international level. Worldwide prices do impact them now. (c) The increase in their savings capacity makes the risk of any savings in the form of assets denominated in the local currency to depreciate.
These three elements: transactions being nominated in local currencies, new linkages with the global economy, and increased savings generate a new scenario for the micro-financed entrepreneurs which are for the first times exposed to the global macroeconomic trends.
Is there anything to be done?
The efforts of the Microfinance institutions face a new challenge. Their success or failure is now associated with the global economy. For the microfinance institutions to succeed, they need to add to their tasks not only the provision of capital and financial literacy, buy provide the ailments to the global economy maladies. This is a major undertaking.
The expansion of financial services to the poorest brackets of the population have seen an enormous expansion in the latest decade as significant publicity was gained after Mr. Yunus’s Nobel award. Deutshe Bank has suggested that this is a $250B market, and new financial products have been slowly released (investment banks have invested in BoP securitized debt, climate insurance has been rolled out, etc.) Microfinance institutions might want to explore the use of inflation hedging mechanisms either via embedding them in their loans or as a standalone offering. The explosive boom in global derivatives trading might provide an interesting field where experience might be “imported”.
Sustainability of the Microfinance organizations
On the supply side, microfinance institutions face their own share of problems. As their loans for the most part are fix interest and not indexed to the inflation, in an inflationary environment they will get payments in devalued currencies and thus, their might experience net loss. Depending on their managers ability to generate inflation risk hedging strategies they will fare this inflationary period with success, or simply will be forced to reduce their capital base and take significant write off from loans that are underperforming in real terms. Nothing big banks have not seen lately.
Effects of the (USA) credit crunch:
Global effects
Other than countries that were direct buyers of US asset-backed securities (mortgages), I don't see much of a contraction of credit in emerging markets.
Let's look at Brazil for example; In May of 2008 (6+ months into the "credit crisis of 2007"), I see no contraction of credit conditions at all. In fact, there is an ongoing explosion of credit available to consumers in Brazil (even if the industrial credit markets are still as tight as ever). On the consumer side, however, it appears as if Brazil is swimming in available credit, in spite of the so-called "credit crisis". Maybe the troubles are not as global as some analysts are predicting. Not directly anyways.
Mexico is another example. According to a recent article from the Economist magazine, lending in Mexico "has ballooned. Credit to the private sector has nearly tripled since 2001, while consumer credit has increased by around seven times." This is hardy a global credit crisis. Again, it seems to be localized just to banks that were buyers of mortgage backed securities, or other financial innovations. But, in Mexico, the article goes on to explain that there has been an increase in the sophistication of the credit markets, as there has also been a massive growth of mortgage-backed securities markets, and improved credit ratings systems. But, in contrast with the US, there has been a very minimal housing price increase (even less than inflation).
So, in spite of a credit crunch, it appears as if the phenomenon is mostly US-based one.
Additionally, the Mexican Banks are benefiting from the extra consumer credit (mentioned above), with which the banks charge large fees. The extension of the credit to the large and growing consumer class has been a boom for Mexican banks (as it has for all banks in emerging markets servicing the credit-to-the poor marketplace). (insert ethical discussion here if you wish...)
ACCION International: Large, Boston-based microfinance institution which provides loans to entrepreneurs inLatin Americaand throughout the developing world.
Banking With The Poor: Network of 20 national policy institutions, commercial banks, and NGOs from eight countries inAsia.
Calmeadow: Toronto-based company focused on the development, fundraising and governance of ProFund Internacional and AfriCap Microfinance Fund.
FINCA International: FINCA provides financial services to the world's poorest families so they can create their own jobs, raise household incomes, and improve their standard of living. FINCA operates a network of village banks (community-based microfinance institutions) and creates community-run credit and savings associations.
The Foundation for International Community Assistance: FINCA provides financial services through a village banking system to the world's poorest families so they can create their own jobs, raise household incomes, and improve their standard of living.
Grameen Foundation USA: GFUSA is a global non-profit organization that works to replicates the success of Grameen Bank around the world. GFUSA’s programs create a network of microfinance institutions,Provide training to microfinance institutions, develop and provide technology to microfinance institutions, and link microfinance institutions with domestic and international capital markets
Microfinance Information Exchange: Resources for the microfinance industry including investment information about microfinance funds and profiles of MFIs.
Microfinance Network: The MFN facilitates information flow between microfinance organizations and practitioners, technical exchanges, and publications of best practice materials.
Microfinance Management Institute: MFMI collaborates with top MBA schools in developing countries to support academic research and teaching materials dedicated to microfinance research and works to integrate microfinance into MBA programs worldwide.
Opportunity International:OpportunityInternational provides small loans to poor entrepreneurs. Opportunity International is a Christian ecumenical organization serving women and men of all beliefs to impact the future of millions of poor families.
Planet Finance: Provides technical assistance, advice, and training for those involved in microfinance; assesses and rates microfinance institutions; and provides financing to microfinance institutions.
Planet Rating: Planet Rating is a for-profit, microfinance rating agency which evaluates and rates microfinance institutions and trains staff on how to conduct evaluations using Planet Rating’s methodology
Pro Mujer: establishes microfinance institutions for women in Latin America and provides credit and training in business skills and links women with health services
ShoreBank International: ShoreBank International is a member of the ShoreBank group of companies.Following ShoreBank model, SBI leverages private capital and technical assistance resources to benefit disinvested urban communities in developing economies.
Women’s World Banking Network: The Women's World Banking network aims to have a major impact on expanding the economic assets, participation and power of low income women as entrepreneurs and economic agents by opening their access to finance, knowledge and markets.
World Council of Credit Unions, Inc.: WOCCU is the world's leading advocate, platform for knowledge exchange, and development agency for credit unions. WOCCU serves its members by facilitating knowledge exchange, acting as a broker of global alliances, developing future leaders, and creating innovative products and services.
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