The Microfinance Promise By Jonathan Morduch

Journal of Economic Literature

Vol. XXXVII (Decmber 1999), pp. 1569–1614

Morduch: The Microfinance Promise

Journal of Economic Literature, Vol. XXXVII

(

December 1999

)

The Microfinance Promise

Jonathan Morduch

1. Introduction

BOUT ONE

billion people globally

live in households with per capita in-

comes of under one dollar per day. The

policymakers and practitioners who have

been trying to improve the lives of that

billion face an uphill battle. Reports of

bureaucratic sprawl and unchecked cor-

ruption abound. And many now believe

that government assistance to the poor

often creates dependency and disincen-

tives that make matters worse, not bet-

ter. Moreover, despite decades of aid,

communities and families appear to be

increasingly fractured, offering a fragile

foundation on which to build.

Amid the dispiriting news, excite-

ment is building about a set of unusual

financial institutions prospering in dis-

tant corners of the world—especially

Bolivia, Bangladesh, and Indonesia. The

hope is that much poverty can be allevi-

ated—and that economic and social

structures can be transformed funda-

mentally—by providing financial ser-

vices to low-income households. These

institutions, united under the banner of

microfinance, share a commitment to

serving clients that have been excluded

from the formal banking sector. Almost

all of the borrowers do so to finance

self-employment activities, and many

start by taking loans as small as $75, re-

paid over several months or a year. Only

a few programs require borrowers to

put up collateral, enabling would-be en-

trepreneurs with few assets to escape

positions as poorly paid wage laborers

or farmers.

Some of the programs serve just a

handful of borrowers while others serve

millions. In the past two decades, a di-

verse assortment of new programs has

been set up in Africa, Asia, Latin Amer-

ica, Canada, and roughly 300 U.S. sites

from New York to San Diego (The Econo-

mist 1997). Globally, there are now

about 8 to 10 million households served

by microfinance programs, and some

practitioners are pushing to expand to

1569

Princeton University. JMorduch@Princeton.

Edu. I have benefited from comments from

Harold Alderman, Anne Case, Jonathan Conning,

Peter Fidler, Karla Hoff, Margaret Madajewicz,

John Pencavel, Mark Schreiner, Jay Rosengard,

J.D. von Pischke, and three anonymous referees. I

have also benefited from discussions with Abhijit

Banerjee, David Cutler, Don Johnston, Albert

Park, Mark Pitt, Marguerite Robinson, Scott

Rozelle, Michael Woolcock, and seminar partici-

pants at Brown University, HIID, and the Ohio

State University. Aimee Chin and Milissa Day pro-

vided excellent research assistance. Part of the re-

search was funded by the Harvard Institute for

International Development, and I appreciate the

support of Jeffrey Sachs and David Bloom. I also

appreciate the hospitality of the Bank Rakyat In-

donesia in Jakarta in August 1996 and of Grameen,

BRAC, and ASA staff in Bangladesh in the sum-

mer of 1997. The paper was largely completed

during a year as a National Fellow at the Hoover

Institution, Stanford University. The revision

was completed with support from the Mac-

Arthur Foundation. An earlier version of the pa-

per was circulated under the title “The Microfi-

nance Revolution.” The paper reflects my views

only.

100 million poor households by 2005.

As James Wolfensohn, the president of

the World Bank, has been quick to

point out, helping 100 million house-

holds means that as many as 500–600

million poor people could benefit. In-

creasing activity in the United States

can be expected as banks turn to mi-

crofinance encouraged by new teeth

added to the Community Reinvestment

Act of 1977 (Timothy O’Brien 1998).

The programs point to innovations

like “group-lending” contracts and new

attitudes about subsidies as the keys to

their successes. Group-lending con-

tracts effectively make a borrower’s

neighbors co-signers to loans, mitigat-

ing problems created by informational

asymmetries between lender and bor-

rower. Neighbors now have incentives

to monitor each other and to exclude

risky borrowers from participation, pro-

moting repayments even in the absence

of collateral requirements. The con-

tracts have caught the attention of eco-

nomic theorists, and they have brought

global recognition to the group-lending

model of Bangladesh’s Grameen Bank.

The lack of public discord is striking.

Microfinance appears to offer a “win-

win” solution, where both financial in-

stitutions and poor clients profit. The

first installment of a recent five-part se-

ries in the San Francisco Examiner, for

example, begins with stories about four

women helped by microfinance: a tex-

tile distributor in Ahmedabad, India; a

street vendor in Cairo, Egypt; an artist

in Albuquerque, New Mexico; and a

furniture maker in Northern California.

The story continues:

From ancient slums and impoverished vil-

lages in the developing world to the tired in-

ner cities and frayed suburbs of America’s

economic fringes, these and millions of other

women are all part of a revolution. Some

might call it a capitalist revolution . . . As

little as $25 or $50 in the developing world,

perhaps $500 or $5000 in the United States,

these microloans make huge differences in

people’s lives . . . Many Third World bank-

ers are finding that lending to the poor is not

just a good thing to do but is also profitable.

(Brill 1999)

Advocates who lean left highlight the

“bottom-up” aspects, attention to com-

munity, focus on women, and, most im-

portantly, the aim to help the under-

served. It is no coincidence that the rise

of microfinance parallels the rise of non-

governmental organizations (NGOs) in

policy circles and the newfound attention

to “social capital” by academics (e.g.,

Robert Putnam 1993). Those who lean

right highlight the prospect of alleviat-

ing poverty while providing incentives

to work, the nongovernmental leadership,

the use of mechanisms disciplined by

market forces, and the general suspicion

of ongoing subsidization.

There are good reasons for excite-

ment about the promise of microfi-

nance, especially given the political

context, but there are also good reasons

for caution. Alleviating poverty through

banking is an old idea with a checkered

past. Poverty alleviation through the

provision of subsidized credit was a cen-

terpiece of many countries’ develop-

ment strategies from the early 1950s

through the 1980s, but these experi-

ences were nearly all disasters. Loan re-

payment rates often dropped well below

50 percent; costs of subsidies ballooned;

and much credit was diverted to the po-

litically powerful, away from the in-

tended recipients (Dale Adams, Douglas

Graham, and J. D. von Pischke 1984).

Recent theoretical studies of microfinance in-

clude Joseph Stiglitz 1990; Hal Varian 1990; Timo-

thy Besley and Stephen Coate 1995; Abhijit

Banerjee, Besley, and Timothy Guinnane 1992;

Maitreesh Ghatak 1998; Mansoora Rashid and

Robert Townsend 1993; Beatriz Armendariz de

Aghion and Morduch 1998; Armendariz and Chris-

tian Gollier 1997; Margaret Madajewicz 1998;

Aliou Diagne 1998; Bruce Wydick 1999; Jonathan

Conning 1997; Edward S. Prescott 1997; and Loïc

Sadoulet 1997.

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Journal of Economic Literature, Vol. XXXVII

(

December 1999

)

What is new? Although very few pro-

grams require collateral, the major new

programs report loan repayment rates

that are in almost all cases above 95

percent. The programs have also proven

able to reach poor individuals, particu-

larly women, that have been difficult to

reach through alternative approaches.

Nowhere is this more striking than in

Bangladesh, a predominantly Muslim

country traditionally viewed as cultur-

ally conservative and male-dominated.

The programs there together serve

close to five million borrowers, the vast

majority of whom are women, and, in

addition to providing loans, some of the

programs also offer education on health

issues, gender roles, and legal rights.

The new programs also break from the

past by eschewing heavy government in-

volvement and by paying close attention

to the incentives that drive efficient

performance.

But things are happening fast—and

getting much faster. In 1997, a high

profile consortium of policymakers,

charitable foundations, and practitioners

started a drive to raise over $20 billion

for microfinance start-ups in the next ten

years (Microcredit Summit Report 1997).

Most of those funds are being mobi-

lized and channeled to new, untested

institutions, and existing resources are

being reallocated from traditional pov-

erty alleviation programs to microfi-

nance. With donor funding pouring in,

practitioners have limited incentives to

step back and question exactly how and

where monies will be best spent.

The evidence described below, how-

ever, suggests that the greatest promise

of microfinance is so far unmet, and the

boldest claims do not withstand close

scrutiny. High repayment rates have

seldom translated into profits as adver-

tised. As Section 4 shows, most pro-

grams continue to be subsidized di-

rectly through grants and indirectly

through soft terms on loans from do-

nors. Moreover, the programs that are

breaking even financially are not those

celebrated for serving the poorest cli-

ents. A recent survey shows that even

poverty-focused programs with a “com-

mitment” to achieving financial sustain-

ability cover only about 70 percent of

their full costs (MicroBanking Bulletin

1998). While many hope that weak fi-

nancial performances will improve over

time, even established poverty-focused

programs like the Grameen Bank would

have trouble making ends meet without

ongoing subsidies.

The continuing dependence on subsi-

dies has given donors a strong voice,

but, ironically, they have used it to

preach against ongoing subsidization.

The fear of repeating past mistakes has

pushed donors to argue that subsidiza-

tion should be used only to cover start-

up costs. But if money spent to support

microfinance helps to meet social objec-

tives in ways not possible through alter-

native programs like workfare or direct

food aid, why not continue subsidizing

microfinance? Would the world be bet-

ter off if programs like the Grameen

Bank were forced to shut their doors?

Answering the questions requires

studies of social impacts and informa-

tion on client profiles by income and

occupation. Those arguing from the

anti-subsidy (“win-win”) position have

shown little interest in collecting these

data, however. One defense is that, as-

suming that the “win-win” position is

correct (i.e., that raising real interest

rates to levels approaching 40 percent

per year will not seriously undermine

the depth of outreach), financial viabil-

ity should be sufficient to show social

impact. But the assertion is strong, and

the broader argument packs little punch

without evidence to back it up.

Poverty-focused programs counter

that shifting all costs onto clients would

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FAQs of The Microfinance Promise by Jonathan Morduch

What are the main themes discussed in The Microfinance Promise?

The Microfinance Promise discusses themes such as the potential of microfinance to alleviate poverty, the innovative lending practices of various institutions, and the socio-economic impacts on borrowers. It emphasizes the importance of financial sustainability and the challenges faced by microfinance programs in reaching their goals. Additionally, the document highlights how microfinance can empower women, improve household incomes, and foster community development.

How does microfinance impact women's empowerment according to the document?

The document illustrates that microfinance significantly impacts women's empowerment by providing them with access to financial resources that were previously unavailable. Women borrowers often use loans to start small businesses, which can enhance their economic independence and decision-making power within their households. Furthermore, the programs often include training and education components that promote gender equality and improve women's social status in their communities.

What challenges do microfinance institutions face in achieving sustainability?

Microfinance institutions face several challenges in achieving sustainability, including high operational costs, the need for ongoing subsidies, and the difficulty of reaching the poorest clients. The document points out that while many institutions report high repayment rates, they often rely on donor funding to cover costs. Additionally, competition from other financial institutions can dilute the effectiveness of microfinance programs and lead to increased default rates.

What innovative lending models are highlighted in The Microfinance Promise?

The Microfinance Promise highlights several innovative lending models, including group lending, where borrowers form groups to guarantee each other's loans, and individual lending tailored to the needs of specific clients. These models are designed to mitigate risks associated with lending to low-income households and improve repayment rates. The document discusses how these approaches leverage social capital and community ties to enhance the effectiveness of microfinance.

The Microfinance Promise by Jonathan Morduch

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FAQs of The Microfinance Promise by Jonathan Morduch

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