ESSA Admin
February 5, 2012

The concept of microfinance has gained popularity recently through stories of grand success and its promise as a panacea for global poverty. Microfinance institutes provide financial services to low-income people who would otherwise be rejected by more commercial banking institutions. Microfinance includes products such as savings, insurance and loans. Microcredit is a specific name for the loans given through microfinance, and is generally the main focal point of discussion.

Microcredit is not a modern invention. If one chooses to argue that microcredit is just a very small loan, then its origins go as far back as when one tribesman gave another his sheepskin, expecting it back, and promising banishment if not returned. If one wants more specificity, one of the earliest formal micro-credit institutions, which provided small loans to rural poor with no collateral, was the Irish Loan Fund, created in the early 1700s by the author, Jonathan Swift. By the 1840s, around 300 similar funds around Ireland had been initiated, which, at their peak, provided loans to 20% of Irish households annually.

In 2006, Mohammad Yunus, the founder of Grameen Bank, a microcredit institute in Bangladesh, received the Nobel Peace Prize. While the principles of microcredit have not changed, the ideals surrounding the idea have matured. They are still given to the poor as a small loan has a disproportionately positive effect on their lives, and helps them seek out a better life through increasing their credit-worthiness, financial literacy and self-sufficiency.

The interest rates on the loans are quite high when compared to those offered to the wealthier developed world. This is because, apart from the proportional costs of a loan such as the cost of money and default, transaction and administration costs are for the most part fixed, so the smaller the loan, the higher the interest rate percent will be, as the fixed costs account for a larger portion of the loan. Some loans carry interest rates of 50%. In some countries such as India, the interest rates charged on these microloans are still far less than those charged by local moneylenders.

The modern twist on microcredit is in the social responsibility which has become attached to it. Loans are made to mostly women, who are encouraged to begin small businesses in order to repay the loan and interest and keep excess profits for their families. This has the added benefit of improving women’s social standing in societies where women are viewed as inferior. More sophisticated social mechanisms are employed to encourage repayment. In some communities, loans are denied to everyone if one cannot repay his/hers. This adds the pressure of peers to avoiding default.

The premise of microfinance seems clean and encouraging. Reality, however, cannot be encapsulated in economic models or econometric studies. In India’s south-eastern state of Andhra Pradesh, the father of a family owned a small street store selling betel nuts and tobacco, the mother worked occasionally as a maid and the daughter, Monica, tailors clothes. They initially borrowed 10,000 rupees from a microfinance company, but struggled to repay it. So they began borrowing from other microfinance companies to repay their existing debt.

Eventually, the family could not borrow any more money and was still unable to make the repayments. The companies sent recovery agents, who harassed and humiliated the family 2 to 3 times a day, seizing family assets such as their sewing machine, and ultimately suggesting that Monica be sold to pay off the loan. Soon, Monica could not endure the pressure any longer and set herself on fire. Her family tried desperately to save her. Her story is not unique in Andhra Pradesh, where at least 80 suicides in the last year have been attributed to microfinancing.

There are over 1000 microfinancing companies in India, yet in Andhra Pradesh, a microfinancing hub, four companies dominate 80% of the market. ‘Multiple lending, over-indebtedness, coercive recovery practices, and unseemly enrichment by promoters and senior executives (of microcredit companies) have all led to this situation,’ says Vijay Mahajan, chairman of India’s Microfinance Institutions Network. The ideals with which the microfinancing revolution was first conceived are decaying. Venkat Narayana, a professor of economics at Kakatiya University, says that ‘(Microfinancing companies) are guided by greed, and the social purpose is completely ignored’; the original social purpose being increasing financial literacy and the quality of life of the poor.