Poor Economics

by Abhijit Banerjee

  DOES MICROCREDIT WORK?

  The answer obviously depends on what you mean by “work.” According to the more enthusiastic backers of microfinance, it means transformation of people’s lives. The Consultative Group to Assist the Poor (CGAP), an organization housed at the World Bank and dedicated to promoting microcredit, reported at some point in the FAQ section of its Web site that “there is mounting evidence to show that the availability of financial services for poor households—microfinance—can help achieve the MDGs”11 (including universal primary education, child mortality, and maternal health, for example). The basic idea is that it puts economic power in the hands of women, and women care about these things more than men do.

  Unfortunately, contrary to CGAP’s claims, until very recently, there was in fact very little evidence either way on these questions. What CGAP called evidence turned out to be case studies, often produced by the MFIs themselves. For many supporters of microcredit, this appears to be enough. We met a prominent Silicon Valley venture capitalist and investor, and supporter of microcredit (he was an early backer of SKS), who told us that he needed no more evidence. He had seen enough “anecdotal data” to know the truth. But anecdotal data do not help with the skeptics out there, including large sections of governments everywhere that worry that microcredit might be the “new usury.” In October 2010, just two months after SKS’s successful IPO, the Andhra Pradesh government blamed SKS for the suicide of fifty-seven farmers, who allegedly were put under unbearable pressure by the loan officers’ coercive recovery practices. A few loan officers from SKS and Spandana were arrested, and the government passed a law making the weekly collection of loans difficult—among other things, by requiring repayment to take place in the presence of an elected official—thereby sending the clear signal that borrowers did not need to repay. By early December, all credit officers of the major MFI (SKS, Spanda, Share) were still sitting idle and losses were mounting. The anecdotes, and the assurance by Vikram Akula, the CEO of SKS, that the fifty-seven farmers who committed suicide were not in default so they could not possibly have been driven to death by SKS loan officers, did little to help them out.

  One reason the MFIs were lacking a powerful argument in their defense is that they had been reluctant to gather rigorous evidence to prove their impact. When we approached MFIs (starting around 2002) to propose to work together on an evaluation, their usual reaction was, “Why do we need to be evaluated any more than an apple seller does?” By which they meant that as long as the clients came back for more, microcredit had to be beneficial to them. And because MFIs are financially sustainable, and do not depend on the generosity of donors, evaluating exactly how beneficial they are is unnecessary. This is a bit disingenuous. Most MFIs are subsidized by the generosity of donors and the enthusiastic efforts of their staff, largely based on the belief that microcredit is better than other ways to help the poor. Sometimes they are also subsidized by policy. In India, microfinance qualifies as a “priority sector,” which gives banks powerful financial incentives to lend to them at concessional rates, which is a massive implicit subsidy.

  Furthermore, it is not obvious that people are entirely rational when they make long-term decisions like taking out a loan—the U.S. press is full of stories about people who got themselves into trouble by overusing their credit cards. Perhaps people do need protection from lenders, as many regulators seem to believe. The government’s position in Andhra Pradesh was precisely that the borrowers did not know what they were getting into when they took loans that they could not repay.

  Partly as a result of such criticism, and partly because many leaders of MFIs genuinely want to know whether they are helping the poor, several MFIs have started evaluating their own programs. We were involved in one such evaluation, Spandana’s program in Hyderabad. Spandana is believed to be one of the most profitable organizations in the industry and has been one of the main targets of government activism in Andhra Pradesh. Padmaja Reddy, Spandana’s founder and CEO, is a small, vibrant, and ferociously intelligent woman. She was born into a prosperous farming family from the Guntur area. Her brother was the first person in the village to complete high school, and he went on to become a very successful doctor. He persuaded his parents to let Padmaja go to college and then to do an MBA. She wanted to help the poor, so she started working with an NGO. This was when she met the ragpicker we described earlier, who prompted her to start a microcredit operation. When the NGO she worked for refused, she opened Spandana. Despite her success and her commitment to microfinance, Padmaja Reddy describes the potential benefits modestly. For her, access to microfinance is important because it gives the poor a way to map out the future in a way that was not possible for them before, and this is the first step toward a better life. Whether they are buying machines, utensils, or a television for their home, the important difference is that they are working toward a vision of a life that they want, by saving and scrounging and working extra hard when needed, rather than simply drifting along.

  It was perhaps because she had always been careful not to overpromise that she agreed to work with us on an evaluation of the Spandana program. The evaluation took advantage of Spandana’s expansion into some areas of the city of Hyderabad.12 Out of 104 neighborhoods, fifty-two were chosen at random for Spandana to enter. The rest were left as a comparison group.

  When we compared the households in these two sets of neighborhoods, some fifteen to eighteen months after Spandana started lending, there was clear evidence that microfinance was working. People in the Spandana neighborhoods were more likely to have started a business and more likely to have purchased large durable goods, such as bicycles, refrigerators, or televisions. Households that did not start a new business were consuming more in these neighborhoods, but those who had started a new business were actually consuming less, tightening their belts to make the most of the new opportunity. There was no clear evidence of the reckless spending that some observers feared would happen. In fact, we saw exactly the opposite; households started spending less money on what they themselves saw as small “wasteful” expenditures such as tea and snacks, perhaps a sign that, as Padmaja has predicted, they now had a better sense of where they were heading.

  On the other hand, there was no sign of a radical transformation. We found no evidence that women were feeling more empowered, at least along measurable dimensions. They were not, for example, exercising greater control over how the household spent its money. Nor did we see any differences in spending on education or health, or in the probability that kids would be enrolled in private schools. And even when there was detectable impact, such as in the case of new businesses, the effect was not dramatic. The fraction of families that started a new business over the fifteen-month period went up from about 5 percent to just over 7 percent—not nothing, but hardly a revolution.

  As economists, we were quite pleased with these results: The main objective of microfinance seemed to have been achieved. It was not miraculous, but it was working. There needed to be more studies to make sure that this was not some fluke, and it would be important to see how things panned out in the long run, but so far, so good. In our minds, microcredit has earned its rightful place as one of the key instruments in the fight against poverty.

  Interestingly, this is not how the main results played out in the media and the blogosphere. The results were mainly quoted for the negative findings and as proof that microfinance was not what it was made out to be. And though some MFIs accepted the results for what they were (chief among them, Padmaja Reddy, who said this was exactly what she had expected, and financed a second wave of the work to study the longer-term impacts), the big international players in microfinance decided to go on the offensive.

  The representatives of the “big six” (Unitus, ACCION International, Foundation for International Community Assistance [FINCA], Grameen Foundation, Opportunity International, and Women’s World Banking), the largest MFIs worldwide, held a meeting in Washington, DC, shortly after ou
r study was made public. They invited us to participate, and our colleague Iqbal Dhaliwal went, thinking that there would be some conversation on what the results meant. Instead, it turned out that all the big six wanted was to know when the results from other randomized impact studies were expected, so they could put together a SWAT team that would be in a position to respond (they were apparently convinced all the studies would be negative). A few weeks later, the SWAT team produced its first attempt at damage control. The MFIs responded to the evidence from the two studies (ours, and another by Dean Karlan and Jonathan Zinman, with even more lukewarm results)13 with six anecdotes on successful borrowers. This was followed by an op-ed in the Seattle Times by Brigit Helms, CEO of Unitus, that simply declared, “These studies are giving the inaccurate impression that increasing access to basic financial services has no real benefit.”14 It was somewhat surprising to read, since our evidence shows, quite to the contrary, that microfinance is a useful financial product. But that apparently is not enough. Trapped by decades of overpromising, many of the leading players in the microfinance world have apparently decided they would rather rely on the power of denial than take stock, regroup, and admit that microfinance is only one of the possible arrows in the fight against poverty.

  Fortunately, this is not the way the rest of the industry seems to be going. At a conference in New York City in fall 2010, where similar results were presented, all the attendees agreed that microcredit as we know it has its strengths and its limits, and that the next order of business was to see what microfinance organizations could do to deliver more to their clients.

  THE LIMITS OF MICROCREDIT

  Why didn’t microcredit deliver more than it did? Why didn’t more families start new businesses, given that they now had access to capital at affordable rates? In part, the answer is that many poor people are not willing, or able, to start a business, even when they can borrow (why this is the case is one of the central themes of Chapter 9, on entrepreneurship). What is much more puzzling is that even though three or more MFIs were offering credit in the slums of Hyderabad, only about one-fourth of the families borrowed from them, whereas more than one-half borrowed from moneylenders at much higher rates and that fraction was more or less unaffected by the introduction of microcredit. We don’t claim to be able to explain in full why microcredit is not more popular, but it probably has something to do with precisely what makes it able to lend relatively cheaply and effectively—namely, its rigid rules and the time costs it imposes on its clients.

  The rigidity and specificity of the standard microcredit model mean, for one thing, that since group members are responsible for each other, women who don’t enjoy poking into other people’s business don’t want to join. Group members may be reluctant to include those they don’t know well in their groups, which must discriminate against newcomers. Joint liability works against those who want to take risks: As a group member you always want all other group members to play it as safe as possible.

  Weekly repayments starting a week after the loan is disbursed are also not ideal for people who need money urgently but aren’t exactly sure when they will be able to start repaying. MFIs do recognize this and sometimes make exceptions for emergency health-care expenses, but that is just one of the many possible reasons one might need an emergency loan. What happens, for example, when your son is suddenly offered a chance to take a course that would really help with his career, but the course fee is 1 million rupiah ($179 USD PPP), to be paid by next Sunday? Presumably, you borrow from the local moneylender, pay up, and then start looking for an extra job that will allow you to pay for the loan. Microcredit would not offer you this flexibility.

  The same requirement must also discourage taking on projects that only pay off after some time, since there needs to be enough cash flow every week to make the scheduled payments. Rohini Pande and Erica Field persuaded an Indian MFI, the Kolkata-based Village Welfare Society, to allow a randomly chosen set of clients to start their prescribed repayments two months after they got the loan, instead of one week. When they compared the clients who got to repay later to those who stayed on the standard repayment schedule, they found that the former were more likely to start riskier and larger businesses, for example, buying a sewing machine instead of just buying some saris to resell.15 This presumably means that, down the line, they would be able to make more money. However, despite a clear increase in client satisfaction, the MFI decided to go back to its traditional model because the default rates in the new groups, though still very low, were 8 percentage points higher than under the original plan.

  One way to summarize all these results is to observe that, in many ways, the focus on “zero default” that characterizes most MFIs is too stringent for many potential borrowers. In particular, there is a clear tension between the spirit of microcredit and true entrepreneurship, which is usually associated with taking risks and, no doubt, occasionally failing. It has been argued, for example, that the American model, where bankruptcy is (or at least was) relatively easy and does not carry much of a stigma (in contrast with the European model, in particular), has a lot to do with the vitality of its entrepreneurial culture. By contrast, the MFI rules are set up not to tolerate any failure.

  Are MFIs right to insist on zero default? Could they do better, both socially and commercially, by setting up rules that leave scope for some default? Most leaders of the MFI community firmly believe that this is not the case, and that relaxing their guard on defaults could have disastrous consequences. And they may well be exactly right. After all, they are still operating in environments where they have very little recourse if a client decides not to reimburse them, which means that exactly like the banks, they would have to rely on the slow and creaky court system. In many ways, their success comes from making repayment an implicit social compact, in which the community ensures that loans will be repaid and the MFI continues to provide further loans. This gradual building of trust may be one reason many MFIs have gradually moved away from the formal requirement of joint liability. And indeed, a study found no difference in repayment whether clients are formally under joint liability contracts or not, as long as they continue to meet regularly (when they don’t meet weekly, but instead monthly, another study found that social connections within the group do not build up as fast, and eventually default rates do creep up).16

  But a social equilibrium based on the combination of collective responsibility and an ongoing relationship is necessarily somewhat fragile. If the two reasons I repay are that everyone is repaying and that I will get a new loan in the future, then whether I repay or not gets tied to what I believe about what everyone else is doing and the future of the organization. Indeed, if I were convinced that everyone else was about to default, I would assume that the organization was about to go under and would therefore give up on getting any further funds from it. As a result, the situation can quickly unravel when there is a shift in beliefs.

  This is what happened to Spandana in the Krishna District of Andhra Pradesh, the epicenter of India’s microfinance movement. Some bureaucrats and politicians in the district were keen to promote their own brand of microfinance and decided that they needed to get rid of the competition. Suddenly, sometime in 2005, the local-language newspapers (or by some accounts, fake newspapers made to look like the real thing) filled with stories about Padmaja Reddy. In some, she was reported to have fled to America; in others, to have killed her husband. The implication was that Spandana had no future and hence there was no point in repaying a loan the company might have given. We saw one “newspaper” page claiming that Padmaja herself had suggested that they default, since she had made enough money and was quitting.

  It was a masterful effort to shift beliefs in exactly the way that could totally undermine the organization: Convincing people that an MFI has no future is the easiest way to make sure that it in fact does not have one—since it becomes in everyone’s best interest to default. Padmaja was distraught (though she laughed at the idea th
at she would flee to America to avoid facing her obligations—after all, it was the borrowers who had her money, not the other way around), but she was determined to fight. She drove across the state, appearing at meetings in every little town and large village, saying, “I am still here, I am not going anywhere.”

  This particular crisis was thus averted. But a few months later, in March 2006, a new “scandal” broke out which exposed a different dimension of fragility. This time, Spandana and Share, one of its competitors, were accused of being the reason a number of farmers had committed suicide. According to a new series of articles in the press, loan officers had pushed the clients to overborrow, then put unfair pressure on them to repay. The MFIs obviously denied the charges, but before anything could be resolved, the district commissioner of Krishna (the administrative head of the district) decreed that repaying one’s loan to Spandana or Share was . . . illegal. Within days, almost all the clients in Krishna had stopped repaying. At the time of the crisis, Spandana had approximately 590 million rupees ($34.5 million USD PPP) of principal outstanding in the Krishna District, which represented 15 percent of Spandana’s gross loan portfolio across India in 2006.