Private Sector Brief

September 2012
Microcredit:
A suitable instrument for poverty reduction?

Introduction
It is over 30 years now since microcredit started off, and over 20 years since
the movement caught on internationally, principally fuelled by the efforts of
Mohammad Yunus, who was later, in 2006, rewarded the Nobel Peace Prize
for his work.
1
The goal of the movement is to reduce poverty through the
access to and provision of microloans, which usually do not exceed a few
hundred dollars.
2
This brief will look at the existing evidence in how far this
goal is being achieved. It mainly does so by comparing the results of various
more recent reviews that systematically analyse the impact of microcredit
and draw preliminary conclusions.
The impact of microcredit on the different dimensions of poverty can be
divided into three categories. Microcredit can: 1) reduce poverty by
increasing people's disposable income (the income-generating effect of
microcredit); 2) alleviate poverty by helping people to smoothen
expenditure requirements so that they can better cope with their plight (the
vulnerability-reduction effect); and 3) generate non-financial benefits by
reducing social exclusion through, for example, improved education or
empowerment (the empowerment effect).
3

Measuring the impact of microcredit
The core value proposition is that microcredit enables poor people to make
profitable investmentsusually into micro-businesses, thus increasing their
income and consumption potential and lifting them out of poverty. In fact,
many do regard a
especially for the poorest of the poor.
But as Duvendack et al. (2011) show, based on a review of 58 studies, this
claim is not supported by the evidence: Almost all impact evaluations of
microfinance suffer from weak methodologies and inadequate data [...],
thus the reliability of impact estimates are [sic] adversely affected. This can
lead to misconceptions about the actual effects of a microfinance
programme, thereby diverting attention from the search for perhaps more
pro- 1 that no well-known study
would robustly show any strong impacts of microfinance.
4

This result should not surprise: after all, the impact of credit depends on
how it is spent. Do borrowers use it profitably? What is the time frame for
measuring changes in profitability?
5
Moreover: the precise use of funds
cannot easily be tracked because of their inherent fungibility.
6

PrivateSector
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IssueII,Sep.2012

StephanSchmitt-
Degenhardt,with
contributionsby
BenSlay,Nick
MaddockandJoern
Rieken
UNDP,2012
2



Accepting the inherent methodological flaws of most studies, it is nevertheless useful to look at the
existing research results related to the identified three categories.
Evidence of the impact of microcredit on poverty reduction
Chowdhury (2009), in a UN/DESA study referring to over 20 research papers, concludes that its
impact on poverty reduction remains in doubt. Stewart et al. (2010, p. 6), in a review of 15 studies of
S-Saharan Africa,
7
similarly conclude that microcredit has mixed impacts
in relation to incomes of poor people. Many other studies come to similar conclusions.
8

Of course reflects
studies that found positive as well as negative impact. So it is worth looking at some details. An
influential research by Hulme and Mosley in 1996 found that microcredit had little, none or even
negative impact on the poor and poorest, but positive impact on the slightly better off (in terms of
human or financial assets) and those who are already in business. Other studies, among others SIDA
(2004), confirm these results.
9
Banjeree et al. (2009, pp. 20f.), in a randomized study of 104 slums in
India for the Centre for Micro Finance, find that when provided with access to microcredit, existing
businesses, better-off households and also households with a high propensity to start a business
reduce consumption of non-
initial investment, and improve their well-being.
10

Why does microcredit not lift poor people above the poverty line? First, loans might be much less
frequently invested in income generating activities than it is assumed. Although donors and many
microfinance organizations claim that credit is predominantly provided to promising start-ups and
? C 8 few studies attempt to verify the claimed use
of the microloans. One research showed that borrowers usually and significantly underreport their
loan use for consumption purposes (stating it to be about one third to one half of the actual value).
11

The same research estimates that borrowers in fact spend 20 percent to 30 percent of their loans on
household expenses, health or education. But in a debate between Bateman and Roodman,
Bateman claimed that only 20 percent of the microloans are really invested in micro-businesses
the rest being invested in consumption a claim that Roodman did not contest.
12
No wonder, then,
that the impact of microcredit is lower on income generation than on more consumption-oriented
uses.
Second, credit alone does not turn a poor person into an entrepreneur: entrepreneurial motivation,
skills and opportunity are also required (see also PS Brief #1). In most countries, being a micro-
entrepreneur means the equivalent of not having a job. As so- necessity entrepreneurs
usually invest in low skill - low capital businesses such as retail, where price competition is intense
because of overcrowding. Hence, they often do not manage to improve their income situation
through these business activities.
Why do the poorest benefit less from microcredit than the better off? First and foremost, there
appears to be a bias in the selection of clients by microfinance institutions: many microfinance
institutions do exclude the poorest, as this might endanger their repayment rate, or because there is
a methodological bias in client selection. Instead, they focus on those clients that 1
above mentioned focus of donors confirms this.
13

Second, the poorest often exclude themselves from micro-borrowing, as they are too risk averse or
lack the confidence.
14

Third, while the better-off may have to struggle to generate additional income from their business
activities, the poorest will have even more problems.
15

3



Does microcredit create jobs? One could therefore conclude that microcredit has the potential to
help the better off to establish or expand businesses, thus creating jobs which again might help the
even less fortunate. For most microfinance institutions, employment creation is their declared
mission statement, and it is widely acknowledged that employment creation is a key link to poverty
reduction. Unfortunately, also here there is little conclusive evidence.
In a survey of 46 MFIs the ILO found that
which is inconsistent with their declared
mission statements (Balkenhol, 2006, p. 5). Studies devoted to the topic use very different

nature of most microcredit clients being household enterprises. Some studies focus only on salaried
employment while others include any family employment; some look only at the impact on the

the community. Mostly, a positive impact on employment is only found in those studies that use the
broader concept of employment. But once the substitution effect is accounted for it turns out that
households mostly re-compose their activities and concentrate more of their time on the income
generating activity for which the loan has been taken up.
16

The European Commission (2003, p. 37) finds that microcredit created between zero and one
additional job (besides the founder) in 10 European countries. But for the reviewed 15 Sub-Saharan
countries, Stewart et al (2010, p. 38) found little evidence that microcredit has any impact on job
creation. Given the higher formality of European businesses and business start-ups, both findings
appear to 8 2006, p. 8) that borrowers with larger business
operations at the point of first contact are more likely to increase employment. This again is in line
with other findings that businesses beyond a certain size are more likely to create jobs (see PS Brief
#1).
Evidence of the impact of microcredit on poverty alleviation
The idea of poverty alleviation through microcredit is that poor people experience high variations in
expenditure requirements. Microcreditswhich are still cheaper than funds obtained via local
money lenderscan help to smooth these variations and therefore spread expenditure patterns
more evenly.
17
All studies that focused on this type of impact found supportive evidence for it.
18

SIDA, however, warns
consumption-smoothing purposes raise [sic] additional concern about long-term improvement for

SluA , given the interest rates of microloans. The valid
question arises if microcredit (that is, micro-debt) is better suited for consumption smoothing than
micro-saving? As Harper (2011) and others point out, this is rather counter-intuitive: reductions in
consumption to service and amortize debt incurred at high interest rates always places a higher
burden on households than do reductions in consumption necessary to yield savings. Roodman and
Qureshi (2006, p. Mll
rather than savings appears to have arisen for practical business reasons rather than because it has
been shown that credit helps
Evidence of the impact of microcredit on non-financial benefits
Researched non-financial benefits of microcredit usually include housing, food, health, education
and especially women empowerment. Improvements in these areas can reduce the impact of
poverty, increase social inclusion, and as a consequence help to lift people out of poverty in the
longer term. Studies usually find no or some positive effect.
19

4



One notable exception is the recent review by Stewart et al (2010, p. 36) who found considerable
evidence that microcredit may result in reduced school attendance, and thus do even harm.
20
This
finding is in line with the mentioned effect of re-composition of employment within a household
i.e., families who receive microcredits are more likely to pull their children out of school.
Conditioning microcredit on the maintenance of school attendance, as some microcredit institutions
do, would help countering this effect.
Conclusion
The analyses of the impact of microcredit are in all aspects rather inconclusive. Still, a moderately
positive potential can be attributed in all but the core claim of microcredit: its poverty reduction
impact, especially for the poorest.
Researchers as well as microcredit advocates frequently agree (although to quite different extents)
that microcredit can only be one of the instruments used for poverty reduction. Poverty is multi-
facetted, so the instruments to reduce it need to be multi-facetted as well.
21
It is for example
obvious that the capacity of people to generate additional income to reduce poverty does not only
depend on finance, but on many other factors within and beyond their control. The creation of
income generating activities or micro-enterprises cannot be seen as a panacea. As Scully (2004)
emphasises: A -enterprise development is offered as a substitute for meaningful
social development [...] it will only impede progress towards finding real answers to the very real
S
Microfinance institutions are often encouraged to provide training and advice in addition to loans.
But the resulting potential for conflicts of interests when finance as well advice or training are
provided is often overlooked. A loan officer might be reluctant to admit that an advice provided was
wrong and attempt to cover this mistake up with more loans. Similarly, a debtor might be
encouraged to blame the loan officer if the advice provided did not have the desired success. As this
topic has been emerging in more recent discussions on microfinance, it might indicate that this
problem is slowly being recognised.
22

It is encouraging thatin recent yearsthe microfinance industry has woken up to the challenge of
while 500 to 800 million poor people have access to finance, only 110 to 130
million of these had ever received any sort of financial capability training (Monitor, 2012)which,
officially, is a precondition for the provision of credit in most countries. Once people are really
capable of assessing the financial implications of their borrowing, the demand for credit might sink.
23

But Bateman and Ha-!
24
Three
principal reasons are given by them and others for this. First, micro-enterprises are unable to
capture scale economies, and can crowd out other micro-enterprises and even small industrial
businesses, reducing a chance to become competitive.
25
This, however, is more a critique
of microenterprise development than of microfinance. Second, microcredit (like other forms of
credit) can lead to a vicious debt spiral, bringing borrowers into ever more desperate
circumstances.
26
Third, for a number of years there has been an oversupply of microfinance capital,
leading at times to aggressive competition for clients and the resulting underwriting of loans that
should not pass sound eligibility criteria.
27

Still, the potentially positive effects on poverty alleviation and non-financial benefits should not be
overlooked.
How should we approach microcredit now?
In short: very carefully! Even after 30 years and much investment, the evidence is inconclusive. But is
the evidence inconclusive because there is a problem with microcredit itself? Or is it inconclusive
5



because of inadequate evaluation methods? The resulting more moral question is: if an intervention
intended to reduce poverty and affecting the lives of so many people has a not insignificant
likelihood of continuing or even increasing poverty, should it be continued?
Since the apparent net effect of microcredits is neutral,
28
a more financial question arises: is
microcredit a cost-effective poverty alleviation or reduction strategy?
29
Microcredit advocates can
rightfully reply to these questions with a business argument: as long as there is a high and
unsatisfied demand for credit, credit should be supplied. Is this a sufficient answer for development
practitioners?
Stewart et al. (2010, pp. 6, 7 and 49) There is an obligation amongst donors and
policy-makers not to falsely raise expectations with development aid in this way. The apparent
failure of microfinance institutions and donors to engage with evidence of effectiveness perpetuates
the problems by building expectations and obscuring the potential for harm. A growing microfinance
industry may as easily be a cause for concern as one of hope. There is nothing to add.

ThisBriefanswerssomequestions,butopensupmanyothers.FutureBriefs willbedevotedto,for
example, the following topics: Business incubators; Cooperatives; Domestic migration; Economic
aspects of gender; Functionalareas; Cool storage and cooltransport; Household heating systems;
The local development trap; Market assessment; Networks and associations; Paying for business
developmentservices;Apositivelookonunderemploymentalong-termvision;Privatesectorand
human development. If you would like to contribute a brief for dissemination, please be in touch
withstephan.schmitt-degenhardt@undp.org
6





1
Please note that microcreditcollateralised and uncollateralisedhas existed since the advent of money and business, if not of
mankind. The microcredit movement just changed somewhat the form of delivery.
2
According to Mixmarket, the average loan balance per microcredit borrower is in by far highest in Eastern Europe and Central Asia
($1,934.5), followed by Latin America and the Caribbean ($1,037.0), Middle East and North Africa ($655.1), Africa ($477.9), East Asia and
the Pacific ($431.2) and South Asia ($156.8). Source: http://www.mixmarket.org/mfi, accessed September, 25, 2012.
3
Cf. also Balkenhol (2006, p. 3, FN4), Duvendack (2011, p. 13), Osthoff (n.D., pp. 8ff), World Bank (2000, pp. 74f), Majoux (2001), Steward
(2010, pp. 40 and 60).
4
See also de Aghion and Morduch (2005 and 2010), Goldberg (2005), Odell (2010), Orso (2011), all referred to in Duvendack et al (2011).
Also SIDA (2004, p. 26).
5
Zeller and Johannsen (2006, p. 32), e.g., observe in Bangladesh and Peru declining poverty rates with increasing length of client

6
As money is interchangeable (fungible), specific funds cannot reliably be linked to specific expenditures. It is therefore not possible to
associate specific funds with specific changes in well-being.
7
The 15 studies reviewed in-depth resulted from a rigorous screening process starting with 383 studies, and 35 analysed studies. 12 of the
15 are of newer date (since 2005).
8
See also Copestake (2002), Hermes and Lensink (2007), Khandker (2005), Roodman and Morduch (2009), Westover (2008), World Bank
(2007).
9
See also Copestake et al., (2001), Copestake et al., (2005) for Peru, Cuong (2008) for Viet Nam, Kondo et al. (2008, p. 68) for the
Philippines Morduch (1998), Scully (2004) and SIDA (2004, pp. 3, 26). The opposite resultthe very poor benefitting more than the poor or
better offhas been identified by Eda Rural Systems (2004), Khandker (2005) and Nichols (2004).
10
Cf. also Beck et al. (2009, pp. 14ff), Hartarska & Nadolnyak (2008), Imai & Annim (2010). For similar results see Chowdhury (2009, p. 9).
11
Karlan and Zinman (2011). See also Karlan (2011)
12
Bateman and Roodman (2012). See also Rosenberg (2009).
13
See also Galusek (2007, p. 6)
14
See Li (2011), Thornton (2008) and Simanowitz (2002).
15
See Chowdhury (2009, p. 2)
16
See Balkenhol (2006, pp. 7ff.)
17
See also World Development Report 2000/2001, p. 74, describing the two poverty impacts of microfinance, income-generating effect
gement.
18
Some evidence was found by Stewart (2010, pp. 6, 49); clear support by SIDA (2004, p. 3), Alemu (2006), and Chowdhury (2009)
19
Housing: Stewart et al. (2010, p. 6) found a positive impact. Food: Dean and Zinman (2009, p. 1) found no discernible effects, but Karlan
and Zinman (2007), Montgomery and Weiss (2011) and Stewart et al (2010, p. 6) all found positive impact, partially even among very poor
households. Health: Banerjee et al (2009) found no impact, but Montgomery and Weiss (2011) and Stewart et al (2010, p. 6) found
positive impact, in the former case especially on the health of children and even in very poor households. Interestingly, Karlan and Zinman
(2007) found a significant and negative impact on other aspects of mental health (depression and stress). Empowerment: Banerjee et al
(2009) again found no impact, but Stewart et al (2010, p. 6) found at least some evidence, though inconsistent, and Montgomery and
Weiss (2011) as well as Rajendran and Raja (2010) confirm effectiveness. Note that there are a number of pre-2005 surveys that found
negative impacts such as exploitation of women, increased income inequality, increased workloads, creation of dependencies and creating
barriers to sustainable local economic and social development (referred to in Steward, 2010, p. 14).
20
Note that there might be additional external effects of group lending. Marr (2004, p. 7), analysing group lending schemes in Peru, warns
y foundations of these schemes by disrupting the social fabric
A

poorest and most vulnerable (pp. 38f.). Bateman and Ha-Joon (2009) express similar warnings.
21
For example, Appah et al. (2012, p. 38), Chowdhury (2009, p. 3), Daley-Harris et al. (2007, p. 1), Yunus (2003, p. 171), Zaman (2004, p.
15)
22
See the more recent blogs and articles http://www.socialedge.org/blogs/kiva-chronicles/moral-hazard-with-ducks,
http://www.gdrc.org/icm/micro/counseling.html, mftransparency.org (2011a, 2011b).
23
For further information see CGAP (2009), Gonzalez et al. (no date) and MicroRate, Luminis (2011).
24
See also Feiner and Barker (2012).
25
See Bateman (2007, pp. 2f), Bateman and Ha-Joon (2009, pp. 7ff), and SIDA (2004, p. 26).
26
See for example Steward (2010, pp 44, 48). Also note the massive suicides by Indian farmers.
27
See MicroRate and Luminis (2011, pp. 4, 5), Bateman and Roodman (2012), Bateman et al., (2012).
28
See Duvendack (2011, p. 75), Roodman (http://www.microfinanceusaconference.org/blog/2012/01/30/david-roodman-and-milford-
bateman-debate-recap/ and https://irgltd.adobeconnect.com/_a984430303/p78xdnea97j?launcher=false&fcsContent=true&pb
Mode=normal)
29
For example, Mahajan (2005, p.5) sees the resources better invested in social sector programmes, Chowdhury (2009) in broad-based
productive employment creation, Karnani (2007, quoted in Stewart et al, 2010, p. 14) in large labour-intensive industries for job creation.

7



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