What is microcredit and the idea behind it?

Microcredit helps poor households by fostering

entrepreneurship or allowing them greater freedom in their consumption choices, or it could
potentially harm them by creating credit bubbles or over-lending?

What is microcredit and the idea behind it?

Microcredit is an extremely small loan given to those who lack a steady source of income,
collateral, or any credit history. It aims to support and kickstart entrepreneurs who are unable
to obtain the financial backing needed to start a small business or capitalize on an idea.
It is also more common in underdeveloped countries, as it is aimed to support people of a
lower socioeconomic background. Individuals who receive a microcredit loan may be
illiterate; thus, they are unable to apply for conventional loans due to the paperwork involved.
Microcredit is also part of microfinance, a line of finance that aims to help people of a lower
socioeconomic background through catered financial services, which include savings
accounts and loans.
Microcredit helps poor households by fostering entrepreneurship
or allowing them greater freedom in their consumption choices, or
it could potentially harm them by creating credit bubbles or over-
lending?
Microcredit helps poor households by fostering entrepreneurship or allowing
them greater freedom in their consumption choices
So how does microcredit benefit individuals if not by increasing their average income? Credit
frequently plays a key role in borrowers' lives, according to research that closely examines
the financial lives of persons who make $2 or less per day, such as the work of scholars
Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda Ruthven in Portfolios of the
Poor.
In reality, microcredit institutions are by no means the only sources of credit; for instance,
many people obtain small loans from friends, relatives, or local shopkeepers.
But what makes microcredit so beneficial is its dependability: Borrowers can count on
receiving a loan at a specific time and then make the tiny, regular repayments necessary to
qualify for more loans.
As Jonathan Morduch writes:
Incomes are seldom steady and predictable; needs vary as well: families need to pay for
schools, medicines, and food during slow periods…Evidence that microfinance loans are
used to fund non-business needs (even if for education or health) is sometimes used to
criticize microfinance, but that misses the point....poor families, like richer families, need
broad financial tools. In fact, the poor may need them more urgently.
The expansion of loan availability may have further advantages as well. In Due Diligence,
Roodman also makes reference to Nobel Prize-winning economist Amartya Sen's
perspective on the importance of greater freedom, namely greater agency in one's life.
According to Roodman, microcredit can improve this form of independence by giving the
poor a wider range of options for managing their finances.
Roodman emphasizes that the details matter — some ways of offering microcredit might
offer more freedom than others. For example, he writes that group microcredit “emerges in a
surprisingly negative light” when looking at financial diaries. Groups that are “responsible for
each other’s loans can generate ‘peer support’ in times of difficulty — or peer pressure to
pay no matter what.”
A research conducted in the Philippines by economists Xavier Giné and Dean Karlan
provides some evidence that group liability may not be required to obtain high repayment
rates. Some organizations still hold group sessions but have over time switched to individual
loans.
Finally, there is data that points to a possible wider good function for microcredit. For
instance, economists Emily Breza and Cynthia Kinnan investigated the effects of the 2010
closure of microcredit organizations in Andhra Pradesh, India. They discovered that a
noticeable drop in salaries in rural areas followed this. This outcome "shows that
microfinance, despite its tiny loan levels, can have considerable impacts on rural
economies," the authors write. Additionally, it implies that the complete picture of microcredit
isn’t captured in studies that only look at individual borrowers.
In conclusion, even though microcredit is not transformative, it does appear to be highly
significant in the lives of the poor. Microcredit might be a very cost-effective technique to
assist people because of how little it costs. Some people might not find the new vision of
microcredit as appealing as the old one because it focuses on assisting the underprivileged
in better coping with their financial difficulties. However, the new story inspires the
researchers who produced Portfolios of the Poor and extensively examined the lives of
people making $2 per day: Whether the microfinance movement was correct to emphasize
loans for microenterprises or was too sluggish to accept savings and other services, its
greatest contribution is, to us, beyond dispute It is a significant step toward improving the
financial security of low-income households.”
Could it potentially harm them by creating credit bubbles or over-lending?
Microcredit has a lengthy history of reliable repayment; there haven't been many cases of
delinquency or default. But more lately, there have been issues with collection in several
important markets. According to Chen, Rasmussen, and Reille (2010)'s analysis of four
nations, overdue loans, which made up an average of 2% of portfolio in 2004, plunged to
2009 levels of 7% in Bosnia-Herzegovina, 10% in Morocco, 12% in Nicaragua, and 13% in
Pakistan. In some of these nations, subsequent levels have significantly increased. More
recently, collection has collapsed in the Indian state of Andhra Pradesh.
Default and delinquency pose a threat to the continued existence of microlending
institutions. However, this essay primarily examines repayment issues from the viewpoint of
the clients rather than the lenders. We investigate many definitions of "over-indebtedness,"
but for the purposes of this discussion, let's use the following basic, preliminary definition:
Borrowers are over-indebted if they have significant difficulties repaying their loans.
According to this concept, debtors might be over-indebted even if they are making loan
payments.
Over-indebtedness frequently suggests heightened vulnerability and increasing
impoverishment of debtors. Reduced consumption, late fees, asset seizures, spirals of ever-
increasing debt, and eventually a loss of creditworthiness are examples of tangible
repercussions.
So does microcredit really help poor people?
By Richard Rosenberg
Since microcredit first came to public attention in the 1980′s, the usual story line has been
that it funds creation and expansion of microenterprises, producing additional income that
lifts the borrowers’ households out of poverty. But is it true?
It has been clear for some years now that many–sometimes most–microborrowers in fact
use their loan proceeds for non-business purposes. Recent analysis has cast doubt on some
of the older research studies that found that microcredit increases household income. A new
generation of more rigorous randomized studies is now in the works. The first two of them to
be published have not found evidence that microcredit raised household income and
consumption, at least over the 1-1.5 year term of the studies. Does this mean that
microcredit might have been a bad idea all these years? I’ve just drafted a brief paper on this
question. The paper should be available in a month or two, but in the meantime let me trot
out its core arguments.
I think an honest appraisal of the current state of the evidence is that we simply do not know
whether microcredit raises incomes and consumption. If the case for microfinance depended
on whether it was lifting people out of poverty, then the appropriate response right now
would probably be to declare a moratorium on support for microfinance until further research
clarifies this question more.
I’ve worked in microfinance for over a quarter of a century, and I’ve always been agnostic
about whether microcredit raises incomes. But I’m pretty sure that it does some other things
that are very important to poor people, helping them to cope with poverty whether or not it
helps them escape poverty. These other benefits are described compellingly in the brilliant
new book Portfolios of the Poor by Daryl Collins et al., which gives a high-resolution picture
of how low-income households actually use financial services, based on hundreds of 18-
month-long financial diaries in three countries. Portfolios points out that the problem with
being poor is not just that income is low, but also that it tends to be uneven and vulnerable to
disruption. Given the variability and vulnerability of their income, poor households have to
save and borrow constantly (more so than richer households) in order to put food on the
table and meet other consumption needs. The informal credit and savings mechanisms they
have tend to be unreliable. They value formal microfinance highly because it is more reliable,
even if it is often less flexible than their other tools to manage their cash flow.
When we hear that microcredit may not lift people out of poverty, we tend to be
disappointed, and regard consumption-smoothing as a “mere palliative.” But we react this
way only because our own basic consumption needs are seldom if ever threatened. As
Portfolios demonstrates, poor people see it very differently.
I think there is strong evidence that poor people find microcredit very valuable in helping to
deal with their circumstances. When you offer microcredit in a new setting, you almost never
have to advertise: customers come out of the woodwork in droves. Most of them come back
for additional loans. Most importantly, they usually repay those loans at extremely high rates
year after year, when the main motive to repay is not collateral or group pressure, but rather
their desire to keep future access to a service they find very helpful. They are voting with
their feet.
But does microcredit hurt a lot of poor people by over-indebting them? We need more work
on this question, but I think the general answer is very probably no. When a lender is over-
indebting a lot of borrowers in a bad situation, sooner or later it will show up high default
rates, just as it did in the current financial crisis. But the predominant pattern is that the vast
majority of microborrowers repay at very high levels year after year.
When all is said and done, a year of microcredit probably doesn’t help poor people as much
as a year of girls’ primary education (for instance). The value proposition of microcredit, and
microfinance more generally, is that each “dose” costs far less. Education, health, and many
other social services require large subsidies year after year. When microfinance is done
right–and only when it’s done right–small one-time initial subsidies can generate service
delivery to very large numbers of people year after year. Not only is no further subsidy
needed, but microfinance providers can leverage their initial subsidies with very large
multiples of commercial funds. This is not a pipe dream–it’s happening already in dozens,
even hundreds, of cases all over the world. For instance, BancoSol in Bolivia represents a
few million dollars of donor subsidies in the mid-1990s that have turned into $200 million of
loan portfolio and services for 300,000 active savers and borrowers as of the end of 2008.
Whether donors and other public funders now lose interest in microfinance is pretty much
irrelevant to such MFIs.
In Conclusion
From our research, this is the strong value proposition of microfinance. The benefits of each
dose may turn out to be more modest than some have claimed, but poor people really value
those doses, and you can buy an awful lot of them with relatively little subsidy. We certainly
need further research on the nature and extent of benefits of microfinance, but we think it’s a
very good bet that the observed behavior of millions of microborrowers is telling us that
those benefits more than justify the investment.