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Berkeley A,RESEC C253 - Microfinance - Where do we Stand

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1355Microfinance: Where do we Stand?Beatriz Armendáriz de Aghion and Jonathan Morduch1 IntroductionEconomies are built upon people buying and selling, lending andborrowing. The beauty of the market is that, when it works well, sellersare matched to buyers and lenders are matched to worthy borrowers.But when the market does not work well, goods go unsold and promis-ing investment projects go unfunded. We understand why markets fail –the economics of information provides rigorous underpinnings for whycredit markets, in particular, are so problematic.1The challenge has beento move from diagnosis to prescription. The challenge is particularlygreat in poorer regions, where individuals may have workable ideas andrelevant experience but lack collateral. Even a £100 loan can make a dif-ference to a small-scale shopkeeper or craftsperson in countries likeNepal or Uganda, but formal sector banks have steered clear, focusinginstead on larger loans to better-established, wealthier clients.The microfinance movement has aimed to change all that. The hopeis that by using innovative new contracts, microlenders can both makeprofits and serve the under-served. While the full promise is as yetunmet (profits remain hard to squeeze out and the very poor are toughto reach), there are a growing number of success stories and, world wide,nearly 70 million low-income individuals are served by microfinanceinstitutions (Daley-Harris 2003).In this chapter we first focus on the innovations that have made micro-finance possible. We then deliver an overview of recent trends. We arguethat the future of microfinance institutions is ultimately in the hands ofinternational donor agencies and local governments, which have beenrecently promoting competition and stressing financial self-sustainabilityas a way to maximize the breadth of outreach. The strategy is a majorGoodhart_05.qxd 23/4/04 3:42 PM Page 135136 Beatriz Armendáriz de Aghion and Jonathan Morduchdeparture from traditional approaches to foreign aid, and it challengesthe role of applied welfare economics as the leading framework for pol-icy analysis. In the traditional framework, cost–benefit analyses are usedto determine the allocations of subsidies that can do the greatest goodfor the greatest number. In the new world of microfinance, manyeschew subsidies for all but start-up expenses, and the aim is to becomefully profitable, independent institutions.In Section 1 we provide background to the current debate on the roleand scope of microfinance institutions. In particular, we deliver a briefexplanation of how the innovative “group lending” technique gaineddonors’ attention, and how it captured the imagination of academiceconomists. In Section 3 we argue that the dissemination of microfi-nance institutions was facilitated by additional innovations, and wefocus on four: the use of “progressive lending”, the flexible treatment ofcollateral, the focus on women as customers, and the promotion ofclients’ savings. In Section 4 we conclude by spelling out three mainareas where the support of international donors and local governmentscan most effectively help microfinance institutions meet both their self-sustainability and social objectives.2 BackgroundMicrofinance grew out of experiments in Latin America and South Asia,but the best-known start was in Bangladesh in 1976, following a wide-spread famine in 1974 and a hard-fought war of liberation in 1971. In the1970s Henry Kissinger famously called Bangladesh an “international bas-ketcase”, but 30 years later Kissinger’s prognosis proves to be quite wideof the mark. Bangladesh continues to face economic, political, and socialchallenges, but it is hardly a basketcase. Fertility rates have dropped froman average of seven births per woman in 1970 to half that today; theeconomy has slowly moved forward, despite the continuing need formacroeconomic and fiscal reforms; and the microfinance movement hastaken root across the nation, with over ten million customers spreadacross the country’s villages. Advocates argue that the microfinancemovement has helped to reduce poverty, improved schooling levels, andgenerated or expanded millions of small businesses (e.g. Khandker 1998).The idea of microfinance has now spread globally, with replications inAfrica, Latin America, Asia, and Eastern Europe, as well as in richereconomies like Norway, the United States, and England. The latest countincludes over 2500 institutions worldwide, each serving on average over25 000 low-income customers.Goodhart_05.qxd 23/4/04 3:42 PM Page 136Microfinance: Where do we Stand? 137No person is more closely associated with microfinance thanMuhammad Yunus, an economist who was teaching at ChittagongUniversity in the 1970s. In the midst of the famine, Yunus started look-ing for ways to improve the lives of the villagers living adjacent to hisuniversity. Together with his students, he seized on the credit market asthe most direct and effective vehicle for development. Yunus started bylending to villagers from his own pocket and found that not only was herepaid on time but that the villagers were demonstrably benefiting fromthe new opportunities that the loans opened up. Yunus could not self-finance an initiative that hoped to spread beyond the village, however,and the challenge was to devise a mechanism that could be quicklyreplicated and that ensured high repayments while containing costs.With the government’s blessing, the Grameen Bank was inaugurated in1976, based on the premise of lending to the very poor at reasonableinterest rates and without requiring collateral. In order to keep focusedon the poorest clients, the bank instituted a rule (eventually relaxed)that they would only lend to households owning under a half acre ofland, a rough indicator for being functionally landless.The essence of microfinance is to draw ideas from existing “informalsector” credit mechanisms – like intra-family loans, Rotating Savingsand Credit Associations (ROSCAs), and local moneylenders – while cre-ating a viable conduit for capital infusions from formal sector banks,donors, and governments.2The lack of formal financial institutions invillage economies has been long-acknowledged as a barrier to develop-ment, and millions of dollars in subsidy were channeled through state-run development banks beginning in the 1950s with the aim ofreaching the poor. The initiatives were poorly designed, however, andcredit was allocated


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Berkeley A,RESEC C253 - Microfinance - Where do we Stand

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