Question 2 In 2006, Muhammad Yunus and Grameen Bank received the Nobel Peace Prize for their work in Microfinance. Muhammad Yunus was cited for developing “micro-credit into an even more important instrument in the struggle against poverty”. What is micro-credit? Why do poorer people need micro-credit? Discuss how the availability of credit might be able to help someone move out of poverty. Make sure to discuss empirical evidence as well.
Having ‘about one billion people globally live in households with per capita incomes of under one dollar per day’, with ‘policymakers and practitioners who have been trying to improve the live of that billion facing an uphill battle.
’(Murdoch,1999,p. 1569); microfinance, and in particular micro-credit, has been key in the gradual alleviation of world poverty. This has been most apparent in the developing part of the world in countries such as Bangladesh (where Muhammed Yusuf founded the Grameen Bank), Bolivia, Indonesia and Pakistan.
Before going into detail about the role of micro-credit and how its availability might help move someone from poverty, it is important to establish the definition of microfinance, and more crucially, micro-credit.
Microfinance is a term that is used to describe financial services catering to poor and low-income clients, and is offered by different types of service providers (known as microfinance institutions) offering those less well-off, loans and other financial services such as savings, remittances, insurance and credit in order to better their financial well being and standard of life.
The added bonus would be the fact that these institutions take little or no collateral when handing out credit. The availability of microfinance has shattered stereotypes of the poor as not bankable…[and shown] that it is possible to provide cost-effective financial services to the poor”(Islam,2007,p. 2). When looking at what characterises micro-credit, you can identify the point that it comprises of very small loans being provided to unsalaried borrowers, with little or no collateral, with these loans being handed out by legally registered institutions. This is done in the hope that economic nd social structures can be fundamentally transformed and that poverty can be alleviated(Murdoch,1999). The loans are created exclusively to serve “clients that have been excluded from the formal banking sector”(Murdoch,1999,p. 1569). Women who are less well-off in particular, have hugely enjoyed from the availability of micro-credit, being able to take out these small loans to initiate some form of self-employment. “Between December 1997 and December 2005 the number of microfinance institutions rose from 618 to 3133. The number of people who received credit from these institutions increased from 13. million to 113. 3 million (85% of this increase resulting from women taking out loans), during the same period(Hermes and Lensink,2007,p. 1). Logically, the next issue to be discussed, after having established a definition for micro-credit, would be why do poorer people require the existence of micro-credit? Many people would argue that all people should be able to get loans from respective lenders and banks. Unfortunately, and especially in the third world, these financial institutions tend to charge interest rates that allow loans to surpass the financial restrictions of the poorer people’s incomes.
This then, acts as a deterrent in taking out a loan for the less well-off, and hence results in no improvement for their financial well being; and on a national as well as international scale, no real reduction in poverty. “Almost all of the borrowers do so to finance self-employment activities, and many start by taking loans as small as $75, repaid over several months or a year”(Murdoch,1999,p. 1569). With only a very small number of programmes that require borrowers putting up collateral, micro-credit accommodates for would-be entrepreneurs that have few assets to escape positions as poorly paid wage labourers or farmers(Murdoch,1999).
Another reason why the less well-off need micro-credit relates to the idea of poorer people abandoning a culture which dependency on aid distribution from international organisations forms their standard of living and quality of life. When you look at the impacts of offering aid to less developed countries, you notice that for the huge amount of aid that the poorer parts of the world receive, a disproportion reflection is shown in the level of poverty that exists. This is down to various external factors such as the orruption that occurs in certain national government of the developing world, which tend to keep a considerable amount of monetary and capital aid given to them by international organisations. In addition to this, there is also the fact that aid doesn’t seem to get distributed (or re-distributed) evenly across poor countries. Probably the mist significant factor would be the exponential rise in the populations of developing countries, causing aid provisions to be less and less adequate.
This can be seen in the diagram below. Figure 1: Exponential rise in population within developing regions Source: http://saferenvironment. wordpress. com/2008/08/19/explosive-population-growth-affects-world-food-supplies-and-environment/ The introduction of micro-credit has allowed for a sustainable culture to develop, whereby poorer people can get loans to start-up their own businesses and provide for themselves instead of depending on hand-outs from the government and foreign institutions.
Poorer people generally remain in poverty if their main dependence of living is the aid given to them. Significantly greater amounts of less well-off people escape poverty when they have access to micro-credit. Another reason why micro-credit provides significant assistance to the poor relates to the fact that poverty often results in irregular and undependable income. Therefore; access to these small loans helps those less well-off in evening out cash flows, while dodging period where access to food, clothing, shelter, or education is lost.
The availability of credit can make it easier to control shocks such as sickness of someone who earns a wage, the occurrence of natural disasters, and even theft. The poor also utilise micro-credit to build assets like land for instance, which provides the poor with some form of security in the long run. A more economically focused approach that can be taken to also explain the need for the poor to access micro-credit, would be to highlight the socio economic issues of moral hazard and adverse selection; both of which prevent the poor from getting financial support from banks and lenders. Moral hazard arises when the action undertaken by the agent is unobservable and has a differential value to the agent as compared to the principal(Darrough and Stoughton, 1986, p. 501). ’ When there are two or more parties involved in a scenario, and one of these parties has private information; it can create two possible issues. The first is a ‘hidden action’(Arrow,1984) known as a moral hazard, whereby an alteration in behaviour can take place due to the fact that imperfect knowledge exists, meaning that they are insured against certain outcomes.
Let’s say that a bank or lender has given a poor client a loan. Seeing as the poor person has no available assets that can be offered as collateral, derived from the problem of limited liability, this individual faces very low costs in terms of the risky action undertaken by receiving a loan. The borrower “benefits from the project if it goes well, but is cushioned on the downside”(Ray,1998,p. 533). Such a situation is a nightmare for banks and lenders alike, and therefore formal financial institutions will avoid it by not lending to the poor.
The fact that wealthy people have collateral to offer ensures that no ‘reckless’ behaviour is adopted by the borrower, as failure to repay the loan will result in the collection of the agreed collateral. Adverse selection, known as ‘hidden information’(Arrow,1984), is where a party would engage in some sort of action, knowing that they would be better off if they chose not to go forward with it. Another interpretation would be that, “Adverse selection problems arise when the agent has more information than the principal”(Darrough and Stoughton,1986,p. 501).
In this case, the banks or lenders cannot distinguish between the ‘safe’ and the ‘risky’ borrowers. The poor tend to lack in a financial profile by which a risk assessment can be undertaken by lenders and hence make it difficult for them to decide whether it is feasible to offer a loan to the poor. If a poor client does not have a regular fixed income, or has never taken out a loan, it is impossible to then to adjudicate whether giving a loan to them is a ‘safe’ option. Formal lenders solve this issue by allocating loans to those who have assets that can be used as collateral within the agreement.
By doing this, only ‘reliable’ borrowers will go for loans, because once again they understand the implications of adopting a risky behaviour towards the loan repayment. The limited liability concept can be numerically illustrated using an example that Debraj Ray (1998,p. 532) used to convey a scenario in which a poor borrower has an option of two project in which they can invest in. However, the lender cannot identify which project is selected, and as the borrower has no wealth to repay the loan, they will eventually default on the loan repayment if his chosen project fails (this outcome represents their limited liability).
This example sees a borrower requiring a loan of 100,00 pesos to finish either project. The interest rate on borrowing this amount is 10%. If the borrower invests in the 1st Project (P1), they could see a return of 120,000 pesos with a likelihood of 100%. Investing in the 2nd Project (P2), could result in either a return of 230,000 pesos or 0 pesos; both with a 50% chance of occurring. This gives an expected return of 120,000 pesos for Project 1 (1*120,000), and 115,000 pesos for Project 2 (0. 5*230,000 + 0. 5*0). If the borrower chooses Project 1, the lender can expect a return of 10,000 pesos (110,000? 00,000) and minus 45,000 pesos (0. 5*[110,000? 100,000] + 0. 5*[0? 100,000]) for Project 2. The lender here would obviously only want to provide a loan for the 1st Project, because the return of that project would pay off both the loan and interest charges. On the other hand, the borrower’s decision is determined from a different perspective. Under Project 1, the borrower is guaranteed 120,000 pesos and therefore will earn 10,00 pesos once the loan, including the interest, has been paid to the lender. The 2nd Project will result in either 230000 pesos or nothing at all.
Therefore Project 2 is the most desirable option for the borrower, because they expect a return of 60,000 pesos (0. 5*[230,000? 110,000] + 0. 5*0), exceeding the loan and interest charges. Due to the difficulty of observation for the lender, they will presume that the borrower will opt for the second project; and therefore the lender will refuse to offer the Loan. The only way of resolving this issue would be if the lender could be reassured that the borrower will use the loan to complete Project 1. The final part of this essay will be discussing how the availability of credit might be able to help someone move out of poverty.
It has been witnessed that the formal credit and lending market does not provide the much needed service to the poor. Therefore, micro-credit attempts to counter these disadvantages and provide a gateway through which those in poverty can be entrepreneurs. The first way in which micro-credit availability may assist an individual from escaping poverty relates to the purpose of a poor individual seeking micro-credit. Someone in poverty usually uses the loan to purchase working capital for a business (such as wood for carpentry), or to purchase fixed assets. Fixed assets are those with a typical life span of greater than a year that are used over time in a business, such as machinery, property and equipment”(Ledgerwood,2000,p. 136). This use of micro-credit directly allows someone to improve productivity, and hence profitability. Such entrepreneurial activities result in a positive movement away from poverty for those less well-off. Another way in which micro-credit might be able to move someone out of poverty, focuses on the single female poor individuals who take this credit.
By using the money to start up a business, the demand to have children and start a family tends to fall by a significant amount, as there is no time to have a family, poor women who take micro-credit have the opportunity to increase their wealth first, before focusing on settling down; the opposite of what tends to happen in the developing world, as women generally have children at a relatively early age with an insufficient household income to support the family; and this consequently fixes the family in a state of poverty.
There are arguments from scholars that would counter the belief that microfinance, and in this instance micro-credit, has the sole ability to move someone from a state of poverty. Khandker (2005) argues that the Grameen Bank is situated in the worst poverty-stricken areas, so by making a comparison with both poverty programme areas and non-programme areas, could present a distortion that microfinance increases poverty. Goldberg (2005) lso highlights the fact that microfinance programmes are different and emphasise on various factors, so a rise or fall in health, nutrition or education levels cannot be solely credited to the existence of micro-credit and microfinance. To conclude, it can be understood that the introduction of micro-credit has been a financial revelation to those in poverty, and an alternative way to borrow money to start- up a business that most banks and financial lenders refuse to allow.
Micro-credit has encouraged the emancipation of women in the developing world and provided the chance for a more sustainable way of living for the poor, when compared to the usual aid provision lifestyle. It is not the perfect way of alleviating poverty, and there are some problems associated with this method such as the control subsidised NGO’s have in microfinance. With further improvements however, microfinance as a whole could potentially be the perfect solution for all in poverty to escape. BIBLIOGRAPHY Arrow, K. J. The Economics of Agency. Ft. Belvoir: Defense Technical Information Center, 1984.
Print. Darrough, Masako N. , and Neal M. Stoughton. “Moral Hazard and Adverse Selection: The Question of Financial Structure. ” Journal of Financial Structure 41. 2 (1986): 501-13. Print. Das Sharma, Partha. Keeping World Environment Safer and Greener. Digital image. Partha Das Sharma’s Weblog on Keeping World Environment Safer and Greener. WordPress. com, 19 Aug. 2008. Web. 15 Jan. 2013. Goldberg, N. (2005). Measuring the Impact of Microfinance: Taking Stock of What We Know. Grameen Foundation USA Publication Series, 1? 56. Hermes, Niels, and Robert Lensink. “The Empirics of Microfinance: What Do We Know? The Economic Journal 117. 517 (2007): F1-F10. Print. Islam, Tazul. Microcredit and Poverty Alleviation. Aldershot, Hants, England: Ashgate, 2007. Print. Khandker, S. R. (2005, September). Microfinance and Poverty: Evidence Using Panel Data From Bangladesh. The World Bank Economic Review , 1? 24. Ledgerwood, J. (2000). Microfinance Handbook: An Institutional and Financial Perspective. Washington D. C. : World Bank. Morduch, J. (1999). The Microfinance Promise. Journal of Economic Literature , 37 (4), 1569? 1614. Ray, Debraj. Development Economics. Princeton, NJ: Princeton UP, 1998. Print.
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