Microfinance has been hailed as a boon to the developing world. By extending small amounts of credit to would-be entrepreneurs, the model is said to raise incomes, reduce unemployment, and empower previously marginalized groups, notably women. First tested in Bangladeshi villages in the 1970s, microfinance was embraced by the development community in the 1990s and 2000s and has held a special status as a “transformative” idea. In 2006, Muhammad Yunus won a Nobel Prize for his microfinance work along with his organization Grameen Bank.
How well does it work, though? In the last decade, researchers have taken a closer look at that question and their conclusions aren’t as positive as they might be. It turns out that when you assess the idea scientifically–as a series of new studies do–the idea is not as world-changing as first appears. It has positive impacts, but not to the extent that some donors, policymakers and microfinance groups have claimed.
The seven new studies, which cover different countries and types of microcredit, each use the gold standard method of social science: a randomized trial. Rather than going into a village and comparing the outcomes of people who’ve taken credit and haven’t, the studies randomly assign credit to one group and not another. That’s important because it lets researchers discount other factors, like the possibility that people who take credit are more entrepreneurial to start with.
Five themes emerge from the research, both positive and negative:
In four countries–Ethiopia, India, Mexico, and Morocco–take-up ranged from 13% to 31%, which is lower than projected by lenders themselves. In many cases, people had no other options for finance and finance had never been offered before, and yet many people reject offers. “Taken together, these results suggest that microcredit may be valued as a useful financial tool by some, but not all, borrowers,” says an excellent summary of the studies from The Abdul Latif Jameel Poverty Action Lab (J-PAL) and Innovations for Poverty Action (IPA), two development groups.
In six of the seven programs, microfinance did exactly what it’s supposed to do–it allowed people to start businesses and start generating revenue. The catch was that higher sales didn’t necessarily mean higher profits. In Morocco, for example, livestock farmers increased revenues but only the largest businesses actually benefitted. In studies from Bosnia and Herzegovina, Ethiopia, India, and Mexico, there was “no overall effect on borrowers’ profits.” These small businesses may have hired more people or stocked more inventory, but if sales increased, they weren’t enough to offset added costs.
Without substantial profits, the families studied generally didn’t see improvements in household circumstances. “While microcredit helped some entrepreneurs invest, none of the seven studies found that it had a significant impact on income for the average borrower,” says the J-PAL/IPA summary. In the India and Morocco trials, consumption among microcredit households was no different from the control group. In Ethiopia, researchers found “microcredit offers may have actually resulted in increased food insecurity.” Microfinance is supposed to enable investments in shelter, education and health as a first step to better well-being, but the studies provided little evidence for the theory.
On a more positive note, there was evidence for greater financial freedom and flexibility. In six studies “microcredit [played] an important role in expanding the ways in which borrowers make employment decisions, consume, and invest,” the summary says. In Mexico, families with microcredit said they were less likely to sell something to make a payment for something else, as they would have done previously. Credit smoothed consumption. “These results suggest that although microcredit may not be transformative in lifting people out of poverty, it can afford people more freedom in their choices.. and the possibility of being more self-reliant,” the summary says.
The empowerment of women is a key goal for microfinance and a central pillar of its success story. However, the research finds little evidence of empowerment or for knock-on benefits, like more money going to schooling. In India and Morocco, there was little impact on schooling rates. In Bosnia and Herzegovina, those households taking credit were actually 9% less likely to send kids to school. Three of four studies that looked at empowerment questions found “no effect on female decision-making power or independence.”
The papers, which cover 37,000 individuals in total, are published in full in the American Economic Journal: Applied Economics. The tone isn’t all negative. While J-PAL and IPA say donors should be wary about handing out large sums of money to microfinance programs, they certainly don’t discount the idea. Far from it. They just think the programs could use some tweaking. Ideas could include longer grace periods before repayment or less frequent repayment schedules. At the moment, loans are often required to be repaid very quickly and frequently, which limits investment opportunities.
More generally, reformers in financial exclusion would like to see a greater diversity of programs, more cultural sensitivity and greater attention paid to the actual needs of customers (as discussed here). There are also opportunities to lower transaction costs by using mobile and other digital channels, and to use mobile phone billing data as a proxy for credit scoring to allow slightly higher loan amounts. Increasing the riskiness of microfinance programs may lead to more defaults, but it could lead to better development outcomes.
“These results point to opportunities for more nuanced investment by providers and donors in piloting, testing, and scaling new credit models,” the summary report says. “As these new products may not be immediately commercially viable, the donor and nonprofit community could play an important role in supporting products [as they’re developed].”