In a dramatic turnaround for an industry that was on the brink of collapse five years ago, India’s microfinance sector saw its total loan portfolio rising 61% to Rs40,100 crore in fiscal 2015 over the previous year, according to the latest issue of Micrometer, a publication of the industry body Microfinance Institutions Network.

The scorching pace of growth brings to mind the heyday of microfinance, when the industry seemed to symbolize all that is great and glorious about capitalism. In those years, the industry, which offered small loans to the unbanked poor, seemed to be a win-win proposition for both investors and the poor. The poor got loans at lower interest rates than what the traditional moneylender charged, while microfinance firms made handsome profits. Microfinance firms were able to deliver attractive returns to shareholders even as they seemed to help a new generation of entrepreneurs to set up small businesses and climb out of poverty. The poor do not need subsidized credit, said microfinance proponents, and most believed them.

Microfinance’s dream run ended when the lenders faced protests from clients who complained of high interest rates and the use of strong-arm tactics by some microfinance firms to recover loans. Several firms in India, and elsewhere, faced mass defaults. With politicians taking up the cause of microfinance clients, a regulatory clampdown followed. Still, the central challenge to microfinance today does not arise from regulatory pressures. The central challenge is an intellectual one.

A substantive body of academic research published in recent years by some of the most influential names in development economics has shaken the foundational promise of microfinance—that it can help poor people, especially women, set up successful businesses and escape poverty.

A 2014 research paper by Abhijit Banerjee and Esther Duflo of Poor Economics fame showed that the overwhelming majority of businesses funded by microfinance firms did not grow at all even though their owners had been using micro-credit for a long period of time. To the extent that it helped businesses to grow, microfinance helped those firms which were already the most profitable (the top 15%).

The study conducted over a long period of time in Hyderabad’s slums also showed that there was little impact of microfinance on either consumption levels or human development outcomes. There was no discernable impact on women’s empowerment.

“For those who choose to borrow, while microcredit ‘succeeds’ in leading some of them to expand their businesses (or choose to start a female-owned business), it does not appear to fuel an escape from poverty based on those small businesses," wrote Banerjee, Duflo and their co-authors. “Monthly consumption, a good indicator of overall welfare, does not increase for those who had early access to microfinance, neither in the short run (when we may have foreseen that it would not increase, or perhaps even expected it to decrease, as borrowers finance the acquisition of household or business durable goods), nor in the longer run, after this crop of households have access to microcredit for a while."

Evidence from other parts of the world offer a similarly stark prognosis—microfinance does not seem a good bet to end poverty. A 2010 review of evidence on microfinance in sub-Saharan Africa pointed out that some people are made poorer, not richer, by microfinance.

“This seems to be because: they consume more instead of investing in their futures; their businesses fail to produce enough profit to pay high interest rates; their investment in other longer-term aspects of their futures is not sufficient to give a return on their investment; and because the context in which microfinance clients live is by definition fragile," wrote the authors of the study led by Ruth Stewart of the University of London.

The idea that the poorest of the poor can be turned into entrepreneurs overnight with a dose of micro-credit may be fundamentally flawed, Stewart and her colleagues noted. “There may be a need to focus more specifically on providing loans to entrepreneurs, rather than treating everyone as a potential entrepreneur."

What about the reported success of Bangladesh then? That seems to have been a statistical mirage. The early evidence on the success of self-help groups and microfinance in lifting people from the jaws of poverty in the country appears to have been gross exaggeration, recent research shows.

One of the most influential early research papers on Bangladesh’s microfinance industry was a 1998 research paper by Mark Pitt of Brown University (Providence, US) and Shahidur Khandker of the World Bank. The duo showed that micro-loans raised consumption levels by 11 taka for every additional 100 taka borrowed by men, and by 18 taka for every additional 100 taka borrowed by women. A 2011 research paper by Maren Duvendack and Richard Palmer-Jones of the University of East Anglia (Norwich, UK) which replicated their analysis found faults with Pitt and Khandker’s use of statistics. Duvendack and Palmer-Jones pointed out that several borrowers took loans from multiple sources (including microfinance) and concluded that it was not possible to establish a causal link between microfinance and increased consumption from the available data.

An interesting hypothesis on why microfinance may be failing the poor came from a 2013 research paper by Erica Field of Duke University (Durham, US), Rohini Pande of Harvard University, John Papp of Highbridge Capital Management and Natalia Rigol of Massachusetts Institute of Technology (MIT). Field and her co-authors show that micro-loans fail to boost profit and income levels of borrowers because of immediate repayment obligations, preventing borrowers from taking the big risks (involving illiquid investments) that would enable them to transform their enterprises and their lives. They contend that the choice of an alternative debt contract with a grace period for borrowers is more likely to be transformational. The risk, of course, is that default rates are likely to be higher, and even if microfinance firms charge higher interest rates, their margins could be lower in this alternative world.

Thus, the debt contract which maximizes profits for the microfinance firm does not maximize investments by borrowers, and the one that maximizes investments by borrowers does not maximize microfinance profits.

Microfinance firms may have engineered a successful business model, and they may even be helping poor people sometimes (though not always) to smooth consumption shocks, but there is very little evidence to show that they have helped dent poverty levels.

In contrast, there is now evidence to show that the much-maligned rural bank expansion programme in India had considerable success in fighting poverty over a long stretch of time. In the world’s largest branch expansion programme, roughly 30,000 bank branches were opened in unbanked rural areas of India between 1969 and 1990, in the period following bank nationalization and preceding the liberalization of the economy.

Using state-level data between 1977 and 1990, Robin Burgess of the London School of Economics and Rohini Pande showed that the expansion of branch banking led to a significant decline in rural poverty levels, even after controlling for other policy variables that impacted poverty rates. Their results show that as much as half of the poverty reduction in this period was because of rural branch expansion, which facilitated growth of agriculture and rural enterprises—sectors most closely linked to poverty outcomes.

Bank nationalization is blamed for the persistence of bad loans in the banking system, but it also deserves credit for fostering financial inclusion. Not microfinance firms but state-owned banks have been at the forefront of the fight against poverty, and the fight against the traditional moneylender. Aggregate debt figures from National Sample Survey Office (NSSO) surveys show that the share of households accessing institutional credit in rural India moved up only by 2 percentage points over a decade to 59.8% in 2012 despite the rapid expansion of self-help groups and microfinance firms during this period.

In contrast, between 1971 and 1981, the share of households accessing institutional credit rose by 32 percentage points to 61.2%. India’s savings rate also rose sharply over this period as the unbanked began depositing money in state-owned banks. The period between 1981 and 1991 was problematic, as bank lending became increasingly politicized. The share of households accessing institutional credit rose modestly by 3 percentage points during this phase.

The Pradhan Mantri Jan-Dhan Yojana launched by the National Democratic Alliance government last year relies largely on the wide network of state-owned banks to reach the unbanked (as was the case with the scheme by the previous government to provide no-frills bank accounts to the poor).

“The branch licensing policy helped increase and equalize bank branch presence across and within Indian states," wrote Burgess and Pande. “We also find that the reductions in rural poverty were linked to increased savings mobilization and credit provision in rural areas. Taken together, these findings suggest that the Central Bank’s licensing policy enabled the development of an extensive rural branch network, and that this, in turn, allowed rural households to accumulate more capital and to obtain loans for longer-term productive investments."

However, Burgess and Pande caution that such a programme should not be attempted without a careful consideration of implicit costs and subsidies involved. After all, high default rates in the range of 40% during the 1980s led India to eventually abandon the branch expansion programme.

The history of credit interventions, in India and elsewhere, suggests that the financial inclusion agenda is a double-edged sword, especially if it is based on easing access to credit. While it can lift people out of poverty, it can also create big risks in the financial system and end up being counterproductive. Reckless credit expansion in the name of inclusion has wreaked havoc on the balance sheets of Indian banks in the past.

More recently, it was the drive for inclusion that sowed the seeds of the 2008 sub-prime crisis in the US. It led government-backed agencies to lend to customers with limited ability to repay. Regulatory forbearance led to effervescent lending before the eventual bust. And the bust effectively threw the global economy into a deep recession, from which it is yet to recover. The excessive lending by the microfinance industry before crisis struck in 2010 was also partly due to regulatory forbearance, and guided by the desire to foster inclusion.

Thus, efforts to drive greater financial inclusion can end up harming rather than benefiting those in whose name such efforts are launched: the poor and the vulnerable.

What lies ahead then? Should we abandon financial inclusion as an end in itself?

One tentative answer lies in the 2014 Global Financial Development report published by the World Bank. The report notes the growing evidence of problems with micro-credit interventions but points out that there may be succour yet, if countries and firms were to focus on micro-savings products rather than on credit. The report points out that the early evidence on micro-savings products appears promising.

The study led by Stewart and others cited earlier offered similar recommendations. “Micro-savings may be a better model than micro-credit, both theoretically (because it does not require an increase in income to pay high interest rates and so implications of failure are not so high) and based on the currently available evidence," the report said.

Savings products by definition do not lead to defaults, and therefore are unlikely to lead to systemic risks. Also, the availability of micro-savings products offers the poor a viable alternative to the sundry agents of fly-by-night operators. Finally, as in India’s case, post bank nationalization, the availability of savings products where none existed can boost savings rates, and help an economy fund investment and growth in the long run.

Micro-savings products do not promise the big-bang transformation that several credit interventions promised in the past. Nonetheless, they offer a safer and more sustainable path towards inclusion compared to the strategies of the past.

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