Can a re-focus on financial inclusion save microfinance? Case study: Latin America

Charlie Crossley

Street vendor

Informal enterprises have proliferated in countries like Peru as a result of microfinance. Photo source: Frank_am_Main via Flickr.

The brainchild of Bangladeshi economist Muhammad Yunus, microfinance was first piloted as an innovative development strategy in South Asia in the 1970s. A desire to tackle poverty from the ground up informed its founding principles: that a lack capital was a barrier to the naturally entrepreneurial poor lifting themselves out of poverty; and that access to credit in the form of small loans would remedy this. Early field-based studies largely targeted women, as a means of empowerment and also because they were seen as being more reliable debtors. Microfinance’s pioneers reported initial success in the form of high demand for the loans. International admiration soon followed.

By the turn of the millennium, microfinance had become entrenched in many parts of Latin America. Its influential backers included USAID and the World Bank. Microfinance’s growth in the region has continued virtually unabated since. The number of active users in Latin America and the Caribbean increased from 6 million in 2006, to almost 11 million by 2011.

The pattern is consistent across the region, but certain nations have seen exceptional levels of market penetration; Peru had a microfinance portfolio of over $10 billion in 2012, while 37% of Bolivia’s financial resources are intermediated through the microfinance sector.

With the credit flowing, the model of best practice for Microfinance Institutions (MFIs) – traditionally not-for-profit NGOs funding their lending through subsidies – has gradually shifted. Latin America led a new emphasis on the commercial-viability of MFIs. The mainstream development community appeared to be swept up in a tide of optimism for this ‘magic bullet’, market-based poverty reduction strategy. In terms of global profile, microfinance reached a summit when the UN named 2005 the ‘international year of microcredit’.

But pressing questions were soon posed: Is microfinance actually contributing to sustainable development? Is it reducing poverty? An evidence-based critique has become a priority for the donor community.

The UK Government has been a consistent supporter of microfinance through its Department for International Development (DFID). In 2011, DFID commissioned a substantive review of the impacts of microfinance on development. The review concluded that there was “no good evidence to support the claim microfinance has a beneficial effect on the well-being of poor people.” Moreover, it questioned whether the substantial development resources invested in microfinance – in terms of both time and people – could have been better focused on “alternative interventions”.  Hitherto peripheral concerns about microfinance’s status as an in-vogue development strategy were thus thrust in to the spotlight.

In Latin America, the microfinance model received relatively little scrutiny in the early 2000s as the region made impressive progress in poverty reduction on the back of strong economic growth. However, a slowing of the rate of poverty alleviation since the financial crisis has prompted fresh examination of microfinance as the prominent development strategy in the region.

Critics have pointed to problems of market saturation, over-indebted clients and high interest rates. Rising personal debt levels have grabbed the attention of many Latin American policymakers.

Some have criticised microfinance on a more fundamental level, claiming it has actively disrupted development by channelling resources to the ‘wrong’ type of enterprises. The picture painted is bleak: credit is oversupplied to tiny microenterprises which are unlikely to invest in people, technology, or pay taxes. Meanwhile, established financial institutions are incentivised to downscale to microfinance lending rather than provide credit for larger, more productive enterprises. Exacerbating this is the fact that the state effectively washes its hands of its responsibility to directly intervene to promote economic development, because microfinance is supposedly doing it from the ‘bottom-up’.

In the wake of this stinging criticism, the microfinance community has entered a period of self-reflection. Alongside calls for better regulation of MFIs, one of the most demonstrable products of this has been an increasing focus on financial inclusion. The realignment has been timely; recent years have seen the donor community increasingly turn its attention to the fact that 2.5 billion people across the world are excluded from financial services.

Microfinance practitioners and supporters now commonly speak of improving financial inclusion as an important external benefit of lending to the poor. For example, the Microcredit Summit Campaign, a prominent network of microfinance stakeholders, was a key backer of Global Money Week, celebrated in March this year. The event promoted microfinance as being “uniquely placed to reach millions of children and youth, providing responsible savings products and programs.”

It is in this diversification of products that microfinance may find its contemporary relevance. Credit is just one financial service. In fact, it may not even be the most desired by people in poverty. Products facilitating saving and financial security are of huge importance, as is effective financial education. ‘Banking on change’, an ongoing financial inclusion scheme based in Africa, has particularly noted a strong demand for savings products among the poor.

Latin America is an important test-case for the new financial inclusion agenda. Microfinance is deeply ingrained in the region, strong economic growth is returning and technological development is fast spreading the potential benefits of innovations like mobile banking.

But to truly reach those in poverty, microfinance intermediaries must have a social mission at their core. Commercially-focused MFIs and banks will always be reticent to provide a full range of services to the poor; this is where community-minded organisations like credit unions come in. Credit unions are financial co-operatives which operate on the principle of social solidarity. Their members, who are often previously financially excluded, take advantage of the savings products they provide, and gain access to affordable credit. In Latin America, the sector is growing fast, with over 600 new credit unions established between 2011-2012 alone, serving over 2.5 million new members.

As of 2010, credit unions and rural banks represented 25% of the microfinance industry across the world. But their potential as a provider of microfinance services in Latin America has not been tapped: only 3% of Latin American microfinance clients in 2011 borrowed from co-operatives. The time has come for established microfinance NGOs in the region to explore the potential of working alongside and promoting financial co-operatives.

Over forty years since its creation, it is evident that microfinance will not prove the panacea to poverty that its most optimistic proponents once thought it would be. Direct interventions in healthcare, education and disaster management will always be necessary. However, financial inclusion helps people plan for the future, deal with income shocks and realise ambitions to start businesses. Microfinance has established links with people in poverty, now community-minded organisations like credit unions must be encouraged to take up the baton to provide financial services to the poorest. These organisations can play an important role in realising some of the bottom-up development ambitions that Yunus and his followers first set out to achieve.

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