Mistake or miracle: New evidence on the effects of microcredit

Published: Thursday, May 23 2013 11:55 p.m. MDT

For years microfinance, the practice of making small loans to the poor, has been lauded as a promising solution for eradicating poverty in the developing world. The idea is that a small loan could enable some poor people to invest in business opportunities that could improve their income.

For example, a poor woman might be given a loan to buy goats to produce milk or a sewing machine to make clothing. The hope is that microloans have the potential to generate enough income for the recipients that they can both improve their lives and repay the loans with interest.

Enthusiasm for microfinance reached its peak in 2006 when Muhammad Yunus won the Nobel Peace Prize. Yunus helped develop the concept as an academic and then began to apply in Bangladesh through the now famous Grameen Bank. Since then, a growing stream of criticism has fed a furious debate about the effectiveness and side effects of offering credit to the extremely poor. A recent study by a group of economists from MIT and Northwestern on microfinance in Hyderabad, India, provides new evidence that access to credit does not increase income. However, the same study suggests that microloans may be improving lives in other ways, such as giving people in poverty the opportunity to make better long-term financial decisions.

Controlled study

Despite the fierce debate, until recently rigorous data on microfinance has been surprisingly sparse, said Cynthia Kinnan, assistant professor of economics at Northwestern University in Chicago. Part of the problem is that little data has been gathered on people who qualify for microloans but don't actually participate. Without such a comparison group, it is difficult to draw meaningful conclusions about the causal effects of microfinance, Kinnan said.

Kinnan, along with her colleagues at MIT, Abhijit Bannerjee, Esther Duflo and Rachel Glennerster, are determined to find a more precise way of evaluating microfinance. Their proposal is to use randomized controlled trial techniques (the same approach used by the medical industry to test the effectiveness of medications) to identify how microcredit programs are actually working. This would allow them to compare borrowers to non-borrowers in a more precise way.

These researchers conducted a three-year study in Hyderabad. The team selected neighborhoods to observe based on two criteria, absence of financial institutions and residents who were desirable potential borrowers — "poor, but not the poorest of the poor," Kinnan said. Loans were offered through an organization called Spandana, which unlike other microfinance providers, does not require borrowers to start a business to qualify for a loan. Spandana charges a 24-percent annual interest rate, which while high by American standards, is less than what local moneylenders charge.

The findings, published in an April 2013 report, show that "at the highest level and in the broadest terms both claims (about microcredit) are true," said Kinnan. While it hasn't cured poverty just yet, that doesn't mean it is an entirely useless program.

Affect on income

One of the first things that jumps out in the summary of findings from the Hyderabad study is that the demand for microloans wasn't robust. "By the end of our three-year study, only 38 percent of households borrowed," Kinnan said, "and this is among households selected based on their relatively high propensity to take up microcredit. These are neighborhoods that are booming, so if there is any place people have investments that would yield a 24-percent (return on investment), it would be Hyderabad," she added.

If microcredit helps people get out of poverty, as proponents argue, why didn't more people use it?

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