Is microcredit a debt trap?

April 17, 2010

According to India's National Crime Records Bureau, more than 87,000 farmers committed suicide between 2002 and 2006 because of failing harvests and huge debts. Young women in South India have one of the highest suicide rate in the world.

Sudhirendar Sharma, a former World Bank analyst and now director of the Delhi-based Ecological Foundation, thinks that microfinance is part of the problem. The rural suicides, he wrote, "cast a dark shadow on the fledging microfinance sector."

Sharma complains that usurious interest rates of up to 40 percent and forced loan recovery practices were intimidating the poor. This and other incidents have led to mounting criticism of microcredit as a debt trap for the poor.

Suvarna Gandham, manager of Indian operations for the Oikocredit microfinance fund, says that microfinance is not to blame for the suicides. She says many of those driven to suicide had outstanding debts with commercial banks and moneylenders; not microfinance institutions (MFIs). Moreover, Gandham believes the high suicide rates are a symptom of India's massive economic transformation.

"In many transition countries, the suicide rate has shot up because many people were not able to adjust to a changing economy," she says. For India's farmers, the situation had been worsened by a drought.

But Gandham argues that microfinance also helps to avoid the debt trap by giving poor people an alternative to local moneylenders, who are known to charge interest rates of up to 1,000 percent. 

Economists who have looked at how microfinance impacts national economic growth have not yet been impressed by microcredit. Aneel Karnani, a professor at the University of Michigan's Ross School of Business, argues that microcredit does not increase the number of people with jobs or the gross domestic product of a country.

Karnani devised a simple thought experiment to illustrate his criticism. In one scenario, a lender gives out 200 dollars to each of 500 women so that each can buy a sewing machine and set up their own sewing microenterprises. In the alternative scenario, a traditional financier lends 100,000 dollars to a single entrepreneur who sets up a garment manufacturing business that employs 500 people.

In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. The garment manufacturer, however can exploit economies of scale and use modern techniques.

"The biggest problem with microcredit is that people who get these small loans usually start or expand a very simple business," Karnani concludes. "We need to create more jobs, and microcredit does not help to do that yet."

Surprisingly, Suvarna Gandham agrees. "What can you expect if you give a 70-dollar loan for one year to a person? What magic can you expect from him? At the most, he can survive, and there can be small changes in his quality of life."

Microfinance, she says, is consolidating the subsistence level of poor people. The question is whether this is considered a gain. For Gandham, the equation is simple: "They will be able to eat two meals and slightly improve their quality of life." That alone, she says, is worth the effort. 

Many people who embrace microfinance are still shocked by the double-digit interest rates that MFIs charge their poor clients. Y. S. Rajasekhara Reddy, chief minister of the Indian state of Andhra Pradesh, complained that some MFIs were "worse than moneylenders" because they charged interest rates over 20 percent.

But Suvarna Gandham argues that a "reasonable" interest rate has to cover costs of both the finance and distribution of the loans. Delivering money to villages can be costly, which she says justifies interest rates of 20 to 25 percent for the final borrower. Trying to cut on these delivery costs would mean paying MFI employees less what they typically earn, around 100 dollars per month.

Critics say that many poor people do not have the financial knowledge or experience to use debt to increase their wealth. Instead of using microloans to invest in the business, many poor clients use them for a wedding, a festival, or to buy something.

"Even people in rich countries often don't know how to use debt," says Aneel Karnani. "They think that once you have a credit card, you can buy anything. If you get microloans, it doesn't necessarily mean you can buy things you couldn't afford before."

Sometimes, however, there are situations when taking loans is inevitable for poor people, says Ralf Radermacher of the Delhi-based Microinsurance Academy. According to Radermacher, the main reason for loan default is illness or death of a family member.

"I think in such emergency situations people are particularly vulnerable and need to take loans, even with unfavorable conditions," says Radermacher. "This can result in a debt trap." Microinsurance, he argues, could offer some potential protection here.

Another problem with microfinance, that even proponents acknowledge, is its rapid growth. More and more institutions are catering for the same regional markets, sometimes leading to fierce competition.

"MFI One has given a loan to Lady X and MFI Two will also try to give her a loan," says Gandham. "That is what we call multiple loans, and that is what can trigger some problems."

But Gadham insists that both sides would learn very quickly, because defaulting is neither in the interest of the creditor nor the debtor. 

Thilo Kunzemann

This could be interesting for you

Growing inequality makes countries worse, Richard Wilkinson argued at the TEDGlobal 2011 conference. In a world of 7 billion, this trend must be confronted. 
A review of ten of the world's most innovative and important microfinance organizations and projects. 
Even as millions rise out of poverty, Indonesians still lag when it comes to financial literacy. Education may be the key to continued development.