Commercial Microfinance: Undermining Development

The October 2006 award of the Nobel Peace Prize jointly to Bangladesh’s Grameen Bank and to Dr. Mohammad Yunus, Grameen’s founder, is the latest turn in a decade of media hype surrounding microfinance. As is well known, the Grameen Bank model was discovered by the international community in the 1980s, and thereafter gradually deployed within developing countries to address issues of poverty and under-development. The ascendance of the neoliberal project from the early 1990s onwards then led to crucial commercializing modifications of the basic Grameen Bank approach, resulting in the now dominant ‘new wave’ commercial microfinance model, led by microfinance institutions designed to operate as independent, commercially oriented, financially self-sustaining entities. These ‘new wave’ commercial microfinance institutions, it is said, avoid the need for constant international and government financial support while still extending microcredits to many poor individuals and communities.

The commercial microfinance mirage
The ‘new wave’ commercial microfinance model arrived in Southeast Europe in the early 1990s, and is today widely seen as one of the most successful donor interventions in the region. Indeed, such is the presumed positive impact of Bosnia and Herzegovina’s new microfinance sector that the country is now often described as the ‘best practice’ example that all developing and transition states should carefully follow, particularly other post-conflict countries.

However, many of the alleged developmental benefits of the commercial microfinance model in Southeast Europe, and by extension in many other countries, are a mirage. Very little solid evidence has emerged to confirm that commercial microfinance has facilitated sustainable economic and social development–as opposed to some largely temporary impacts involving a lucky few, well-publicized microenterprises. In fact, far more evidence is emerging to suggest that commercial microfinance may well have undermined, if not largely destroyed, prospects for sustainable socio-economic development trajectories in the region.

The informal sector serves as the final destination of almost all microenterprises supported by microfinance. It is fundamentally wrong to assume that the informal sector has unlimited abilities to elastically expand and absorb all new microenterprises. New informal microenterprises do not raise the total volume of business so much as redistribute or subdivide it between new and existing microenterprises. Globalization-driven conditions of an unlimited labour supply and dramatically reduced formal sector (especially public sector) employment opportunities have combined to ‘saturate’ economies with informal-sector microenterprises almost everywhere. As the UN’s 2003 ‘Challenge of the Slums’ report emphasized,¹ this ‘saturation’ trend has produced recognizable declines in incomes and wages in many developing countries, trapped within increasingly dominant urban slums. There is very little evidence to support Hernando de Soto’s idea that an ever-expanding informal sector can serve as the decisive ‘agency’ factor to precipitate an eventual sustainable growth and development trajectory.

This ‘saturation’ phenomenon is increasingly becoming the norm in Southeast Europe. Many sectors are increasingly under pressure from an influx of new entrants, all desperate to survive in conditions of flat demand. Obvious examples include the retail sector, cross-border trade, simple services, cafes and local transport (e.g., taxis). One reflection of ‘saturation’ is the high rate of microenterprise exit emerging almost everywhere in the region. For example, the World Bank’s 2005 evaluation of its Local Initiatives Project (LIP) microfinance programme in Bosnia and Herzegovina found that 30 percent of the microenterprises surveyed in 2002 had failed after just two years.² Using panel household survey data for 2001-2004, World Bank researchers estimated that around half of the individuals in Bosnia and Herzegovina starting a new microenterprise in 2002 and 2003 closed their new business within one year of its establishment.³ 

With two more cows this micro-farm would qualify for state subsidies

Commercial microfinance institutions in Southeast Europe have been more than willing to support microenterprises operating well below minimum efficient scale, and thus with little realistic chance of long-run survival. In a desperate attempt to survive, most of these microenterprises are forced into hyper self-exploitation – accepting ultra-low earnings, long hours, and so on – while others, as noted above, simply collapse. Many microfinance institutions are more than willing to do this because ultimately unsustainable microenterprises are nevertheless very often able to repay their microcredit in the time allowed. These microfinance institutions are more interested in their own survival even if this is achieved through constructing local microenterprise structures with very little real future – a ‘house of cards’. Examples of this trend can be found in Croatia, where many patently unsustainable ‘micro-farms’ were established in the dairy sector thanks to microfinance support–many of which were only able to survive thanks to the Croatian government’s subsidies available for ‘three-cow-and-above’ farms.

Commercial microfinance has also ‘crowded out’ potentially sustainable microenterprises wanting to deploy relatively advanced technologies, skills, and product and process innovations. Southeast European countries in the early 1990s had significant endowments of technologies, skills and industrial expertise, which could have provided obvious ‘entry points’ for technology-intensive micro- and small enterprises. Many potential micro-entrepreneurs came forward from the most advanced sectors and companies with ideas for establishing sustainable microenterprises. However, many of these potential micro-entrepreneurs simply could not deal with the standard commercial microfinance business model–high interest rates and short repayment periods–and most quickly abandoned their ideas. Potential entrepreneurs were instead forced to establish simpler businesses, such as in retail trade. The ‘deindustrialization’ that characterized economic development in the region was therefore consolidated with the help of commercial microfinance. This represents a huge opportunity cost for a region that once boasted a high degree of technological sophistication.

Microfinance and local development need not go together
Inter-enterprise connections are now understood to be a crucial determinant of a local economy’s ultimate sustainability and progress. When many enterprises are engaged in activities that make use of technology, innovation, skills, coordination and planning, managerial competences and so on, a local economy can gradually advance and prosper in a sustainable manner. But such beneficial grass-roots dynamics cannot arise if the local economy is dominated by microenterprises with little need, ability, or wish to cooperate. While commercial microfinance in Southeast Europe has clearly produced significant numbers of new microenterprises, the overwhelming majority of these companies is unable to forge the efficiency-enhancing horizontal (‘proto-industrial districts’) and vertical (sub-contracting) connections that are crucial to establishing a sustainable development trajectory.
Many of the early microenterprises in Southeast Europe were always going to prefer to enter into simple shuttle trading operations if they could, as these sectors are the mainstay of microfinance operations across the world. However, the subsequent entry of many microenterprises into such operations helped generate the surge in imports (many EU-subsidized) that arrived in Southeast Europe after 1990, and in Bosnia and Herzegovina after peace was concluded in late 1995. In Kosovo after 1999, the main microfinance institution – ProCredit Bank – was very heavily engaged in supporting trade-based microenterprises, quickly becoming the most profitable microfinance bank in Europe.⁴ However, by first monopolizing and then channelling both international donor funds and local savings overwhelmingly back into simple trade-based microenterprises, commercial microfinance created a most unsuitable foundation for sustainable development and growth.

Finally, the rapid rise of commercial microfinance has contributed to the steep declines in social capital levels experienced since 1990. Recasting individual survival as a function of individual entrepreneurial success can undermine the bonds of solidarity, shared experience, and trust that often exist within poor communities. This is a truism. Recasting community development and support activities as commercial operations – a central operating principle of commercial microfinance – can also dissolve local solidarity, interpersonal communication, volunteerism, trust-based interactions, and goodwill. Operating in the informal sector is itself associated with a diminution of social capital, not least since most informal microenterprises do not need to develop the trust-based linkages with government and other enterprises that typically underpin legitimate business operations and ethics.

Commercial microfinance: An ‘anti-development intervention’?
It has yet to be shown that commercial microfinance is associated with sustainable economic and social development, or sustainable poverty reduction, in Southeast Europe. Microfinance has instead undermined most local economic and social development triggers, such as cumulative and coordinated investments, capturing economics of scale and scope, technological innovation, inculcating social capital, or incorporating technical skills and knowledge. Commercial microfinance therefore amounts to what the former World Bank economist David Ellerman has called an ‘anti-development intervention’ – an intervention that, like bad medicine, produces some modest short-run pain relief (quick poverty reduction for a lucky few), but in the longer run undermines prospects for a sustainable recovery and eventually leads to ‘death’ (to the chances of sustainable economic and social development). In light of this, current efforts by the US-based MicroCredit Summit, growing numbers of commercial banks, and some high-profile charitable foundations, to effectively ‘flood’ developing and transition countries with microfinance can only be looked upon with real concern.

Milford Bateman is an independent consultant and Visiting Professor of Economics at the University of Pula, Croatia. He has been a regular consultant to UNDP on poverty reduction and local economic development issues in Southeast Europe and elsewhere. Dr Bateman’s most recent published output on microfinance can be found in the edited book by Thomas Dichter and Malcolm Harper entitled What’s Wrong with Microfinance?, to be published in July 2007 by Practical Action Publishers.