Financial Transparency Coalition

Microfinance Clients in India | McKay Savage, Flickr

The initial swell of enthusiasm for microfinance has somewhat subsided recently, as an elegantly simple idea founders on the rocks of reality. Despite the early successes of projects such as Muhammad Yunus’s Grameen Bank in Bangladesh, billions of people from Dhaka to the Dominican Republic remain shut out of the global financial system. The scarcity of credit available to the world’s poorest is still a significant impediment to ending global poverty.

The current crisis in the Indian state of Andhra Pradesh is a case in point. A rash of defaults- and even suicides- among borrowers have led to calls for stringent regulation to combat ‘predatory’ lending practices. Some local politicians have gone so far as to draw parallels with the explosion of sub-prime mortgage defaults in the United States in 2008.

While the situation is serious, such parallels are overblown. According to banking officials quoted in the New York Times, India’s large banks currently have approximately US $4 billion invested in the microfinance industry. Not pocket change, but still far too low to pose a systemic risk to the Indian economy.

The central problem confronting the Indian finance ministry, and indeed policymakers throughout the developing world, is how to balance two competing priorities. On the one hand, there is a desire to keep the industry honest to prevent unscrupulous lenders from taking advantage of society’s most vulnerable. On the other, there is an awareness that firms already face high costs in monitoring myriad tiny transactions, and that a rush to regulate could leave the sole providers of credit to many of the world’s poorest people ‘strangulated’ by red tape. Managing this tradeoff demands a deft touch on the part of governments.

The recent microfinance boom has been part of a broader trend to realize the financial potential of so-called ‘dormant capital’; those assets which individuals in developing countries have effective ownership of, but not legal title to. Economists such as Hernando de Soto have long argued that if these assets—particularly housing—could be fully realized in legitimate markets, the poor would face significantly lower credit costs. This would in turn make it easier for them to make the investments in their family’s health and education necessary to lift themselves out of poverty.

Further research to determine just how effectively microfinance is able to deliver such benefits is required, but one thing is certain. In the absence of a recognised low-cost banking sector, informal lending flourishes. Governments need to protect their citizens from duplicitous lending practices, but they can also do a lot more to expand the reach of legitimate credit to society’s poorest.

The high cost of remittances is just one example of how the poor are priced out of the formal financial system. For example, despite the fact that the countries share a border, it costs more than twice as much to transfer money from the Dominican Republic to Haiti than it does if the same funds are sent from the United States.

It is therefore unsuprising that traditional mechanisms of exchange—such as ‘hawala’ transactions in the Middle East and North Africa—continue to be utilized across the developing world. These kinds of informal financial arrangements are often the only option open to those on the global periphery. They are unfortunately also an excellent channel for criminals, drug traffickers and terrorists to transfer funds across borders.

The challenge, therefore, is to replace informal networks with formal alternatives, which would allow the poor to experience more of the benefits of globalization, reducing the demand for illicit financial services. Monitoring and policing are only a part of this solution. Governments, civil society groups and the private sector should work to promote low-cost, transparent alternatives to closed systems to reduce the amount of funds in the informal economy.

New technologies have greatly aided this approach. The success of the M-PESA scheme in Kenya, which allows individuals to transfer funds using their mobile phones, is a promising example of how people in remote areas without a bank account or credit history can be integrated into the global financial system at the touch of a button on an aged Nokia.

As such schemes win broader interest, it is hoped that they may increasingly supplant informal finance. According to the World Bank, Indians received almost US $50billion in remittances from overseas through legitimate channels in 2008. The same year however, more than US $20 billion left India in illicit financial flows.

Providing the poor with access to credit is a problem that resists simple answers. Governments must take a firm stance on corruption, but a flexible approach to innovation. Yet policymakers should be optimistic: part of the solution may already be on their cellphone.