A Free-Market Approach to Development

October 7th, 2010

Aid doesn’t work.

It’s a statement I hear a lot.  Development aid often gets siphoned off by corruption.  Aid in the form of money is inefficient, often getting lost in red tape and bureaucratic mess, while those in need see nearly none of it.  Aid in the form of goods encourages dependency.

Almost in response, private sector capitalists have responded with microfinance.  Indeed, the microfinance has seemed like an answer to this conundrum. It the free-market’s response to one of the most difficult questions in development economics: how can we help without undermining the very goal we seek to achieve?

Microfinance is “the practice of extending small loans,” often no more than $20 or $30, to borrowers who have “traditionally lacked access to credit.”  The concept is simple, but powerful.  You lend directly to those who need it,thereby cutting off corruption and bureaucracy and you expect the borrower to pay you back (with interest) to reduce dependency.  Recipients include poor people, often in developing countries, but most notably women who want to start a business or grow an existing business. A traditional bank or other lender would consider these loans too risky and too small to justify, but from a philanthropic perspective they are quite worthwhile.

One notable pioneer of this practice is Grameen Bank in Bangladesh (which, incidentally, also funded the Grameenphone, a topic of a recent blog).  After nearly 35 years of making such loans, the bank has reached over three million borrowers and has disbursed a total of $4 billion.  And the bank is not alone.  Today the global microfinance industry disburses over $60 billion in assets.

Anecdotally, these programs have been a great success.  There are a plethora of heart-warming stories of job creation through small-business start ups and borrowers who have risen to middle-class income through hard work and a little finance.  Many proponents of microfinance also argue the loans benefit women, in particular, as a woman can elevate her status when she is responsible for managing loans and savings. Also “the ability to generate and control their own income can further empower poor women.”

Though they are philanthropic, these companies have often turned out to be quite profitable.  For example, Compartamos, a Mexican firm that began as a tiny non-profit, generated $458 million when it went public in 2007.  More recently, SKS Microfinance, founded by Vinod Khosla an Indian venture capitalist, recently made a $117 million profit in an initial public stock offering.

However these profits have turned out to have a somewhat negative impact on the practice microfinance.  It seems the profits have brought the sharks. Many new microfinance companies, particularly in Nigeria and Mexico, lend at predatory rates.  For example, Te Creemos, a Mexican lender, charges a whopping 125% annual rate, compared to the average in Mexico, 70%, and the world average, about 37%. Emmanuelle Javoy, the managing director of Plant Rating, a firm that evaluates microlenders notes that “Mexican microfinance institutions charge such high fees simply because they can get away with it.” Although it’s also worth nothing that this practice is in no way illegal, it just doesn’t line up with the sentiment on which these companies were once founded.

The irony I see is that although proponents espouse microfinance as a way for “capitalism to help the poor,” this recent evidence shows that it is not really the free markets working at all.  Microfinance requires an element of philanthropy at its core–after all the loans traditional microlenders (the non-extortionary kind) make loans that are too risky, too small, and at too low a profit margin to exist in a traditional model.  The Mexican companies charging interest rates of 100 percent or more are the free market’s version of this practice.

To me, traditional microfinance represents a hopeful blend of capitalism’s efficiency and development’s altruism.  Of course the practice has been riddled with missteps and the jury is still out on whether microfinance can provide sustainable economic development at the aggregate.  Nonetheless, I think it’s worthwhile to take a long, hard look at the practice and consider a more prominent role for it in the implementation of traditional multi- and bilateral aid.

Written by Ann Hollingshead

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