A critical review on

“Microfinance was largely viewed

as an instrument for poverty
alleviation”

By Nuru Hussen Mohammed

An assignment for the course Monetary Theory

and Practice

Submitted to Dr. Okurut Nathan

August, 2010
 Table of content

Contents page
1. Introduction……………………………………………………………………….1

1. 1 Poverty in developing countries…………………………………………....2

1.2 Concept of microfinance…………………………………………………….2

1.3 The need for micro financing………………………………………………..3

2. Operation of micro finances…………………………………………………….....5

3. Emperical literature review………………………………………………………..7

3.1 Achevement of microfinance

as an instrument for poverty alleviation ……………………………………..7

3.2 Drawbacks of microfinance

as an instrument for poverty alleviation………………………………………11

4. Concluding remarks………………………………………………………………..13

Reference
Introduction
Poverty is a common problem of almost all developing countries. As a result their main and

immediate objective is to strive to break the vicious cycle of poverty and to reduce the magnitude

and extent of poverty. In this struggle, as to all poor countries, the binding constraint is capital

formation to alleviate poverty and encourage investment by poor. In this regard, the micro-

finance institutions recently gain more and more acceptance.

Currently, these institutions play a very vital role in global poverty reduction debates. The usual

argument made by this institutions is that enabling poor households access to credit helps and

then households begin micro entrepreneurship which would enable them improve their incomes

and eventually escape poverty.

Microfinance could be a powerful strategy or instrument, among several others, for alleviating

poverty in developing countries. Although many developing countries, such as Bangladesh (the

Grameen Bank) and Indonesia , have scored relative successes in using microfinance as an

instrument for alleviating poverty , it has not been so for many other developing countries,

especially in Africa and some other developing countries Countries. Rather than improve the

conditions of the poor, most of the microfinance programs operated in these countries have left

the so-called beneficiaries in debts.

However, following the success of the Grameen Bank in Bangladesh, the importance of

microfinancing for poverty reduction has gained momentum in the policy agenda of several

countries. Despite the fact that results are inconclusive, a bulk of the literature indicates that

microfinance could help the poor in many respects such as serving as a buffer against shocks and

could work as an instrument of consumption smoothing. It could also help households to

increase their income and assets; help them increase consumption expenditure and develop

savings habits.
Poverty in Developing Countries

Poverty has no precise definition. It is a multi-dimensional phenomenon related to the

inadequacy or lack of social, economic, cultural, and political entitlements. Poverty is hunger.

Poverty is lack of shelter. Poverty is being sick and not being able to see a doctor. Poverty is not

being able to go to school and not knowing how to read. Poverty is not having a job, is fear for

the future and living one day at a time. Poverty is losing a child to illness brought about by

unclean water. Poverty is powerlessness, lack of representation and freedom (World Bank 2000,

cited in Juanah 2005).

Poverty has many faces, changing from place to place and across time, and has been described in

many ways. Most often, poverty is a situation people want to escape. So poverty is a call to

action – for the poor and the wealthy alike – a call to change the world so that many more may

have enough to eat, adequate shelter, access to education and health, protection from violence,

and a voice in what happens in their communities (World Bank 2000 ,cited in Juanah 2005).

Globally, 1.2 billion people are living in extreme poverty. Nearly two thirds of them live in Asia;

South Asia accounts for half of them. About one fourth of the extremely poor people live in Sub-

Saharan Africa (IFAD 2001, cited in Juanah 2005). When measured in terms of the US One

Dollar per day poverty line, poverty seems to be on the increase in the region.

The concept of microfinance

Microfinance is a form of financial development that has primarily focused on alleviating

poverty through providing financial services to the poor. Most people think of microfinance, if at

all, as being about micro-credit i.e. lending small amounts of money to the poor. Microfinance is

not only this, but it also has a broader perspective which also includes insurance, transactional

services, and importantly, savings ( Bakhtari,2006)

The Need for Micro-Financing

Microfinance is about providing financial services to the poor who are not served by the

conventional formal financial institutions. The provision of such financial services requires

innovative delivery channels and methodologies. The need for financial services that allow

people to both take advantage of opportunities and better management of their resources.

Microfinance can be one effective tool amongst many for poverty alleviation. However, it should

be used with caution -despite recent claims, the equation between microfinance and poverty

alleviation is not straight-forward, because poverty is a complex phenomenon and many

constraints that the poor in general have to cope with ( Bakhtiari 2006)Access to formal banking

services is difficult for the poor. The main problem the poor have to take when trying to acquire

loans from formal financial institutions is the demand for collateral asked by these institutions. In

addition, the process of acquiring a loan entails many bureaucratic procedures, which lead to

extra transaction costs for the poor. Formal financial institutions are not motivated to lend money

to them. In general, formal financial institutions show a preference for urban over rural sectors,

large-scale over small scale transactions, and non-agricultural over agricultural loans (Bakhtiari

2006). According to Sadegh Bakhtiari, formal financial institutions have little incentives to lend

to the rural poor for the following reasons.

 Administration difficulties: small rural farmers often live geographically scattered in

areas with poor communication facilities, making loan administration difficult.

 Systematic risks: agricultural production is associated with some systemic risks, such as

drought and floods, which is reflected in a high covariance of local incomes.

 Lack of information: the absence of standardized information, standard lending tools,

such as financial statements or credit histories, does not exist in these areas.
Despite the fact that many rural poor acquire their loans from the informal financial sector in

rural areas of developing countries because of the problem they face in formal financial

institutions; the sector has some basic limitations. A common feature of many rural communities

is that much of the local information does not flow freely; it tends to be segmented and circulates

only within specific groups. Usually the informal credit market is based on local economies and

is thus limited by local wealth constraints and the covariant risks of the local environment. Since

most of the world‘s poor do not have access to basic financial services that would help them

manage their assets and generate income. According to Khandker (1998), the alleviation of

poverty requires diverse measures. The most important being those, which expand the income

and employment opportunities of the poor, enabling them to enhance their living standards

providing the poor with access to financial services is one of the many ways to increase their

income and productivity.

To overcome poverty, they need to be able to borrow, save, and invest, and to protect their

families against adversity. Another shortcoming of the two financial sectors in developing

countries is their inability to satisfy the credit needs of the poor has led to the new development

of microfinance. Micro financing programs are developed to fill this gap. The rural poor in LDCs

are in desperate needs of credits, microfinance programs are supposed to make available this

credit needs and keep the poor to increase their living standard. Lack of saving and capital make

it difficult for many poor people who want jobs in the formal and informal sectors to become self

employed and to undertake productive employment generating activities, providing credit seems

to be a way to generate self-employment opportunities for the poor.

Microfinance programs directly targeting the poor are able to reach clients who are not yet

served by financial institutions, and they are also important for upgrading target groups to more

sustainable microfinance providers, thus increasing the outreach depth of financial institutions.

At the same time, it is necessary to develop and strengthen microfinance institutions in order to

sustain the provision of financial services to a growing number of low-income households

( Arun, T, Imai, K & Sinha,F 2006).

Operation of microfinance institutions

The services provided by microfinance institutions have been classified into four categories

namely, savings facilities, credit facilities, insurance services and money payments or transfer

services (Juanah 2005)

Savings Facilities

With more financial savings, capital is accumulated and greater capacity for self-investment is

enhanced. In addition, the need to borrow at high interest rates from private money lenders is

reduced and the ability to purchase more productive assets improved.

Juanah (2005) states that the recent shift in terms from micro-credit to microfinance reflects that

savings services – and not just loans – may help to improve the well-being of the poor in general

and women in particular and that borrowing is riskier than saving.

Credit Facilities

This is the micro-credit component of microfinance services. It involves giving small loans to

poor rural people for relatively short periods and regular and frequent repayment. ―Small

amounts‖ of loan is however a relative term and varies from institution to institution and from

time to time. Credit is usually provided to groups of individuals or village organizations that use

joint-liability to enforce loan repayment. ―If we can come up with a system which allows
everybody access to credit while ensuring excellent repayment – I can give us a guarantee that

poverty will not last long‖ ( Muhammad Yunus 1994 cited in Juanah 2005).

In addition, micro credit reduces reliance on expensive personal and informal exploitative

sources. It enhances the ability of the poor to face external shocks and reduce the distress selling

of their assets. Ultimately, the impact on the household will include higher income, more

diversified sources of income, increased household consumption and better education for the

children. Furthermore, by reducing the severity of poverty, the rural poor are empowered and

their social exclusion is reduced.

Insurance Services

This encourages more saving in financial assets and reduces the risk and potential losses in times

of unforeseen circumstance. Particularly insurance services reduce the impact of external shocks.

As a result of the above, it leads to an increased desire among the rural poor to invest. The

ultimate impacts are greater income, less volatility in consumption and greater security.

Payments and Money Transfer Services

This service facilities the free flow of money and subsequently trade and investments. The easy

transfer of money from one place to another and from person to person is a very effective

instrument in facilitating business between people and places near and far. Thus with banking

services that enhance investors and even individual to easily access money, greater income is

available among people in the rural area and their consumption level increases.
EMPERICAL LITERATURE REVIEW

When one goes through a number of literatures on the impact of microfinance, one can find quite

different results, which are generally indecisive. In some cases, microfinance is said to have

brought positive impacts on the life of the clients by alleviating poverty. Many empirical studies

show that microfinance has positive impacts to boost the ability of poor people to improve the

conditions in which they live. These studies indicate that the poor have taken advantage of

increased earnings to improve consumption levels, send their children to school, and build assets

due to the availability of credit from microfinance. In some other instances, microfinance is said

to play insignificant role towards mitigating the problem of the poor even some time they may be

exacerbate the poverty.

Achievements of microfinance as an instrument for poverty alleviation

Okurut, Banga and Mukugu(2004) emphasize the achievement of microfinances as a means of

access for both financial and non financial services for the poor people.They also stated that

microfinance solve the problem of the poor who are unable to get access in the formal sector by

providing small loan and saving scheme for generating income

Morduch and Haley (2002) found that there is sufficient evidence to show that overwhelmingly

the impacts of microfinance are positive, particularly through increasing income, reducing risk

and vulnerability, and empowering women.

Rena and Tesfy (2006) attempt to analyze the incidence of poverty in the Eritrea with a particular

focus on Agriculture. They also examine with the microfinance institutions particularly the

saving and Micro Credit Program and its impact in reducing the poverty. They conclude that

microfinance has strong capacity to drive economic growth and poverty reduction in Eritrea.
Alemayehu, Abebe and Daniel (2006) assesses the importance of access to credit in explaining

poverty and a poverty trap by using panel data from Ethiopia that covers the period from 1994 to

2000. First they tested whether access to credit matters for the poverty through a parsimonious

poverty-finance model and controlling for the possible endogeneity between access to credit and

the poverty status of the households, they found out that access to credit significantly reduces

absolute poverty. Secondly they attempted to investigate the channel through which finance may

impact on poverty. This is found to be through consumption smoothing and helping to escape the

possibility of escaping a poverty trap which in turn is related to liquidity constraint.

They also examined the importance of access to credit for consumption smoothing. They showed

that access to credit has a positive and significant effect on ‗permanent‘ consumption implying

that credit is an important component of consumption smoothing and hence it is pro-poor as it

enhances the welfare of the households.

Jemal (2008) try to evaluate the impact of microfinance programs on income, expenditure, child

education and women empowerment in Pakistan. An econometric analysis is carried out to

examine the impact with a relatively sizeable sample of about 3,400 respondents (borrowers and

non borrowers) from six large microfinance institutions of Pakistan. Based on the study results

he suggest that microfinance intervention possibly helps in smoothing consumptions and, to

some extent, generating income. The results also confirm an upper hand of matured borrowers in

terms of child school enrollment as the impact coefficients are positive and significant. The

econometrical results regarding women empowerment are mixed, contradictory and in many

cases, unexpected. He also argued that microfinance interventions do not seem to have a

significant positive impact on the different aspects of women empowerment.

Kondo (2008) analyze the impact evaluation study of the Rural Microenterprise Finance Project

(RMFP) in the Philippines. The results of their study show that the program appears to be hitting

only a limited number of the intended target as majority of the existing clients and the incoming

clients are found to be not poor according to official definition. The estimation results show a

mildly significant positive impact on per capita income, per capita total expenditure and per

capita food expenditure of loan availability. This impact, however, was found to be regressive –

negative on poorer households and positive only for households in the richest quartile. The

program has enabled participants to reduce dependence on presumably higher-priced non-

program loans as well as increased the proportion of those having savings. It has also made

program clients busier with larger number of enterprises engaged in and more workers employed

in these enterprises. No significant impact, however, was found on assets and human capital

investments.

Sharma (2000) studied the impact of credit on household food security. He found again and

again that most loans taken by the poor, especially in the informal sector, are for financing

consumption-related expenditure, especially during low-income seasons. Despite this fact, the

effect of credit on the nutritional status of children has generally remained unclear—mainly

because nutritional outcomes are strongly conditioned by many other factors on which credit, by

itself, has little effect. Many microfinance services in Asia and Africa target women on the

assumption that empowering women and targeting services to them leads to better allocation and

use of household resources. According to Sharma, Several studies in Bangladesh support this

assumption, indicating that services directed to women significantly increase assets, incomes,

and educational attainment of children, especially girls. But positive gender effects cannot
always be taken for granted, as other studies, also in Bangladesh, highlight cases where only a

few of the targeted women were able to exercise effective control over loan use.

Many papers examine the impact of microfinance on household expenditures, example

Alemayehu, Abebe and Daniel (2006), Sharma (2000), but several authors argue that the poverty

impact of microfinance can better be examined by considering the impact on self employment

productivity. The reason is that in many developing countries lack of access to productive capital

is one of the main causes of poverty (Coleman, 1999). Very often the poor are involved in

subsistence activities and therefore unable to generate sufficient income for savings and future

investment. In addition, they are often denied credit by formal institutions. As a consequence,

they hardly improve productivity and remain poor. Microcredit programs may provide a way out

of this dilemma as micro credit can have an impact on household self employment profits of

households, thereby contributing to household welfare (McKernan, 2002).

Mckernan (2002) modeled the role of micro credit programs in determining self employment

profit of rural household of Bangladesh. In his research he found that micro credit programs have

large positive impact on productivity since they used the credit to purchase capital. Hence, he

suggests that microcredit programs may be a viable strategy for the alleviation of poverty among

the landless poor.

Access to credit can contribute to a continuing increase in income by means of a rise in

investments in income generating activities and to a possible diversification of sources of

income; It can contribute to an accumulation of assets; It can reduce the vulnerability due to

illness, drought and crop failures, and it can contribute to a better education, health and housing

of the borrower (Modruch 1999). The potential poverty reducing effect of microfinance is also
called attention to Nobel Prize. Mohammad Yunus, the founder of the Grameen Bank, won the

Nobel Peace prize in 2006 for his effort to alleviate poverty through microfinance.

However, several authors doubt that microcredit can contribute to a substantial reduction in

poverty. Many critics show that microfinance does not reach the poorest of the poor. They also

argue that group loans, which are often used by microfinance institutions, lead to high

transaction costs since most microfinance schemes have regular group meetings (Morduch,

1999).

In addition, it has been argued that the size of the needed loan often exceeds the maximum

amount that can be borrowed from microfinance institutions.

Some authors find that microfinance is essential to promoting poverty reduction (Khandker,

1998, Morduch and Haley, 2002 ), while other studies conclude that microfinance is not always

an effective way out of poverty ( Coleman, 1999). Khandker (2005) argues that it is not unlikely

that the impact of microfinance is modest. The reason is that production activities of microcredit

beneficiaries often have a low return, so that gains will be limited as credit constraints are

removed. In addition, evidence suggests that the impact of microfinance remains sensitive to the

choice of income indicator and the poverty line.

Drawbacks of microfinance as an instrument for poverty alleviation

Krishna (2004) in Indian found that, very large numbers of households have escaped from

poverty as a result of microfinance services; but a very large number of households have also

fallen in to poverty during the same time. According to his findings, diversification of income

sources is the most important reason for households escape from poverty whereas poor health,

high health expenses, high interest private debt, and large social and customary expenses

constitute major reasons for households declining in to poverty.

Its undeniable fact that microfinance programs are expanding both in their coverage and in the

range of services offered can be seen as an evidence of their success .However, According to

Islam (2009) microfinance has so many shortcomings, including those concerning

microfinance‘s financial viability, ability to reach the extreme poor, propensity to charge high

interest rate, limited macroeconomic impact and difficulty in scaling up of operations..

Islam (2009) classified Microfinance scholars broadly into two groups. On the one side are those

taking a more narrow financial efficiency point of view. They emphasize the necessity for being

financially solvent and hence recommend such steps as charging break-even interest rates,

scaling up of operations, etc. On the other side are those emphasizing microfinance‘s proven

capacity to reach those who would otherwise remain outside the track of formal financial

services, and microfinance‘s various non-financial but positive benefits. Accordingly these

scholars do not want microfinance to charge high interest rate or service charge and thereby

neglect the poor in order to become financially viable. In fact many of them have argued that it is

worthwhile providing subsidies to microfinance, at least until it reaches financial viability.

Morduch (1999) for example, argued that micro finance programs, because of their goal to

service the poor, should never be expected to be financially viable, and should therefore always

receive subsidy, in particular to help them experiment and innovate.

Concluding Remark
The contribution of microfinance to poverty reduction through the provision of credit and

savings facilities, insurance and money transfer services may be a very viable way forward for

the socio-economic development of poor societies in developing countries. Poverty has long

been a tragic aspect of human society.

Present studies show that poverty, especially in developing countries in general and Africa in

particular, has not considerably declined, irrespective of several poverty reduction strategies

adopted by these countries (UNDP Human Development Report 2003 cited in Juanah 2005).

Microfinance can be a stimulant to several other economic development activities, with a very

serious multiplier effect on rural and overall national economies. This underscores the

importance of enhancing the effectiveness and efficiency of microfinance services in the various

countries of the developing world so as to enable the rapidly growing population of the rural

poor to escape from the trap of absolute poverty. The lack of proper organization, coordination,

best practices and attractive services which target the poorest of the poor, account for the

ineffectiveness of microfinance as a strategy for reducing poverty in the developing countries.

Many poverty reduction strategies including microfinance operations in the developing countries

fail to ensure the full participation of the rural poor, especially the women. These programs have

had very little significance.

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