28/10/2013 10:20 GMT | Updated 23/01/2014 18:58 GMT

The Trouble With Microfinance

Microfinance fills a specific gap in the market: financial products for those too poor to access normal credit. But it turns out that not all credit is equal.

A nice little piece of publicity has accompanied the launch of, the latest internet-based peer-to-peer credit agency, following in the footsteps of Kiva and other groups. It has produced a YouTube video, which has of course gone viral, of Ugandan women entrepreneurs singing (miming?) to the Jessie J song Price Tag.

It's not about the money, money, money / We don't need your money, money, money / We just wanna make the world dance / Forget about the price tag.

Let's skip aside any questions of cultural discordancy, patronisation, or the fact that Uganda has any number of really great, often European-produced, performing artists such as Bebe Cool, Bobi Wine and Iryn Namubiru, none of whom are adverse to a bit of bling, who would have been more appropriate (and you may not have had to teach people the lyrics either...). Is microfinance a magic bullet for poverty, as its supporters claim, or just another way to ensure the poor don't play by the same rules as the rich, as its critics suggest?

Microfinance has had a bad rap recently. The cool, 'activist', microfinance business model, led by organisations such as Kiva and FINCA has been criticised for the rates of interest charged, leading some to accuse them of usurious behaviour. Perhaps a more lasting charge is that many of these institutions cannot decide if they are charities or a financial service that, mission aside, still have to survive in a marketplace.

Microfinance fills a specific gap in the market: financial products for those too poor to access normal credit. But it turns out that not all credit is equal. A bank will loan a billion pounds to a large corporation because they are willing to take a relatively modest return on such a large sum, as this still works out as a lot of money. But a bank would never loan to a single borrower on these terms. They would either expect a guaranteed return, or would take an equity stake and a say over how the business is run.

Microfinance subverts the logic of lending by making trust the collateral, and absorbs the losses of extra due diligence either by being especially stringent in its lending criteria, or by collecting a very large return on investment from borrowers.

Microfinance has been transformed in the last fifteen years from the dusty, unglamorous lot of agricultural extension banks and rural development programmes to hi-tech, internet-savvy apps that allow graphic designers in Seattle to lend to pig-farmers in Soroti. The ultimate accolade came in 2006 with the award of the Nobel Peace Prize to Mohammed Yunus and Grameen Bank in Bangladesh for their work which grew out of the realisation that communes of lenders in rural areas could collectively guarantee loans to a group through mutual support, peer pressure, and ultimately social ostracism if borrowers defaulted on loans.

It was the realisation that return on investment for the lender was not only relative to the interest charged but also to the size of the loan that created a gap in the market for social enterprise and charitable investment given the social return on investment that could be created in its place.

But in the last few years cracks have appeared in microfinance (which includes microcredit, microinsurance, and a whole host of other innovations). Criticism has focused on loaning money to budding entrepreneurs who find that although they are able to borrow for the first time, they are unable to grow because any profit gets eaten up in debt servicing. Or, to put it another way, a small business relying on an unsecured loan will need to grow at a faster rate than a large business, in addition to the normal pressures of competing in an open marketplace.

It serves to reinforce the point, an uncomfortable one for development workers, that attempts to change the rules for the modern poor often come unstuck when they face the reality of how things work for rich people, a point made by Ha-Joon Chang in his book 23 Things They Don't Tell You About Capitalism. People in England or America didn't work their way out of poverty by some benevolent force extending small loans. Landowners gave way to merchants who gave way to industrialists through innovation and quite a bit of social disruption.

Until recently, finance that couldn't be raised through taxation was micro because business was micro. It was only when capital became globalised (that is moved easily across borders, aided by deregulation) that it took on independent power in its own right. And it is relative ability to access this transnational capital that explains the economic difference between a country like Uganda and a country like the UK, rather than individual entrepreneurs' ability to start small enterprises.

The first corporations such as the East India Company needed a new organisational model because they proposed to do something different to normal businesses. They needed large amounts of capital (that only monarchs had access to) in order to fund a business model of conquest that would provide a healthy rate of return.

Institutions designed to create and fund Empire are still the reason why poor countries remain poor. Not because Goldman Sachs and Exxon-Mobil are engaged in a plot to impoverish Mozambique (the plot, such as it exists, is to maximise revenue and minimise costs) but because an economic system designed around the idea of the corporation, where growth is the most important feature and efficiency is conflated with efficacy, will always find it easier and safer to invest in big things than small things.

The lack of domestic big business in many poor countries leaves the door open for transnational capital and means that the greatest economic advantage rich countries have over poor countries, a mutual symbiosis between firms and the state and all the goodies that go with this such as revenue, employment and infrastructure, becomes self-reinforcing.

Microfinance, as useful as it may sometimes be in reducing poverty, is of limited use in long-term economic development: the macrofinance needed to create economies of scale, increase productivity, and invest in infrastructure and effective institutions. Financial innovations will continue, and the fashion now is for Conditional Cash Transfers (CCT's). But this doesn't alter the basic rules of economic development. Small firms become big firms by reinvesting the fruits of their productivity, creating economies of scale, and investing through taxation in the long-term viability of the state. The danger of microfinance is that it promotes the worldview that poverty reduction, rather than economic transformation, is the central purpose of development.

The trouble is, it is about the money.