What are the Pros and Cons of Microfinance?

According to the World Bank's Global Financial Inclusion Database, 2.5 billion adults lacked access to financial services in the year 2011 due to various reasons such as poverty, costs, travel distance and the requirements involved in opening an account. This lack of financial services partly explain the fixated inequality and poverty in the society. While the necessary focus on repayment discipline, which is also the source of success in lending to the poor, implies that microfinance is not the natural or best way to finance entrepreneurs whose aims are to create larger businesses, microfinance nonetheless granted financial access to those that did not have one before (source:kickloans.org). Many scholars over the past decades have examined the role of microfinance institutions in providing financial services to the poor and their impact on poverty reduction.

First, it is important to understand what microfinance really is. Generally, it includes financial services such as loans, savings, insurances, and training to people living in poverty. It all began when several NGOs started to provide small loans to entrepreneurs to start or expand businesses. In the 1970s, the microcredit movement has encouraged many NGOs and even commercial banks, cooperatives, and non-bank institutions to jump in the industry. The Grameen Bank in Bangladesh, founded in 1983 and now serving over 7 million poor Bangladeshi women, is one great success story in the industry. It should be noted that the industry operates heavily not only in developing countries but also in developed countries. In the US, for example, microfinance institutions (list of top 50 microfinance institutions in the world) aim towards low-income and marginalized minority communities.

Supporters of microfinance assert that it contributes to poverty decline through higher employment and higher incomes, leading to improved nutrition and improved education of the borrowers' children. This effect will break the poverty trap that ties people to a fate of poverty. A poverty trap is the process in which low income leads to poor nutrition which in turn causes low productivity and low income, and the children's lack of education leads to low skills and poor job prospects.

On the other hand, microfinance has received many criticisms (microfinance criticisms). It has been argued that microcredit has driven poor households into a debt trap, since the money loaned is used for daily consumption or luxury goods rather than for business investments. In this way, just like many welfare programs, microfinance leads to financial dependence and decreased income. Even in the case of truly determined and enthusiastic new business owners, due to the lack of experience as well as expert advice, a large percentage has failed to generate the income needed to repay the loan and thrive in the long run.

Moreover, because the loans are targeted to very poor households, it cannot effectively generate macro-level economic growth. In fact, one very big drawback of microfinance is that, even if it does not fail, it can only create income opportunities one person at a time and delivering few changes to infrastructure, institutions, or the capacity of the private sector.

There are several ways to fix microfinance's current problems. First, closer examination of small businesses and detailed consultation can be employed so that small businesses have a higher chance to succeed. Second, while not everyone is inclined or able to start their own businesses, certain subsets of the population can adjust to the requirements of self-employment.

Microfinance can provide stability to farmers' uneven revenue, for example, allowing them to invest more in inputs and capital. As the farmers move from subsistence to surplus, the local economies can also thrive. This type of microfinance will have a higher financial self-sufficiency, since the farmers already have a guaranteed, though fluctuating, income.

The burden cannot be put on NGOs that offer microfinance alone. Indeed, poverty alleviation is about addressing a broad set of needs that go beyond economic ones. Social, cultural, and political freedoms do enable individual income growth, and it is difficult for microfinance to make any estimable changes without those. While changing the political structure in many developing countries is extremely challenging, it is important, for now, that the government collaborate with microfinance institutions closely. They can fund research and development projects to suggest and support entrepreneurs, or simplify policies and reduce taxes to make it easier for small businesses, for example.

Written By: Liz Vu, United States (A Vietnamese)

The Economics of Microfinance: A book on Amazon which is an excellent analysis of the evolution of microfinance and the economic theory behind it.

Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics : A book on Amazon with more than 400 customer reviews.

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Edited by: Rajesh Bihani ( Find me on Google+ )

Disclaimer: The suggestions in the article(wherever applicable) are for informational purposes only. They are not intended as medical or any other type of advice