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Microfinance in developing countries: Does it really help?

Updated: Sep 4, 2021

A woman poses with her microfinance “loan recovery” book at her shop in Hyderabad, India

Global poverty levels are on the rise. Almost a half of the world’s population is living on less than $2.50 a day and as reported by UNICEF, poverty kills around 22,000 children daily. Such appalling facts highlight the need for poverty to be addressed and one of the major initiatives of doing so is the institution of microfinance.

Microfinance increases financial inclusion by extending financial services to small businesses and new entrepreneurs, especially in rural and poor areas. The objective of microfinance is to create an environment where low-income earners can easily access good quality financial services to smooth their consumption, purchase assets and fund their daily activities. Microfinance institutions (MFIs) provide not only microcredit (loans), but also microsavings and microinsurance (modified versions of savings and insurance services available in developed countries, with lower transactional costs and premia).

In recent years, there has been much debate about the effectiveness of microfinance in alleviating poverty. This article will cover the positive and negative effects of microfinance in developing countries, particularly in Africa and South Asia (where most of the world’s poor live) and aims to evaluate the future of microfinance in these countries.

Microfinance, the saviour…

Namono Lakeri, a single mother of five living in rural Uganda, is an apt example of the success of microfinance in developing countries. Her receipt of the Women’s Microfinance Initiative (a MFI based in Uganda and Kenya) loan of US$125 enabled her to develop her second-hand clothing business. From being impoverished and helpless, Namono is today an independent and stable income earner and all her children are receiving education. In another part of the world, in Bangladesh, the Grameen Bank founded by Muhammad Yunus has lent money to more than 2.4 million of the poorest in the country as of 2010. As a result, the rural economy of Bangladesh has improved vastly since the inauguration of the bank, improving the income flows of many poor people. These stories are proof that microfinance yields positive results for its recipients in terms of financial empowerment as it provides start-up capital for the poor to develop self-sustaining income sources. Microfinance, particularly microcredit, also improves the economy as a whole because it provides farmers/fishermen with easy access to loans needed to invest in agricultural/fishing technologies. This develops the primary sector of the economy (a key sector for most developing economies as they have abundant natural resources and relatively underdeveloped secondary and tertiary sectors) which feeds back into the Gross Domestic Product, resulting in higher average living standards.

Since most microfinance projects are done collectively in a community, microfinance also promotes community building and cooperation as people work hand in hand to live better lives. For example, a study conducted in Bangladesh by The Agriculture, Forestry and Fisheries Research Information Technology Center revealed that relationships among groups that participated in microfinance became stronger and their social capital increased as compared to groups that did not.

The Dark Side of Microfinance

Microfinance may theoretically be effective in creating financial inclusion but it has a dark side. Although the global microfinance sector has shown impressive growth and is expected to grow by 15-20% by the end of 2015, this growth is unique to certain areas. For instance, numerous areas in Africa and South Asia still do not have access to microfinance: the industry may be booming in Kenya, Ghana and India but many remote villages in Sudan, Democratic Republic of Congo and Afghanistan have never been introduced to the concept of microfinance. This is largely due to geographical constraints, political conflicts and poor governance that hinder the genuine implementation of microfinance.

A remote village in the Nuba mountains of Sudan that has no access to microfinance.

There are also significant gender gaps in certain countries when reviewing the reach of microfinance. For example, microcredit programs in Nepal have been unsuccessful in reaching women in rural areas due to the social and cultural framework of rural, orthodox Nepalese societies.

Moreover, many MFIs in developing economies, especially those in Africa and South Asia, are increasingly having undercapitalisation problems. Lack of safety of property and lives cause MFIs in war-torn countries, such as Afghanistan, to incur more costs. This leads to higher annual interest rates of 30-35% on loans offered, as compared to the typical 25% elsewhere in South Asia. Weak portfolio management and lack of human resources have also resulted in inefficiencies of many African MFIs. A Director at the Central Bank of Nigeria, Alhaji Ahmed Abdullahi, said recently that microfinance banks in Nigeria are generally undercapitalised due to non-performing loans and high overheads, causing a fall in their capital assets and liquidity. If such situations continue to plague MFIs, their ability to provide the poor with adequate financial support will diminish.

Another pitfall of microfinance lies in the way it is practiced. Most MFIs focus on giving out loans; encouraging savings and other forms of financial planning remains secondary as these activities are not profitable for them. By doing so, the poor may be better off in the beginning but without adequate savings, they will not be able to repay the loans when they come due. This could result in mounting debt figures, further pushing the poor into the depth of poverty.

Room for improvement

It is undeniable that microfinance in developing countries is generally much better today than it was many years ago. Progress has certainly been made to make microfinance more inclusive and effective. However, there is still much room for improvement. To expand the reach of microfinance to those who really need it, international organisations, such as The United Nations and the World Bank, should step in to push kleptocratic national and state governments to welcome and support the idea of microfinance. Undercapitalisation issues should be addressed by reorganising spending within MFIs and recruiting more local and international donors to support the cause. Financial education is also key in ensuring that the benefits of microfinance are fully reaped. With proper knowledge on how to plan their finances, the poor can make better use of the loans provided and save accordingly to avoid being heavily indebted. Financial education may also enable the poor to invest in profitable assets or business strategies and lift themselves out of poverty.

The future of microfinance in developing countries

The institution of microfinance is indeed a noble one and can bring much benefit to the poor if implemented properly. There have been admirable initiatives to regulate and streamline microfinance in developing countries, such as the recent move by the Asian Development Bank to provide an additional $50 million to facilitate microfinance programs across Asia. If these efforts continue and are intensified, microfinance will enable developing countries to reduce poverty levels, achieve higher growth rates and embark on a solid journey of catching up with advanced economies. However, it is important to keep in mind that microfinance is not a panacea of poverty, it is merely a tool of poverty reduction which will only work if utilised carefully and correctly. Hence, international and local governments should work alongside developing countries’ citizens, as described in the above section, to ensure the proper implementation of microfinance. Here’s hoping that microfinance takes us many steps closer to realising the dream of a world with zero poverty.

Nareen Kaur Sidhu


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