Tom Clougherty is Research Director of the Globalisation Institute.
The Department of International Development is a body with a noble aim: “eliminating global poverty”. Sadly, DFID has not been an unqualified success. It remains wedded to outdated and discredited ideas about development such as believing that pouring money into government budgets in poor countries will work – often referred to as the “big push” approach to development.
But if long experience has taught us anything it is that this approach does not work. In the last 40 years Africa received roughly $400 billion in foreign aid, but its citizens got poorer. But however disappointing this is, it should not lead to us to abandon international development. There are things that work, things that have been proven to lift people out of poverty. Microfinance is one of them.
Microfinance, broadly speaking, is the provision of financial services to the poor. What distinguishes it from the traditional provision of financial services, apart from the small sums of money involved, is that credit is advanced on the basis of reputation rather than collateral. Since many developing countries lack formal systems of property rights the poor are generally unable to provide collateral – this means that microfinance is the only way for them to access credit. And credit is an essential component of the successful market economy.
Microfinance was pioneered by the Grameen Bank of Bangladesh, which was founded by Professor Muhammad Yunus – winner of the 2006 Nobel Peace Prize. Their method remains central to microfinance today. Money is advanced to small groups, with each group member agreeing to be financially responsible for the others. Group members monitor each other at regular meetings, and social pressure is created to fill the role traditionally filled by collateral. The scheme has been very successful. Studies have shown that during an eight-year period, among the poorest in Bangladesh with no credit available to them, only 4% of people pulled themselves above the poverty line. But among those receiving credit from Grameen the figure rose to almost 50%.
The reason microfinance is so much more successful than traditional forms of development aid is that it is based on the philosophy of the hand-up rather than the handout. It isn’t a top down solution to poverty, it is a bottom-up approach that empowers the poor, harnessing their aspirations and abilities and giving them the opportunity to help themselves – often by starting small businesses and learning to make a profit, providing for their families and often creating employment for others.
Microfinance doesn’t see the world’s poorest people as cases for pity and charity, but rather as consumers and potential clients. It identifies the services the poor want and need and endeavours to provide them. This means that microfinance is always adapting and evolving to meet new challenges – no longer just giving loans, but also leasing agricultural equipment and offering affordable insurance. Increasingly it seems that what the poor really want is access to the same financial services that we all take for granted.
It is often said that microfinance fails to tackle the fundamental causes of poverty in poor countries, that it does nothing to promote good governance or the formalisation of property rights. But this critique is misguided. Microfinance empowers people and makes them wealthier. Over time this creates a growing middle-class that is much harder for governments to ignore and exploit than a great mass of poor people. Furthermore, top-down formalisation of property rights is often prohibitively expensive and fraught with difficulties. But microfinance can help accelerate the organic development of property rights – as it makes people richer the pressure from below to formalise property rights increases and the cost of doing so becomes more realistic.
If there is a problem with microfinance it’s that it doesn’t yet reach enough people. Global demand for microfinance is estimated at between 400 and 500 million households – but only 30 million have access to it. While donor money can help microfinance institutions expand it will only ever be a partial solution. The best way for these institutions to meet the demands of their market is to diversify their operations and become profitable. This is not an outlandish idea: research has already shown that 63 of the world’s top microfinance institutions have an average rate of return of 2.5% of total assets, even after adjusting for inflation and taking out subsidies.
The British government also has a role to play. The Globalisation Institute criticised DFID throughout 2005 – the UN’s year of microfinance – for not paying enough attention to the subject. Even now their approach remains little more than a token gesture – few of their programme partnership agreements even refer to microfinance, and none are with organisations focused on the subject. Microfinance institutions complain that they are left out of these agreements, with DFID preferring to support “big name” development agencies instead. This has to change. Enterprise-based solutions to poverty like this may not sound as dramatic as the “big push” solutions currently favoured by the government but, out on the ground, they really are making the difference between poverty and prosperity.