Micro-financing - March 22

Micro-financing as an economic development tool for has gained traction over the past several decades. It seems to make perfect sense. Poor people in developing countries lack financial capital, so if they can access cheap financing, they will channel their entrepreneurship energy into real commerce that will grow the economy. Micro-financing is customizable across different developing countries, and can tap into the potential of large swathes of the population that normally lack opportunities, such as women and the uneducated. The original micro-financing success story is 

Grameen Bank, founded in Bangladesh in 1976, and later won the Nobel Peace Prize in 2006.

The flaws of microfinancing become evident once we dig deeper into its mechanics. Firstly, microfinancing institutions are almost always subsidized by the government. Without government support, lenders must charge near-usurious rates of 40-50% to cover the loan losses, which are exorbitantly high for any borrower to repay. Second, many borrowers have no intention to repay or to invest in their business at all. A significant portion take out loans for consumption purposes, to pay for one-off expenses like weddings and medical bills. The poor are more likely to use cash to solve immediately pressing problems, because many other expenses take precedence over their business.

Those who do invest in their businesses eventually hit a ceiling. Entrepreneurs in developing countries cannot increase the scale of the company or progress to higher value-add businesses without proper technological, financial, physical, and labour infrastructure. They are also limited by their lack of education and specialized skills, so they produce only the most basic products and services. Micro-financing creates a situation where market supply for basic goods like milk, fruits, and fabrics, skyrocket, and prices plummet. With narrow margins and bleak prospects for business growth, the entrepreneurs are rarely better off.

Microfinancing can work for small businesses in developed countries, where entrepreneurs enjoy an acceptable basic standard of living, and are likely to invest loans into their businesses. They are also much more likely to be able to scale their businesses, and to specialize in niche or high-value sectors, because of the better market infrastructure and more skilled population.

Microfinancing falls short though, as a tool to boost small business growth in developing countries.