Explained: What ails the existing microcredit model

Context

  • Microcredit has gained much traction as a tool for ensuring the welfare of the most impoverished in society, and boosting development alongside.

What is Microcredit?

  • Microcredit refers to the granting of very small loans to impoverished borrowers, with the aim of enabling the borrowers to use that capital to become self-employed and strengthen their businesses.
  • Loans given as microcredit are often given to people who may lack collateral, credit history, or a steady source of income.
  • Microcredit agreements frequently do not require any sort of collateral, and sometimes may not even involve a written agreement, as many recipients of microcredit are often illiterate.
  • When borrowers demonstrate success in paying their loans on time, they become eligible for loans of even larger amounts, allowing them to finance expansion.

The idea behind

  • The core idea of microcredit is that a small loan will provide access to the larger economy to people who typically live outside the scope of the institutions on which the mainstream economy rests.
  • Such a loan is meant to enable them to commence with productive activities, and will give them the initial boost required to gain entry into an industry, after which production will be able to sustain itself, and the loan will gradually be repaid.

Part of Microfinance

  • Microcredit falls under the larger umbrella of microfinance, financial services for individuals who don’t have access to traditional services of this kind.
  • Microfinance activities usually target low-income individuals, with the goal of helping them to become self-sufficient. In this way, microfinance activities have an aim of poverty alleviation as well.
  • An example of a microcredit institution is the Grameen Bank in Bangladesh, founded in 1976 by Mohammed Yunus.
  • The Grameen Bank offers small loans to the impoverished without asking for collateral, and was the pioneering institution in the realm of microfinance.
  • The bank has 8.4 million followers, 97% of whom are women, and the bank has repayment success rates between 95 to 98 percent.

Microcredit institutions are failing in India

  • The article in Ideas for India cites a 2015 study that found “a lack of evidence of transformative effects of microfinance on the average borrower”.
  • Another study found that having access to microcredit made very little difference to changing the lifestyles of borrowers, based on six indicators: household business profits, business expenditures, business revenues, consumption, consumer durables spending, and spending on temptation goods.
  • These indicators only saw a 5% impact when microcredit was available.

Why?

  • The primary reason for the lackadaisical effects of microcredit is the stringent repayment schedule offered by most microcredit institutions.
  • Since most borrowers to whom microcredit is given have little to no credit history as a result of their exclusion from traditional systems of credit.
  • Hence institutions offering microcredit are unable to judge the risk associated with lending to certain borrowers, and cannot be sure what the risk of them defaulting will be.
  • To lower the risk of defaulting, microcredit lenders therefore resort to repayment schedules that demand an initial repayment that is almost immediate, to which borrowers must adhere.
  • The effect of this is that borrowers are unable to use the loans on investments that will take some time to be fully realized.
  • The borrowers instead are forced to use the loans they receive on short term investments that only boost production to an extent, and the overall growth of their incomes remains meager.

What are the other applications of microcredit?

  • Conventionally, microcredit has been used mainly for entrepreneurs to begin production and attain self-sufficiency.
  • Small microcredit loans can allow rural labourers –those who are employees, as opposed to entrepreneurs, who are employers– to migrate to urban areas to find work during the lean season, when there is no work to be found on farms.
  • Those who migrated temporarily during this season experienced increased spending in both food and non-food areas, and increased their calories consumed.
  • Microcredit can be used in situations where seasonal factors cause drops in income to overcome these “seasonal credit crunches” and avoid taking decisions which cause people long-term negative impacts.
  • They can also be used to dampen the effects of shocks like floods by providing people with a form of insurance that both increases production before the shock and provides a safety net after.

Conclusion

  • Microcredit has a vast range of applications for poverty alleviation and general development, but existing systems require reform in multiple areas to allow for unfettered benefits that last.
  • Furthermore, in areas were the application of microcredit is relatively new, microcredit systems must be carefully evaluated before they are put into place, so as to enable the greatest benefit from such institutions.

Source:IE