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SYNERGIES BETWEEN CLUSTER DEVELOPMENT AND MICROFINANCE 7iii) Benefits of Microcredit In contrast to conventional bank clients, the economically active poor typically need smaller loans and for shorter durations. They are more sensitive to location, bureaucratic procedures, delays of credit provision and repayment schedules. Microcredit can be a viable alternative to informal financial sources for the economically active poor. It enables access to loans at a much lower price than informal sources, but maintains the ease of access, simple procedures, rapid transactions and flexible loan terms that characterise informal financial markets.
Microcredit programmes have become a favourite strategy of governments and donors to stimulate income-generation and employment creation for the poor. By improving poor people’s access to working capital, enabling productive investments and allowing the poor to take advantage of business opportunities, microcredit has the potential to encourage the development of new businesses owned by the poor and to help existing microenterprises grow or diversify their activities. Microcredit can reduce the vulnerability of poor households by facilitating income diversification and allowing consumption smoothing or by enabling microenterprises to remain in business in times of crisis. It can increase the incomes of women and marginalized groups. All this can be achieved through financially self-sufficient institutions.
The private sector is also becoming aware of the benefits of microcredit. A growing number of commercial banks are developing microfinance activities as a new and profitable business segment. Whereas many international banks have funded microfinance activities as part of their corporate social responsibility agenda for several years now, they are increasingly realising that expanding operations to meet the vast number of lowincome clients that lie at the “bottom of the pyramid” makes good business sense4.
iv) Microcredit Delivery There is significant debate over whether microcredit should be restricted to productive uses or whether consumption loans should also be provided. Proponents of the former argue that only investments in productive uses will entail sufficient returns to enable loan repayment. Advocates of consumption loans counter that loans for consumption purposes are often highly productive. By increasing household liquidity and helping to avoid the higher interest rates of moneylenders, consumption loans free enterprise revenue, which can be directed back into the business in the form of retained earnings. They enable a household to make important investments in education, nutrition and health which in turn strengthen income-generation capabilities, e.g. by allowing sick family members to return to work. Proponents of consumption loans also point to the fact that money is fungible and that it can never be determined with confidence what loans to a household are used for.
Although households may claim to use loans for productive purposes, they may in fact use The “bottom of the pyramid” consists of the 4 billion people in the world earning less than $1,500 per year.
Although their individual incomes are low, their combined purchasing power represents a vast, and largely unexplored, market for the private sector. Since the products and services available to the poor are typically substandard, targeting the “bottom of the pyramid” not only makes economic sense for the private sector, but also contributes to poverty alleviation by providing poor people with services and consumer products, increasing their choices and reducing prices (Commission on the Private Sector & Development, 2004).
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8 SME TECHNICAL WORKING PAPERS SERIEStheir own savings for productive investments and divert the loan to non-productive uses.
Finally, it is argued that access to credit exclusively for microenterprise development is likely to be less valued by poor households than credit which can also be accessed in times of emergency. Some microfinance providers have therefore developed special loan products for education, housing and other consumption purposes.
Most microcredit providers follow a group-based lending approach, which is modelled on informal lending and savings groups, such as rotating savings and credit associations (ROSCAs)5. In group lending schemes, borrowers are required to form groups with people of their own choosing, so-called solidarity or, in the Indian context, self-help groups.
Loans are either extended to individual members of a group or (as in the Indian case) to the entire group, which then on-lends to individual members. In most schemes, if one or more members of a group fail to repay their loan, no other member of that group receives a loan until the defaulting borrower’s debt is repaid. Conventional collateral is thus replaced by peer pressure and/or group guarantees, enabling poor people without assets to obtain credit. In addition to financial benefits, belonging to a self-help group has considerable social advantages. Groups represent a network of people to rely on in times of emergency and can thus function as social safety nets. Experience shows that they can facilitate skills development and the building of confidence and trust. Group membership can thus foster the creation of social capital.
The benefits of group-based lending may be even higher for microfinance providers than for group members. It was seen above that the costs involved in administering small loans, high risk, asymmetric information and lack of collateral are the main deterrents to smallscale lending. Group-based lending approaches address all these factors. By using selfselecting groups that are liable for one another’s debts, microfinance providers can reduce risk and shift screening, monitoring and debt collection costs to the borrowers. Lenders’ costs are further reduced by alleviating the need for loan officers to disburse loans and collect repayments from individual members. They can instead deal with the group leader.
Asymmetric information is overcome since group members are typically from the same neighbourhood and have in-depth knowledge about each other. Peer pressure, group liability and compulsory savings have proven to be good substitutes for physical collateral. Group-based lending is thus cheaper and more effective for microfinance providers than providing loans to individual borrowers.
Although group-based lending is typically presented as the solution to overcoming the difficulties involved in the provision of financial services to the poor, it is not without problems. Firstly, for group members, participation in a self-help group represents significant costs in terms of time spent at meetings and risk of guaranteeing other members’ loans6. For women in particular, microfinance may lead to an increased A ROSCA is a voluntary group in which all members contribute a predetermined amount at weekly or monthly meetings. Members then take turns to receive the full amount collected. This continues until all members have received funds, after which the ROSCA is dissolved or a new round is started. The order in which members receive funds is established by lottery, joint consensus or need. However, unlike groupbased microfinance approaches, ROSCAs lack flexibility in that members cannot always receive a loan when they need it or for the amount required.
The group discipline which is imposed, including compulsory attendance of meetings and small and fixed © United Nations Industrial Development Organization
SYNERGIES BETWEEN CLUSTER DEVELOPMENT AND MICROFINANCE 9workload because traditional responsibilities such as household chores and child rearing are not reduced while they become involved in time-consuming meetings and incomegenerating activities. Secondly, peer pressure may sometimes be excessive. There are incidents in which pressure exerted by peers (and sometimes bank workers) to ensure timely repayment has been so strong that borrowers have resorted to moneylenders to be able to repay the loans of microfinance providers, or in which peer pressure has led to emotional distress and even suicides. Thirdly, self-selection of groups often results in the exclusion of the poorest and most vulnerable. Fourthly, individual members and banks do not build a relationship over time and banks may need to incur group training costs.
Fifthly, although repayment rates of group-based lending seem to be higher than those of individual lending in good years, the repayment rates may be worse in years with some type of crisis. If several group members are unable to repay, the entire group may collapse (Ledgerwood, 1999). Sixthly, group members have to share the details of their financial needs with others. In this sense, group-based microcredit schemes might be demanding something of the poor that those operating the schemes would not accept for themselves (Harper, 2003a). Finally, some borrowers may require loans that are too big for self-help groups to guarantee. For these borrowers, access to individual loans outside the group system is important.
Although microcredit is often associated with group-based lending approaches, this is not the only mechanism to administer it. There are several examples of institutions effectively providing microcredit to individuals, such as Bank Rakyat Indonesia or the Fédération des Caisses d’Epargne et de Credit Agricole Mutuel in Benin. In contrast to group-based schemes, individual lending is more similar to conventional banking. Lending decisions are based on client characteristics such as debt capacity, financial history, collateral or coguarantees. However, collateral is typically defined more flexibly than by conventional lenders and more emphasis is placed on character references. Since individual lending requires that staff develop close relationships with clients, loan appraisal is more costly in an individual approach than in group-based lending7. Loans are therefore typically larger than in group-based approaches and tend to be suitable for production-oriented businesses.
Due to the larger loan sizes and collateral requirements, microfinance providers extending individual loans thus typically do not reach as poor people as those using group-based approaches (Ledgerwood, 1999).
Some microfinance providers have recently begun to issue credit cards as a new form of administering microcredit on an individual basis, allowing clients to access a line of credit to make purchases or obtain cash up to a certain limit at their own discretion. Credit card schemes significantly reduce administrative and operating costs for both clients and lenders. The availability of an ongoing credit line allows borrowers to supplement their cash flow according to their needs and to smooth consumption during income shortfalls.
However, for credit card schemes to be effective, the adequate infrastructure (i.e. cash dispensers and retailers or wholesalers able to accept credit cards) must be in place.
savings, are intended to deter richer people from participating. Richer people are likely to find the procedures involved in group lending too cumbersome and may be able to find cheaper loans elsewhere.
However, individual lending models may be less labour-intensive to establish than group-based models since groups do not have to be created first.
The use of credit cards as a means of administering microcredit is still relatively recent.
The Kisan Credit Card Scheme for farmers in India illustrates the main benefits of credit card schemes (see box 1.3).
Box 1.3 The Kisan Credit Card Scheme in India With the introduction of the Kisan Credit Card (KCC) Scheme in 1998, the National Bank for Agriculture and Rural Development (NABARD) has pioneered an innovative credit delivery mechanism which ensures adequate and timely access to credit for participating farmers. Eligible farmers obtain a revolving cash credit facility which allows any number of withdrawals and repayments within a specified limit. The maximum period of repayment for each withdrawal is twelve months. Cards are valid for three years, subject to annual review. Credit limits may be increased as an incentive for good performance. In March 2002, 23.8 million KCCs had been issued by participating banks.
For farmers, the benefits of the scheme are significant. The credit cards enable farmers to purchase agricultural inputs such as seeds, fertilisers or pesticides, and to withdraw cash for production needs whenever required. Since participating farmers can obtain credit at any time, they no longer need to take out large loans at the beginning of a period and can thus significantly reduce their interest costs. Bureaucratic procedures are minimised and, depending on the bank, cash withdrawals are possible at branches other than the issuing branch. KCC holders are also eligible for a personal accident insurance scheme, which covers them against death or permanent disability resulting from accident.
Participating banks also benefit from the scheme. Transaction costs are reduced since repeat appraisal and processing of loan applications can be avoided and paper work is minimised. The recycling of funds is facilitated and banker-client relations may improve.
Source: NABARD (2004)
v) Risks of Microcredit Despite the obvious benefits of microcredit for the poor, there is a need to be aware of the unintended consequences it may have. The other side of microcredit is ‘microdebt’. The economically active poor do not always have business opportunities to exploit and due to lack of skills or information, bad decisions or events beyond their control, they are not always able to repay their loans (Hulme, 2000). Business failure and the resulting inability to repay loans do not only have adverse economic effects on the poor, but can also result in a further loss of self-confidence from an already low level. In some cases, intrahousehold tensions may also rise because households experience difficulties in repaying loans or because husbands do not approve of their wife’s participation in microcredit schemes. Nevertheless, most impact assessments of microfinance programmes report positive or neutral findings (Simanowitz & Walter, 2002).
Although discussions on microfinance tend to focus on microcredit, other financial services such as savings facilities, insurance and payment services are at least of equal importance to the economically active poor.