Microcredit loans and microbanking on the whole are often cited as a potential route out of poverty for some of the world’s most impoverished. Without the ability to borrow, many of the world’s poorest are destined to a life at subsistence levels. For example, a farmer who wants to increase crop production from one year to the next either needs to save the money to plant more in a coming year, or needs a loan advanced on the ability to repay from the following year’s crops. Without that source of wealth to invest in an entrepreneurial activity, that farmer is limited in the ability to expand his efforts from subsistence to a growing source of wealth.
The poorest among us are sometimes hindered in their ability to access traditional financing because of two aspects of most lending: it is based on collateral and a history of creditworthiness. Most of the poor have nothing to put up as collateral and no history of making timely debt payments to other creditors. They are often, therefore, stuck in a cycle of poverty and living from hand to mouth.
Microcredit loans have the potential to overcome those barriers because they are not dependent on capital for collateral and because they focus more on the future than on past performance. Instead of asking how the applicant has done with paying back debt in the past, the microlender evaluates the prospect that the borrower will be able to turn a small loan into the foundations of successful business. The risk of failure is often high by traditional lending rules, but microcredit lenders limit their risk in individual cases by keeping the amount of the loan small, and not advancing new loans until the first is paid.
There is some criticism of the extent to which microcredit can fight poverty. First, some lenders charge interest rates that are higher than typical loans. There is the potential that a borrower could find himself or herself with little left to build a small enterprise after making those payments. Lenders counter that they boast a surprisingly high repayment rate despite the fact that most of the borrowers would not otherwise qualify for credit, and that the slightly higher rates are necessary to counter the inefficiencies of the micro lending market and the risks of default. Other criticism of the program centers on the extent to which women, who are often the target of the microcredit loans, might be manipulated by husbands into taking the risk and handing the financial rewards to the men in the home.
More significantly, microcredit will have limited success without strong systems of private property and savings. For example, a microloan to buy a sewing machine to start a tailor business is only one step to turning a tailor into an entrepreneur. The tailor needs to be confident that the sewing machine he buys will not be taken, either by other individuals or by the state, and set him back to square one. And in order to grow his tailoring business, the tailor needs a reliable way to store wealth in some type of savings institution so that future growth does not rely on loans, but can be funded through capital expenditure, allowing the tailor to escape from debt and build wealth.
The verdict is not yet in on microcredit loans and their ability to help fight poverty. But with several decades of experience now starting to show signs of progress, the industry has moved beyond the experimental stage and is becoming a mainstream method of lifting future entrepreneurs out of poverty.