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Saturday, October 14, 2006

Microcredit

As noted in email I've received and in comments, I have been negligent in not yet acknowledging this year's Nobel prize winner, Bangladeshi economist Muhammad Yunus, for his work on microcredit through the Grameen Bank. Here are some passages from a New Times article followed by a commentary by Hal Varian explaining the economics underlying microcredit arrangements (thanks anne):

Peace Prize to Pioneer of Loans to Poor No Bank Would Touch, by Celia W. Dugger, NY Times: A Bangladeshi economist, Muhammad Yunus, and the bank he founded 30 years ago won the Nobel Peace Prize yesterday for pioneering work in giving tiny loans to millions of poor people no commercial bank would touch — destitute widows and abandoned wives, landless laborers and rickshaw drivers, sweepers and beggars.

The Nobel Committee praised Mr. Yunus, 66, and the Grameen Bank for making microcredit ... a practical solution to combating rural poverty in Bangladesh and inspiring similar schemes across the developing world.

“Microcredit has proved to be an important liberating force in societies where women in particular have to struggle against repressive social and economic conditions,” the committee said in announcing the prize.

Mr. Yunus has long been an influential champion of the idea that even the most impoverished people have the drive and creativity to build small businesses with loans as small as $12, and Grameen Bank has dedicated itself to helping the poorest of the poor.

The borrowers used the money to buy milk-giving cows, or bamboo to craft stools, or yarn to weave into stoles, or incense to sell in stalls, among myriad other money-making schemes.

Reached in Dhaka, Bangladesh, by telephone yesterday, Mr. Yunus recalled the day in 1976 when he reached into his own pocket to give his first loan, $27, to 42 villagers living near Chittagong University where he said he was then teaching “elegant theories of economics.” The borrowers invested the money and repaid him in full, though they had no collateral and signed nothing.

He said he asked himself that day, “If you can make so many people so happy with such a small amount of money, why shouldn’t you do more of it?”

Still, over the years, Mr. Yunus faced skeptics and detractors, as it became clear that microcredit loans, alluring as they were, were not by themselves a panacea for poverty. ...

But in interviews yesterday, Mr. Yunus’s skeptics and fans alike credited him and Grameen with helping to fundamentally change the way the world saw the potential of poor people and to popularize the movement to provide financial services to the poor. ...

Or, as the Nobel committee put it: “Yunus’s long-term vision is to eliminate poverty in the world. That vision cannot be realized by means of microcredit alone. But Muhammad Yunus and Grameen Bank have shown that, in the continuing effort to achieve it, microcredit must play a major part.” ...

Indeed, in the decades since Mr. Yunus’s first loan, microcredit has become one of the most popular antipoverty strategies in the world. Last year, more than 100 million people received small loans from more than 3,100 institutions in 130 countries, according to Microcredit Summit, a Washington-based nonprofit advocacy group that Mr. Yunus helped found. The average loan from Grameen Bank was $130.

Over the years, the movement to provide financial services to the poor has become more capacious, stressing the need for services beyond loans — for safe places to save small amounts of money, for crop and life insurance, for inexpensive ways to transfer money earned in distant cities and foreign countries to families back home. ...

In 1974, Mr. Yunus, trained as an economist at Vanderbilt University, found himself teaching economics at Chittagong University when Bangladesh was struck by famine. “I decided I must do something,” he said. He began working in nearby villages, among them Jobra, where he made his first loan in 1976.

He said he tried to persuade commercial banks to give loans to poor people who had no assets and had always been dependent on local moneylenders. But the bankers only did so when he personally co-signed as a guarantor.

Mr. Yunus’s new model of banking for the poor had several unusual features, Professor Morduch said. Grameen lent to groups of five people, who helped ensure that each member repaid his or her share. It lent not only to farmers, but also to laborers and women who had a knack for crafts and shopkeeping. And it required borrowers to repay their loans in manageable, bite-sized weekly installments.

“He proved the impossible: that the poor were bankable,” Professor Morduch said.

But Mr. Yunus’s approach went beyond giving the poor economic opportunity to seeking deeper social change, said Amartya Sen, who, like Mr. Yunus, is a Bengali, an economist and a Nobel prize winner.

Mr. Sen, a professor at Harvard, noted that Grameen’s loans had gone overwhelmingly to women, giving financial clout to women who had little power in Bangladeshi society and often lived cloistered in their homes.

In the overwhelmingly Muslim nation of Bangladesh, Mr. Yunus’s approach also offered hope and ideas to compete with the allure of fundamentalist Islamic causes.

“It’s a very secular movement,” Professor Sen said, “very egalitarian, market friendly and socially radical.” ...

Here's Hal Varian. This was written in 2001 so it was written before the prize was awarded:

In a model for lending in developing nations, a Bangladesh bank relies on peer pressure for collateral, by Hal R. Varian, Commentary, New York Times: The village moneylender in Bangladesh charges interest rates of over 150 percent a year. Citibank would love to get that kind of return on its investments -- so why isn't Citibank lending money in Bangladesh villages?

This is a serious question, in terms of both policy and profit. The painfully high interest rates charged by moneylenders in developing countries suggest that marginal investment opportunities there are much more profitable than in advanced industrial nations.

So why isn't there a rush of investment from Western banks to exploit these profitable opportunities -- and, as a byproduct, increase the pace of economic development in these countries?

There are several barriers to entry in the lending business in developing countries, many of which have to do with the information advantages that incumbent moneylenders have over potential entrants.

To begin, the local moneylender is intimately familiar with his clientele, and this gives him a huge information advantage over a bank officer in selecting reliable loan recipients. At the same time, the moneylender is in a very good position to monitor borrowers since he can check up on their activities daily.

Local moneylenders are also familiar with village customs and practices and can offer useful business advice; they are also in a good position to provide informal insurance to the loan recipients, too, since they know when a nonperforming loan is caused by outside causes, like bad weather, and when laziness is the cause.

Finally, moneylenders operate at a much smaller scale than Citibank does. Most of these loans are minuscule by Western standards, and Citibank just is not set up to handle tiny investments, even if they are potentially very profitable.

These factors -- selection costs, monitoring costs, local experience, insurance and inappropriate scale -- conspire to create a virtual monopoly for the moneylender. Even moneylenders from neighboring villages might find it hard to compete with someone who has an intimate knowledge of a particular village's inhabitants. The result is tens of thousands of tiny monopolies and many profitable projects that are never undertaken because of the high cost of borrowing.

But there is hope. About 25 years ago Muhammad Yunus, a Bangladeshi economist trained in the United States, developed a lending model that managed to overcome these kinds of barriers. His business model for microcredit has been immensely successful, spawning imitators the world over.

Most of these lenders are nonprofits, but they are self-supporting nonprofits, which do not require subsidies or loan guarantees. There are even a few for-profit enterprises experimenting with the Yunus microcredit model.

Mr. Yunus put his plan into effect through an institution he called the Grameen Bank.

The critical feature of the program is that a candidate for a loan must form a group with four other people who are not family members. Two members of the group originally receive a loan, and if they do well, the others then receive loans.

The borrowers are encouraged to assist each other, and all loan disbursements and repayments are made publicly, in front of other groups. Loans are always for one year, at a fixed interest rate of 20 percent, and they are always for modest amounts: no more than a few hundred dollars.

The borrowers use the loans to buy looms, chickens, cows and make other small capital investments. They start repaying the loan two weeks after getting it, and once they have repaid the initial loan, they are allowed to apply for new ones.

How does this business model solve the information problems described above? First, take the selection problem. The Grameen design provides strong incentive for good borrowers to join together, since they don't want to risk losing a loan because of one failure or troublemaker. The fact that they cannot join with other family members removes one sort of pressure to dilute group quality.

Second, the members of the group have an incentive to monitor one another's activities actively. They can provide advice, assistance, education and, if necessary, insurance. The group members themselves are in the best position to know whether a recipient is slacking off or has just had a run of bad luck, and they have great incentives to monitor their behavior in an honest and helpful way.

Third, all of this selection, monitoring, educating and insuring is done not by high-paid professionals, but by Bangladeshi peasants. The transactions costs of using groups are far, far lower than are the transactions costs for traditional bank loans.

There are other interesting economic angles. Over 90 percent of the borrowers are women. This isn't so much an ideological choice as a pragmatic one -- women turned out to be better credit risks. They were more tightly tied to the home and had fewer outside temptations, so they focused much more intently than did male borrowers on completing their projects.

All this seems to work. The bank says it has a repayment rate of 99 percent, and over 92 percent of the bank's shares are owned by the borrowers. Peer pressure can be an immensely strong force, and the Grameen Bank has figured out how to make it work in the cause of economic development.

Experiments elsewhere haven't been uniformly successful. In some countries, the poverty stricken do not have enough group solidarity to provide the necessary discipline. In more urban settings, it may be difficult to find appropriate small-scale investments. But there are numerous successful operations inspired by the Grameen bank.

One program, Project Enterprise, runs a Grameen-type program for minority entrepreneurs in New York.

To answer the question posed in the first paragraph: Citibank and other Western banks are well aware of the Grameen model. In 1999 the Citigroup Foundation donated $1 million to the program.

Citibank, along with others, is currently experimenting with microlending in India and other developing countries. Multinational banks may yet find ways to break the moneylenders' monopolies and finance microinvestment in poor countries.

Access to capital is critical for economic development. Grameen and its many offspring, both nonprofit and for-profit, offer an exciting model for alleviating poverty.

    Posted by on Saturday, October 14, 2006 at 12:33 PM in Economics, Financial System | Permalink  TrackBack (2)  Comments (18)

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