Microfinance For Your Average Joe - An Introduction to Microfinanceprint resource
This document serves to introduce volunteers who are interested in microfinance to the basic principles and terminology of microfinance. An example of microfinance in action is used to show the impact financial services can have on the local economy from both a micro and macro perspective.
Microfinance For Your Average Joe
What is microfinance and how does it work?
Microfinance refers to formal sector financial services that are made available to poor people. Services like lending, savings and insurance programs that are accessible in the Western world are very often inaccessible to the world’s poor. And why is this you ask? The standard answer is that poor people do not possess the income or assets to mitigate the costs and risks that traditional financial institutions would incur if they offered these services. How can an institution lend money to a poor person who has no property to secure the loan? What recourse does the lender have if the borrower defaults? Will the institution garner enough deposits from the poor to cover the costs associated with the implementation of a savings program? Microfinance organizations, or “MFOs,” attempt to find creative solutions to these problems in order to deliver the aforementioned financial services to the world’s poor. But why?
On the micro-level, microfinance products can lift a poor individual out of poverty by fostering entrepreneurship and the accumulation of assets. In order to explore this idea in greater detail, I will use the following example of Average Joe.
Imagine a guy named Joe. Joe is poor and lives on an average of $2 a day. To make ends meet, he holds down two part-time jobs: tomato canner and rickshaw driver. Joe does not own the tomatoes he picks, nor does he own the rickshaw he drives. He is paid a meager commission by a cannery for each can of tomatoes he produces, and he works for tips pedaling passengers around in his neighbor’s rickshaw.
Enter the MFO. The MFO sees that Joe is poor and is struggling. The MFO also sees, however, that Joe has skills, work experience and financial savvy. The latter trait is illustrated by Joe’s ability to overcome the odds to provide for himself and his family amidst such a capricious economic situation. Joe’s skills and drive prove to the MFO that he would be a good candidate to receive financial services.
The MFO lends Joe a small amount of money to buy his own tomato seeds, cans and salt. This loan, called microcredit lending in microfinance parlance, is completely unsecured. Joe’s only incentive to repay the loan is the fact that if he does, he will then have access to more loans with a larger principal amount. Joe finds the microcredit loan attractive because the interest rates are much lower than the 100% interest rate that the local moneylender charges. The MFO loan also comes with a personal finance class and the support of the MFO staff.
Joe’s tomato loan proves to be a success. He is able to grow his own small crop, can it and sell the finished product to the cannery that employed him as a seasonal laborer. Joe then uses the revenue earned from selling the product to pay off the loan, and in turn, take out another loan. He repeats this process until he has enough net proceeds to purchase his own rickshaw, which he leases to a cousin. Over time, Joe pays off his outstanding debt and finds himself the owner of two small businesses. He has started saving money through an MFO savings account, which is the only savings account in his area that pays account holders interest on their deposits. More importantly, the MFO savings account is a much safer place to store his money than in his own house or with a relative. Joe hopes to use the savings one day to pay for the education of his children.
Joe’s example illustrates what microfinance can potentially accomplish on the individual level, but other proponents suggest that it can be just as beneficial on the macro-level. In Joe’s case, his infusion of capital into the local economy through the purchase of tomato seeds and a rickshaw would benefit not only Joe, but also the tomato seed vendor and the rickshaw dealer. Joe’s cousin the newly-hired rickshaw driver injects at least part of his new income back into the local economy with every good he purchases. And the education of Joe’s children will hopefully afford them higher income-earning job opportunities in the future, which, in turn, could lead to the local investment of higher wages and human capital. These scenarios illustrate that Joe’s income generation can cause ripple effects that benefit his countrymen.
Even if Joe does not use his loan to start a business, the positive ripple effects can still exist. Perhaps Joe uses the MFO loan to pay down more expensive debt and purchase food. The debt refinancing will mean that Joe can keep more money in his pocket and potentially get back on his feet, while the consumption of goods equals money pumped into the local economy. Sounds like a win-win all around.
Joe is a great example of microfinance gone right. But can it go wrong? Absolutely. Usurious interest rates on microcredit loans, dubious lending practices, fraudulent savings programs, aggressive debt collection policies, lack of educational training and debates on who should qualify for MFO services are all hot topics in microfinance. Adding to these concerns are the fact that many new for-profit MFOs have been added to the fray, tempted by the returns from high interest rates charged on microcredit loans. I will address these concerns, as well as why microfinance interest rates are higher than rates on conventional loans, in a later post. But for now I hope you enjoyed the story of microfinance gone right – Average Joe!