Don't Mess Up Micro-Credit

GlobalGiving facilitates grants. As I said in the San Jose Mercury News yesterday:

"There is no silver bullet in development and poverty reduction. Some things can be funded through microcredit and others need grants." To be successful, Whittle said, people need such basics as health care, clean water, education and transportation.

These "basics" - the things that people need to be healthy, hold productive jobs, and live a dignified life - are the things that we provide through GlobalGiving.

Microcredit has been in the news a lot recently, however, and many people ask me about its relationship to grants. This morning, Tyler Cowen quotes Dean Karlan and Jonathan Zinman, from today's WSJ, "In Defense of Usury," p.A18:

Charge 80% per year on a loan in the U.S. and you're called a usurer. Charge 80% on a loan in Latin America or Africa and you can be a poverty-alleviation charity.

They are right about the appropriateness of charging market rates of interest for micro-credit in developing countries. But they are wrong to conflate that with charity or grants. In fact, subsidizing micro-credit via lower interest rates is usually a bad idea.

One of the most successful micro-credit schemes in the world has been KUPEDES in Indonesia. When I was working in Jakarta for the World Bank in the 1980s and early 90s, KUPEDES was charging about 33% nominal rates (20% real). Their surveys showed that their borrowers were much better off, and get this: KUPEDES was also the biggest money maker for the bank involved, BRI. It was a real win-win.

Few people have heard about KUPEDES. You know why? BRI's management hated the limelight. They intentionally did not brag about their success because there would have been pressure on them to lower their interest rates. BRI's management understood that, in order to be sustainable, the program had to be run on market principles.

I know this first hand: in the late 1980s I tried to lend BRI several hundred million dollars at subsidized rates, and the president told me no. I was shocked! Who would turn down cheap money? He said they would rather raise the money from deposits, since that was healthier. I asked him where they were going to get the deposits, and he pulled out a ledger showing me that their branches were mobilizing a lot of savings from the same communities they were lending money into.

That taught me a lesson about microcredit I have never forgotten.

There can be a healthy role for outside finance in micro-credit. Modern banks borrow through national and international bond markets all the time. There can even be a role for grants when micro-credit organizations are initially setting up operations, which can be very costly. Grants can also help bring excluded, vulnerable or traumatized populations into the micro-credit system. (We facilitate things like this in Bosnia through GlobalGiving.)

But overall, market-based financing works best for micro-credit. A World Bank report summed it up best:

First, it is possible to create a microlending program that serves the poor and is profitable and self-sustaining. But to succeed the bank units will need to lend at market rates, use their income to finance their operations, and devise appropriate savings instruments to attract depositors. Second, developing a savings instrument for the poor is at least as important as providing them with loans. In Indonesia, SIMPEDES, the village savings program, attracted thousands of depositors. And by mobilizing rural savings, it not only provided the banks with a stable source of funds, it also kept financial savings in rural areas, thus helping continue development in the countryside.