Introduction

Chapter 2: The importance of microfinance

This chapter provides the context for the detailed discussion of the policy and regulatory environment for microfinance in chapters 3, 4 and 5. Section 2.2 examines the incidence of poverty in the nine countries included in the study, while section 2.3 goes on to consider the role of microfinance in the overall policy framework for poverty reduction. The recent development of a microfinance ‘sector’, involving specialist microfinance institutions (MFIs) which provide financial services to the poor in an innovative and commercially viable manner, is considered briefly in section 2.4. Section 2.5 discusses the current outreach and self-sufficiency of microfinance programs in the region, while section 2.6 summarises the key points.

The nine countries included in the study had a total population of some 1,559 million in 1995, around 27.5 per cent of the world’s population. They include four of the ten most populous countries in the world, namely India, Indonesia, Pakistan and Bangladesh. Based on national definitions, nearly 500 million people in the nine countries, or 32 per cent of the total population, were living in poverty. More than 425 million of these were in the three large countries in South Asia, namely India (325 million), Bangladesh (57 million) and Pakistan (44 million).

Some basic indicators for the nine countries are provided in table 1. Economic conditions and living standards differ significantly between the countries. While there is overlap in some areas, they can be divided into four broad categories in terms of their economic and social development.

In the first category are Nepal and Bangladesh. They are the two poorest countries in the world outside Africa, with GNP per capita of $200 and $240 respectively in 1995. Indicators of human development are also very low. In both cases life expectancy at birth is below 60, less than 40 per cent of adults are literate, and nearly half the population lives in absolute poverty. These are the least urbanised of the nine countries and have the highest shares of agriculture in GDP. There are also large numbers of landless people in the rural areas relying on self-employment in the informal sector of the economy.

India and Pakistan fall into the second category. They are classified as low-income countries by the World Bank, with GNP per capita of $340 and $460 respectively. They are also classified as having low human development by UNDP. While Pakistan has the higher per capita income, India performs slightly better in terms of human development. Even in India life expectancy is only 62 and nearly half of all adults are illiterate, while in Pakistan these indicators are only marginally better than in Nepal and Bangladesh. In both cases, more than one third of the population lives in absolute poverty.

In the third category are Sri Lanka, Indonesia and the Philippines, with per capita incomes ranging from $700 in Sri Lanka to $1,050 in the Philippines. While all are classified as having medium human development, this is the most diverse of the four groups. Indonesia and the Philippines are middle-income countries. While Sri Lanka is just below the income threshold for middle-income status, it has the best record of the three in terms of human development. In all three countries, indicators such as life expectancy at birth, infant mortality and adult literacy are much better than in the countries in categories one and two, but in Indonesia and the Philippines in particular they fall well short of the levels achieved in the high-income countries. The official incidence of poverty differs considerably between the three countries, at 11 per cent in Indonesia, 22 per cent in Sri Lanka and 36 per cent in the Philippines. Since mid-1997 Indonesia has experienced a severe financial crisis, and the short-term economic outlook is very pessimistic, with poverty expected to increase sharply.

The final category consists of Thailand and Malaysia. While still middle-income countries with per capita incomes of $2,740 and $3,800 respectively, they are clearly much wealthier than any of the other seven countries. The structure of production also differs significantly from the other countries, with less than 15 per cent of GDP derived from agriculture, more than 40 per cent from industry, and much greater reliance on employment in the formal sector of the economy. Both are considered to have high human development by UNDP, although their performance is uneven, with Malaysia’s adult literacy rated below those of the Philippines, Sri Lanka and Indonesia, and Thailand’s infant mortality higher than that of Sri Lanka. The incidence of poverty is quite low at 10 per cent in Malaysia and 13 per cent in Thailand, although significant pockets of poverty persist, particularly in Thailand. Like Indonesia, Thailand and Malaysia have experienced a severe financial crisis and economic slowdown since mid-1997.

2.3 Poverty reduction and microfinance

With more than 500 million people in the nine countries living in poverty, governments clearly face an enormous challenge to reduce poverty. This is particularly so in the poorest countries and those with the greatest concentrations of poor people.

To achieve rapid and sustainable reductions in poverty it is necessary to have an integrated policy strategy, with the various elements of the strategy reinforcing each other. The World Development Report for 1990 (World Bank 1990) found that poverty can be reduced most effectively through a strategy with two equally important elements.

(1) The first element is to promote the productive use of the poor’s most abundant asset, their labour. Broad-based economic growth, through appropriate macroeconomic and microeconomic policies, is critical in this respect. There is also an important role for targeted policies to promote infrastructure development and encourage income-generating activities for the poor.

(2) The second element is to provide basic social services to the poor. The World Bank found that primary health care, family planning, nutrition and primary education are especially important in this regard.

These two elements are mutually reinforcing. Increasing the productivity and incomes of the poor makes it easier for them to access social services such as health care and education. And policies to improve the health and education of the poor enable them to work more productively. The countries that have implemented both parts of the strategy effectively and in a sustained manner have tended to reap the largest gains in terms of poverty reduction. Of the countries in this study, two stand out for their progress in poverty reduction. In Indonesia, in the thirty years to 1996 coinciding with the New Order government of Soeharto, the incidence of poverty declined from close to 70 per cent to just over 11 per cent. In Malaysia, the incidence of poverty has fallen from 42 per cent of households in 1976 to 10 per cent of households in 1995.

In both of these countries, rapid economic growth has increased the demand for labour, creating opportunities for the poor. The two governments have also adopted targeted policies to improve the productivity of the poor, through infrastructure development and income-generating projects. In terms of the second element, both countries have also focused strongly on human development, with a very strong emphasis on improving primary education and nutrition. The mutually reinforcing nature of the two elements described by the World Bank above has contributed to very impressive reductions in poverty. Unfortunately, both countries have recently experienced financial crises, and the short-term economic outlook is not favourable.

Countries that have implemented effective and sustained policies in one of the two areas have been reasonably successful in reducing poverty, but not as successful as those that have implemented both elements effectively. Despite the current crisis, Thailand has been particularly successful at improving employment opportunities for the poor, with more rapid economic growth than even Indonesia and Malaysia. However, there has been less emphasis on targeted programs to improve the productivity of the poor and on providing basic social services. While the incidence of poverty fell from 30 per cent in 1975–74 to 13 per cent in 1992 the benefits of growth have not been spread evenly, with a marked increase in income inequality. Poverty reduction has clearly been slower than in Indonesia and Malaysia.

Sri Lanka, by contrast, has been particularly successful in extending basic social services to the poor. This has contributed to an impressive performance in terms of human development, with indicators such as life expectancy at birth, infant mortality and adult literacy much more favourable than for other countries with similar income levels. On the other hand, Sri Lanka has been less successful in creating opportunities for the poor in employment and income-generating activities. While consistent time series of the incidence of poverty are not available, analysis by the World Bank suggests that Sri Lanka has made good progress in poverty reduction since 1965, with around 22 per cent of the population living below the poverty line in 1990–91. Nevertheless, progress in reducing poverty could have been faster with greater emphasis on measures to improve opportunities for employment and income generation for the poor.

The other five countries included in the study, namely Bangladesh, India, Nepal, Pakistan and the Philippines, have all achieved some reduction in the incidence of poverty. However, the incidence of poverty remains high in these countries, ranging from 34 per cent in Pakistan to 48 per cent in Bangladesh according to the latest estimates. These countries have not been as successful at reducing poverty as the four countries discussed above. While all have implemented a range of policies both to promote employment opportunities and income-generating activities for the poor and to extend basic social services, none of these countries has yet been able to achieve rapid and continuous improvements in either of these elements over an extended period of time.

The above discussion demonstrates that rapid and sustainable poverty reduction depends on the interaction of a wide range of policy measures. The availability of microfinance, defined here as the provision of financial services such as savings and credit to poor households, is neither a necessary nor a sufficient condition for rapid poverty reduction. For instance, Malaysia and Thailand have achieved large reductions in poverty with relatively little emphasis on microfinance. And despite the vast outreach of microfinance programs in Bangladesh, progress in reducing poverty has been slow. Clearly, microfinance is only one factor in any strategy for poverty reduction.

Nevertheless, microfinance can play an important role. As noted above, one element of an effective strategy for poverty reduction is to promote the productive use of the poor’s labour. This can be done by creating opportunities for wage employment, by raising agricultural productivity among small and marginal farmers, and by increasing opportunities for self-employment. Microfinance is particularly relevant to increasing the productivity of self-employment in the informal sector of the economy. In an environment where economic growth is occurring, microfinance also has the capacity to transmit the benefits of growth more rapidly and more equitably through the informal sector. It is well documented that for many microentrepreneurs, lack of access to financial services is a critical constraint to the establishment or expansion of viable microenterprises (see, for instance, FDC 1992, 1995). Microfinance may also enable small and marginal farmers to purchase the inputs they need to increase their productivity, as well as financing a range of activities adding value to agricultural output and in the rural off-farm economy. Access to savings facilities also plays a key part in enabling the poor to smooth their consumption expenditures, and in financing investments which improve productivity in agriculture and other economic activities.

In most developing countries, opportunities for wage employment in the formal sector of the economy are extremely limited, and the vast majority of poor people rely on self-employment for their livelihood. Better access to financial services, enabling the poor to establish and expand microenterprises and improve their incomes, can be very important in reducing poverty. Even in countries such as Malaysia and Thailand where opportunities for wage employment are greater, many poor households rely on self-employment in microenterprises for their livelihood.

Policies to encourage the development of a viable microfinance sector can also reinforce other poverty reduction policies, and vice versa. Many microfinance programs, including that of the Grameen Bank in Bangladesh, encourage members to develop a socioeconomic agenda covering matters such as health, nutrition and children’s education. Even where this emphasis is not explicit, increased empowerment and higher incomes from participation in microfinance programs can reinforce other policies. At the same time, microfinance programs are likely to be more effective in raising members’ incomes where rapid growth in the economy and in agricultural output, and better infrastructure, create a demand for the products and services provided by microentrepreneurs. Microfinance programs will also be more effective where inputs such as education and training enable members to use their loans more productively.

How does microfinance overcome the constraints caused by lack of access to financial services? Microfinance can be defined as the provision of financial services, primarily savings and credit, to poor households which do not have access to formal financial institutions. It is widely documented that the formal financial system rarely provides access to poor entrepreneurs in developing economies. Women’s World Banking (1995) estimated that in most developing countries, the formal financial system reaches at a maximum the top 25 per cent of the economically active population, leaving the bottom 75 per cent without access to financial services apart from moneylenders. This is because the techniques used by financial institutions do not enable them to lend to the poor in a cost-effective manner (although some countries, notably Indonesia, have a better record in this regard).

Until the 1970s at least, loans for microentrepreneurs were provided primarily through government and donor-funded programs. These programs had relaxed collateral requirements, but otherwise used commercial bank methods. They generally charged subsidised interest rates, based on the view that the poor could not afford to pay market interest rates. They also tended to suffer from politicisation, low repayment rates and high arrears. Reflecting a combination of high cost structures, low interest revenues and low repayments, they required large and ongoing subsidies.

Beginning in the late 1970s, however, there has been an emphasis on establishing financial systems able to reach poor clients on a more sustainable basis, both in Asia and elsewhere. A new set of techniques has been developed and applied by specialist MFIs such as Grameen Bank in Bangladesh, and in the village-level operations of Bank Rakyat Indonesia, to name the two institutions with greatest outreach. While these techniques differ between institutions, Rhyne and Otero (1994) argue that there are three key principles behind them.

The first is knowing the market. The poor are willing to pay for access and convenience. Lending outlets are located near the client, application procedures are simple, and loans are disbursed quickly. Second, successful MFIs use special techniques to slash administrative costs. Simple procedures are used and approvals are decentralised. Borrower groups often handle much of the loan-processing burden. And third, they use special techniques to motivate repayments. MFIs have developed a range of techniques to ensure high repayment rates, including the use of self-selected groups in which members guarantee each other’s loans, intensive motivation and supervision of borrowers, incentives for borrowers, progressive lending and compulsory savings requirements.

In recent years MFIs have moved from the margins of the financial system towards the mainstream. It is now more widely accepted that populations traditionally excluded by the formal financial sector can, in fact, be a profitable market niche for innovative banking services. This acceptance is perhaps best demonstrated by the establishment in 1995 of the Consultative Group to Assist the Poorest (CGAP), a multi-donor effort initiated by the World Bank to increase systematically the resources devoted to microfinance. Since then microfinance has continued to gather momentum. The 1997 Microcredit Summit launched a global movement to reach 100 million of the world’s poorest families with credit for self-employment and other financial and business services by the year 2005. Much remains to be done, however, to integrate microfinance fully into the mainstream of domestic financial systems, and for orthodox financial institutions, notably commercial banks, to recognise its full potential.

2.5 Current outreach and self-sufficiency of microfinance institutions

Outreach

Despite the rapid growth of MFIs in recent years, their outreach remains very small compared to the potential demand. CGAP (1995) estimated that fewer than 10 million of the few hundred million people who run micro and small enterprises in developing countries have access to financial services. This is as true in the Asian region as it is in other regions, even though many of the largest MFIs in the world are in Asia. The Bank Poor ’96 Regional Workshop on Microfinance for the Poor in Asia-Pacific found that:

Essentially, the task of outreach remains to be done. Of the target poor households in Asia-Pacific, less than 5 per cent have access to financial services. If we exclude Bangladesh — the only country where truly large numbers have been reached — the numbers to whom microfinance services have been extended falls to less than 1 per cent of the target group (Getubig, Remenyi & Quinones 1997, p.10).

In Bangladesh, MFIs have already reached a significant proportion of poor households. Bangladesh boasts a number of the largest MFIs in the world, including Grameen Bank with 2.1 million clients at end-1995, Bangladesh Rural Advancement Committee (BRAC) with 1.5 million clients, and Association for Social Advancement (ASA) with 400,000 clients. Total microfinance clients number at least 6 million, representing not less than one in four rural households in the country.

Microfinance has also achieved significant outreach in Indonesia. It is difficult to estimate the number of poor households with access to microfinance because most institutions are not specifically targeted to the poor. However, financial deregulation has led to a proliferation of financial institutions serving people at all income levels. Bank Rakyat Indonesia serves some 2.6 million borrowers and nearly 18 million savers, including poor clients, through its unit desa system. In addition, there are around 7,300 registered small financial institutions operating at the local level, together with some 2,000 rural banks, plus hundreds of thousands of self-help groups formed as a result of mass campaigns for poverty reduction.

In the other seven countries included in this study, the outreach of microfinance remains limited. While there is a large number of self-help groups in India, the total outreach of genuine microfinance programs is not more than 500,000, a small number in relation to the 65 million poor households in that country. In the Philippines there is a large number of NGOs engaged in microfinance, but most are very small, with only around 30,000 borrowers in total. Outreach of MFIs is also modest in Nepal and Sri Lanka, and negligible in Pakistan. Malaysia and Thailand, where the incidence of poverty is relatively low, are quite well served by MFIs, although the absolute numbers of poor clients are small.

Self-sufficiency

While most successful MFIs were established originally with significant grant funding from donor agencies, there is a strictly limited supply of such funding. Clearly, it will not be possible for the microfinance sector to expand to cover more than a small proportion of the poor in the region on the basis of donor grants. If the number of microfinance clients is to expand significantly, MFIs need access to commercial sources of finance. This in turn requires MFIs to become self-sufficient. Commercial banks will only lend to MFIs if they are satisfied that the MFIs concerned can generate sufficient income to meet their expenses, including the cost of servicing their loans. Similarly, institutional investors will only invest in MFIs if MFIs are able to generate a positive rate of return that is comparable to other investment opportunities.

The Guiding Principles for Selecting and Supporting Intermediaries agreed by donor agencies (Committee of Donor Agencies 1995) define two degrees of self-sufficiency for MFIs and establish indicative ‘timetables’ for the period over which MFIs should be able to achieve them. CGAP has further clarified these definitions. ‘Operational self-sufficiency’ requires MFIs to cover all administrative costs and loan losses from operating income. This is calculated by dividing operating income by operating expenses. The Guiding Principles suggest that based on international experience successful MFIs should be able to achieve operational self-sufficiency within three to seven years. ‘Financial self-sufficiency’ requires microfinance programs to cover all administrative costs, loan losses and financing costs from operating income, after adjusting for inflation and subsidies and treating all funding as if it had a commercial cost. It is suggested that successful intermediaries should achieve financial self-sufficiency within five to ten years.

While the importance of becoming self-sufficient is now widely recognised, few MFIs have yet attained any significant degree of self-sufficiency. Of the 49 MFIs in the Asia-Pacific region that were studied for Bank Poor ’96, including virtually all the largest and most successful MFIs in the region, only six were financially self-sufficient.¹ Only two of these, the Association for Social Advancement in Bangladesh (400,000 clients) and SEWA Bank in India (57,000 clients), were reaching substantial numbers of poor clients. The other four MFIs that had achieved financial self-sufficiency all had fewer than 2,000 clients. Another six MFIs, including Grameen Bank, Bank Shinta Daya in Indonesia and the Colombo District Union of the Thrift and Credit Cooperative Societies in Sri Lanka, were more than 80 per cent financially self-sufficient. The remaining 37 MFIs studied were less than 80 per cent financially self-sufficient. Hence, it is clear that most MFIs in the Asia-Pacific region have a long way to go before they become self-sufficient. These findings are consistent with the experience of CGAP. In its funding guidelines CGAP requires MFIs to be operationally self-sufficient, but of the 116 self-selected institutions which had applied for CGAP funding as of 30 June 1996, only 5 per cent met this criterion (CGAP 1996).

If microfinance is to make an important contribution to poverty reduction in the region, the microfinance sector will need to develop to the stage where it can reach large numbers of poor people on a sustainable basis. This requires increased attention to all aspects of microfinance, including both the internal operations of MFIs and the external policy and regulatory environment in which they operate. As noted in chapter 1, the purpose of this study is to consider how the policy and regulatory environment can best contribute to the development of microfinance.

2.6 Summary

The nine countries included in the study had a total population of some 1,559 million in 1995, around 27.5 per cent of the world’s population. While economic conditions and living standards differ significantly between the countries, around 500 million people in the nine countries — or one third of the total population — are living in poverty.

To achieve rapid and sustainable reductions in poverty it is necessary to have an integrated policy strategy. The World Bank has found that poverty can be reduced most effectively through a strategy with two equally important elements. The first element is to promote the productive use of the poor’s labour, while the second is to provide basic social services to the poor.

Of the countries in this study, Indonesia and Malaysia stand out for their progress in poverty reduction. These are the only countries that have been able to implement both parts of the strategy consistently and effectively over a sustained period. Thailand and Sri Lanka have also achieved significant reductions in poverty. Thailand has been particularly successful at improving employment opportunities for the poor, but not so effective at providing social services. By contrast, Sri Lanka has been very successful in extending basic social services to the poor but less effective at improving their productivity. The incidence of poverty in these four countries ranges from 10 per cent in Malaysia to 22 per cent in Sri Lanka.

The other five countries included in the study, namely Bangladesh, India, Nepal, Pakistan and the Philippines, have not been so successful in reducing poverty. The incidence of poverty remains high in these countries, ranging from 34 per cent in Pakistan to 48 per cent in Bangladesh.

Microfinance is neither a necessary nor a sufficient condition for rapid poverty reduction. Nevertheless, it can play an important role by increasing the productivity of self-employment in the informal sector of the economy. For such ‘microentrepreneurs’, lack of access to financial services is often a critical constraint to the establishment or expansion of viable microenterprises. Where opportunities for wage employment in the formal sector of the economy are limited, measures to overcome this constraint can be very important in reducing poverty.

Until the 1970s at least, loans for microentrepreneurs were provided primarily through government and donor-funded programs. Beginning in the late 1970s, however, there has been an emphasis on establishing financial systems able to reach poor clients on a more sustainable basis. In Asia and elsewhere, a new set of techniques has been developed and applied by specialist microfinance institutions (MFIs) such as Grameen Bank in Bangladesh, and in the village-level operations of Bank Rakyat Indonesia. It is now generally accepted that populations traditionally excluded by the formal financial sector can, in fact, be a profitable market niche for innovative banking services.

Despite the rapid growth of MFIs in recent years, their outreach remains very small compared to the potential demand. The Bank Poor ’96 Regional Workshop on Microfinance for the Poor in Asia-Pacific found that less than 5 per cent of poor households in the Asia-Pacific region have access to financial services. Of the countries in this study, only in Bangladesh and to a lesser extent Indonesia has microfinance reached a significant proportion of poor households.

It is now widely recognised that if the number of microfinance clients is to expand significantly, MFIs need to become self-sufficient. However, few MFIs have yet attained any significant degree of self-sufficiency. Of the 49 MFIs in the Asia-Pacific region that were studied for Bank Poor ’96, including virtually all the largest and most successful MFIs in the region, only six were financially self-sufficient and only two of these were reaching substantial numbers of poor clients.

While microfinance has the potential to make an important contribution to poverty reduction in the region, this requires the development of a microfinance sector that is able to reach large numbers of poor people on a sustainable basis. This, in turn, requires increased attention to all aspects of microfinance, including both the internal operations of MFIs and the external policy and regulatory environment in which they operate. The purpose of this study is to consider how the policy and regulatory environment can best contribute to the development of microfinance.