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Is Microfinance a Social Investment?

By Jesse Lent (New York City)

If you are among the millions living in poverty in the developing world, your options for attaining a line of credit are limited. Black market lenders or local village banks with sky-high APRs are typically the only option

For would-be local business owners in parts of the world like Haiti or Bangladesh, a few thousand dollars can be the difference between financial independence and a life of poverty. Many entrepreneurs short of the start-up capital required to buy a bread oven or put a security deposit down for a storefront have received help in the form of microfunds.

Microfunds are small loans, typically of a few thousand dollars commonly offered in poverty-stricken areas of the world to small business owners (mostly women) at rates lower than what they would be able to find locally. The lenders or ‘microbanks’ make money on the investment through borrowing money at a lower annual percentage rate (APR) than what they end up charging the borrower.

This hike in the interest rate has caused some controversy over whether microfunds are performing a service to lift developing nations out of poverty or simply making money off of the world’s most downtrodden citizens.

Regulatory Action

On Sept. 13, The Economic Times reported that The Reserve Bank of India is considering capping the APR that can be imposed by microbanks at 24 percent, due in part to the questionable practices of microfinance institutions (MFIs) like the highly profitable organization SKS Microfinance.

“Who are these guys?” wrote Sugata Ghosh. “They borrow from banks at 13 percent, lend to the poor at 26 to 27 percent, spend around 8 percent to deliver the loans and land up with an interest margin of 5 to 6 percent — almost double the margin that banks make.”

However, Ghosh goes on to point out that microlenders offer an APR in the developing world that is typically at least 10 percentage points lower than what it would be through local village banks.

But if India decides to cap the interest rate that microfinance institutions like SKS can charge, this will limit the amount of loans they can approve, according to James Broughel of Hunter College.

“It may mean less exploitation of those in the developing world,” he said of India’s proposed interest rate cap for MFIs. “But it also means there’s less opportunity. So it’s a balancing act.”

Making a Difference?

However, certain MFIs have done considerable work towards combating poverty. Muhammad Yunus, founder of microfinance group Grameen Bank, even won a Nobel Prize back in 2006 for his work in the field.

“It’s something that really makes a difference at the grand level for poor people,” said City University of New York political science professor, Kenneth Paul Erickson.

Erickson feels that rogue organizations like SKI are a small price for a system that really seems to work.

“The consequences of providing small amounts of capital to the poor is that you may get some disreputable people involved,” he said.

It is for precisely this reason that Elisabeth Rhyne, managing director for The Center for Financial Inclusion, stresses the importance of potential investors knowing the motivation for the way a particular MFI is run.

“Let’s assume three kinds of funds: straight commercial funds that obey the rules of the marketplace, social investment funds that explicitly combine social and financial aims, and pure grants,” she wrote in a Sept. 13 article for The Huffington Post. “Each has its own niche.”

But although many Americans view MFIs as charity organizations, Broughel is quick to point out that microfunds are essentially high-risk loans with high interest rates.

“It’s a fine line between giving someone an opportunity that’s going to help them move up in the world, and drawing them into a loan they can’t pay back,” he said.

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