We have understand the seismic shifts going on in the micro-finance industry and get some perspectives from the ground in developing world.   What is clear is that the assumptions that made micro-finance a success in the last two decades have radically changed.  So we have to go back to economic fundamentals to rebuild micro-finance institutions if they are going to play any role in economic prosperity for the poor in decades to come.

Pakistani MFIs are trying to pick up after the fall out of the credit crises has shaken assumptions behind credit markets, and revealed that micro-credit market is actually sub-prime-squared, and does pose significant risks of default.   In fact, the pull back of commercial lines of credit from MFI, tightened loans to poor people, that prompted further defaults because the most likely default to borrowers had nothing no to loose in future loans.  This then triggered a social contagion of defaults because people in groups felt silly paying back when significant number of their friends were defaulting and touting their shrewdness (to rationalize their smartness).  However, I suspect that Pakistan is not the only country where this has happened.

Only the largest established MFIs were spared this type of default contagion because they were backed with non-commercial international credit lines, like Kushali Bank (khushhalibank.com.pk) which is backed by Asian Development Bank’s $150M grant.   Though KB did experience overall increase in defaults, there were some particular groups of borrowers people where the default were remarkably low and only slightly above historical averages.

One of those particular groups of borrowers is serviced by Human Development Foundation (HDF.com).  HDF provides intense vocational and management training as part of the micro-finance loan process. Furthermore, social relationships are much deeper than economic groups.  HDF’s holistic program cover MDG 1-8 through community driven development, where it has spent a lot of effort on building civic leadership, and has thus built significant social capital in the community. This social capital serves to buffer against idiosyncratic defaults turning into a social contagion.

A second problem is that most micro-credit is loaned at median 40% APR and higher rates, that would be considered predatory in Western world.  Some MFI charge as high as 120%, fueling a growth trajectory that has been very suspect from the beginning.  They hired lots of well paying MBAs at the expense of poor developing world entrepreneurs.  These MFIs (I am not going to name them) were nothing more then predatory sub-prime credit card companies pretending to do some social good.  The loan sale officers are incentivied through bonuses and weekly targets to push loans to poor people, with little regard to where debt may add value, or the harm it can do.   What is amazing is this setup of misalligned incentives is no diferent than was has doomed the sub-prime mortgage market in America.  It also reveals the vast scope of the structural reforms required to create a sustainable global financial institutions,

Most of these MFIs do not care what the loans are used for. Incurring a debt of 40% is bad except under some very restrictive circumstances.  There is general only one justification for such loans, that it does more good than harm. So what is more good?  That the debt is leveraged to increase Human Capital, thus creating more gains then loss. This argument is same as using for student loans to pay for MBA program.  So the entrepreneur has to engage in some economic activity that increases their future earning potential enough that after paying back the loan, the increase in NPV of future earnings more than offsets the cost of debt. Well, good we all from the Univ of Chicago and can understand what HC is thanks to Gary Becker.  But the only way to ensure this benefit is to make sure that HC did in fact increase, through vocational training, management training and some hands on experience in running the business.  As I had mentioned, HDF provides very intense vocational, management and leadership training to the borrows, and this is the critical to ensuring their skills increase in the process, and reduces chances that they will fail due to lack most basic mistakes of executing a sustainable business plan.

Some behavioral economic fundamental reality.  Poor people on average tend to have lower social-emotional skills (non-cognitive skills in language of James Heckman) including impulsiveness.  They are likely to misuse supply of cash to things that increase their short-term utility but not their well-being without providing social structure and purpose to the loans.  HDF does not give cash, we get business plans and provide buy intended items for business operation and setup.

More behavioral economic fundamental reality.  According to behavioral finance phenomenon of sub-additive discounting can account for hyperbolic discounting. In English, this means the short time horizon you use for evaluation, the higher the discount rate that people are willing to use.  Most micro-finance loans are short-horizon loans, thus poor people are willing to pay higher discount rates, because they are forced to think in short-term because of immediate needs. Thus, the entire justification for high rates being appropriate for poor people may hinge on a behavioral anomaly.

We also started very intense discussions on how low-skilled micro-finance enterprises can survive globalization and especially the onslaught of cheap Chinese manufacturing going after very low hanging fruit on the planet.  Some news flash, Chinese manufacturers are not just going after high-value American industries, they are going after all low-hanging fruit including African cloth and handcraft now being manufactured in China.  Because where we go from here involves understanding how micro-finance enterprises can survive in globalization demand for rapid changing product specifications that are part of complex dynamic value-add supply chains. This is much harder discussion to have, but have to go down this path.

 Ebay’s founder Pierre Omidyar was probably on right track when he challenged Dr. Mohammad Yunus’ euphoria about micro-credit being the solution to global poverty. Omidyar instead focuses on value creation and markets solution.  I am sure you all know about worldofgood.ebay.com, ebay’s market solution for fair trade. We have to start thinking hard about expanding such next generation solutions that can allow micro-enterprises to form more complex supply chains, do just in-time manufacturing to specifications, create cheap rural/semi-urban logistics networks, and help market these products to retail and wholesale markets.  These innovations are what’s going to reduce barriers for micro-enterprise to compete amid rapid globalization.