Microfinance and its Application in the South African Context

Introduction

Much of the developing world suffers from abject poverty. Since the end of colonialism, numerous measures have been instituted to try and alleviate this problem. Most of these initiatives have consisted of providing cash, and less frequently, goods aimed at addressing the socio-economic challenges facing the developing world. Yet, despite massive amounts of aid being disbursed, these contributions have been largely insignificant as drivers of sustainable change and growth. (Meier,G.M; Rauch,J.E : 2005)

In recent years, an innovative approach to poverty alleviation had, despite humble beginnings, gained traction. This approach, known as microfinance, seeks to provide loans to those sectors of society who are normally excluded from “mainstream” financial institutions.

Brief Historical Overview

Microfinance (specifically, microcredit) began in Bangladesh during the mid-1970’s. Bangladesh had been experiencing a terrible famine at that time. Muhammad Yunus, a professor of economics found that the “elegant theories’’ which he was teaching seemed to provide no answers to the real world economic problems Bangladesh was facing. Yunus discovered that the poor were unable to access credit at reasonable rates. The only credit available to them was via money lenders and then at exorbitant rates of interest. Yunus began to lend personal funds to  villagers, allowing them to engage in small scale crafts. In 1983, Yunus established Grameen Bank, whose sole focus was lending money exclusively to groups of poor households, to establish businesses.

In the subsequent two decades microfinance became the proverbial darling of the developmental economic world. Microfinance schemes were started, and experienced massive growth. Microfinance established itself all across the developing world, from Morocco to Bolivia, Pakistan to Zimbabwe. Developed countries too, quickly adopted the model including the USA and Canada.

The mid- 2000’s saw the apex of microfinance’s popularity. With 2005 being declared the UN “year of microfinance” and Muhammad Yunus winning the Nobel Peace (not economics) Prize in 2006.

However, as microfinance grew in popularity, the model also changed and eventually many Micro Finance Institutions (MFIs) began engaging in the business solely with the profit motive. This led to substantial structural problems which has resulted in microfinance schemes collapsing across the globe. Microfinance has subsequently came under substantial and vocal criticism and is no longer the “darling” of the economic world (Ghosh, J; 2013).

Functioning

Microfinance focuses on providing credit to those poor who are excluded from the formal financial sector. These people are excluded, primarily due to their inability to provide collateral. Collateral, of course, is an integral component to the effective functioning of credit markets. Thus, the challenge for MFIs was to create such a structure which allowed uncollateralised financing whilst enabling a form of protection for the lender.

The structure adopted by Grameen Bank was to loan not to individuals per se, but rather to groups of poor households. Groups are formed voluntarily and all in that group are liable for repayment. Groups consist of five individuals, with loans being provided in rotation to two individuals at a time. Bank staff gather eight groups and meet with these 40 individuals on a weekly basis.

If any individual in a single group defaults, the entire group is denied any subsequent funding.

This utilises societal pressure to enforce payment. This can take the form of isolation or even physical retribution. By allowing the recipients to form their own groups local knowledge is leveraged, as people would only form a group with those whom they’re certain would be to their best advantage. In this manner the risk of asymmetric information is mitigated.

By 1998, Grameen Bank had two million borrowers. The bulk of whom (95%) were women. Repayment rates averaged 97-98%. The duration of most loans is 1 year. At a nominal interest rate of 20%. However, at this interest rate Grameen bank is not profitable and requires donations and other external funding (Meier,G.M; Rauch,J.E : 2005).

A microfinance platform that has proven to itself to be financially viable (without external donations) is the Bank Kredit Desa system (BKDs) found in rural Indonesia. The key difference between this system and Grameen Bank is the term structure of the loans. The BKDs, in 1994, would disburse loans of around $71. The term of the loan would be between 10-12 weeks (as opposed to Grameen’s yearlong loans). Furthermore, interest would be payable at 10% of the principal on a weekly basis. This translated to a nominal rate of 55% had the loan been for a year, far higher than Grameen’s 20%.The  BKDSs method of allocation is also different in application, adjusting for local mores, yet maintains the same broad structural concept as Grameen, i.e. enforcement via social coercion. The BKDSs method entails utilising Indonesia’s entrenched hierarchical system to provide loans through the village-level management commissions which exist countrywide. These commissions also mitigate asymmetric information and are well positioned to ensure payment through social coercion.

(Meier G.M ; Rauch J 2005) have shown that out of the 5 major microfinance schemes only two make use of explicit group lending contracts. However, all schemes make use of progressive lending, offer more competitive terms than other lenders, and deny further finance to defaulters.

The schemes typically begin by providing a loan of a small value. If this is repaid, a loan larger in value is provided. This repeated process is known as progressive lending. This form of dynamic incentive has a number of positive externalities including; the screening of risky candidates, building long standing relationships with clients, creating an anticipation within clients for forthcoming, larger loans if they pay the smaller one.

Microfinance has also morphed into providing loans almost exclusively to women, particularly in Bangladesh. This is due to their exhibiting better fiscal responsibility compared to male borrowers.

A novel feature found in microfinance is the repayment schedule. Repayments are due almost immediately after the loan is disbursed. This in essence means that borrowers need a pre-existing income stream, which implies that the loan is disbursed partially against an income stream. This feature has several other advantages; undisciplined borrowers are screened out early on, emerging problems are detected early on, the bank gains access to cash flows before they’re consumed.

Feasibility

Microfinance suffers a severe defect as a business form, that is, its general inability to attain profitability and financial sustainability. By 2005, experts estimated that less than 1% of all had attained financial sustainability, and that fewer than 5% would ever attain financial sustainability

(Meier G.M ; Rauch J 2005).

For the microfinance model to work in a sustainable manner, a rate of interest would need to levied that would prove to be almost as high as that charged my traditional moneylenders. Thus, mitigating any substantial benefits.

The remaining MFIs, who in fact form the vast majority, are reliant on subsidies and donations to continue their operations.

In terms of sustainability, most MFIs have attained “operational sustainability” where they are able to cover their running costs but are unable to finance the full cost of capital.

Thus, microfinancing is quite clearly not the most profitable of business ventures, but how does it stack up as a developmental tool?

Meier G.M ; Rauch J  quoting Khandker; 1998 has demonstrated microfinance’s strength as a developmental tool via simple cost-benefit ratios. These ratios are ascertained by dividing the value of the subsidies by the benefit gained. He has reported a cost-benefit ratio of 0.91 for women and 1.48 for men participating in Grameen Bank’s microfinance scheme. This means that it costs society $0.91 for women and $1.48 for every dollar of benefit. In comparison, the World Food Programme’s Food-for-Work scheme had a cost-benefit ratio of 1.71 and 2.62 for CARE’s developmental programme of a similar nature. Not all microfinance schemes achieve a comparable result. The BRAC scheme sees ratios of 3.53 and 2.59 for men and women respectively.

The above factors indicate that microfinance is largely unsustainable as a business model, yet may form a separate tool of developmental aid. It should thus be viewed as such and compared with other developmental schemes and not assessed as a business, in terms of financial feasibility and sustainability.

Failures and Criticisms

In a recent 2013 paper Jyoti Ghosh has explained that the microfinance model originally propagated by Yunus and Grameen Bank had undergone a change, and that from the 1990’s onwards a paradigm shift occurred where the emphasis of MFIs was towards “a full cost model”. This shift in focus has led to substantial financial problems being experienced by the microfinance sector, and in fact the collapse of the entire sector in several countries. In fact, in trying to run MFIs as profitable businesses, their behaviour became almost indistinguishable from “loan sharks’s” with exorbitant interest rates being charged, unethical, violent coercive means being used to extract payment.

(Ghosh;2013) has also quoted substantial criticisms from a diverse group of economists which have been levelled against microfinance. These include; microfinance not being theoretically sound, in fact being “built on sand”, to microfinance actually constituting a powerful institutional and political barrier to sustainable economic and social development, and so also to poverty reduction. This particular criticism is substantiated by explaining that microfinance “ignores the crucial role of scale economies and thereby denies the importance of large investments for development.’’ And also “microfinance ignores the ‘fallacy of composition’ and adds to the saturation of local economies by microenterprises all trying to do the same or similar activities. Partly as a result of this, it helps to deindustrialise and infantilise the local economy.” Another core criticism is that microfinance funds have not been used for their intended developmental purposes, instead, people have been acquiring microloans, claiming to use them to start up businesses, whilst, in reality, these funds are used to fund consumption spending.

 These are substantial economic arguments against microfinance. Besides these criticisms aimed at the social effects of microfinance have also been levelled these include; borrowers having to take on the supervisory, and penalising role of lenders, social cohesion can be destroyed in the group monitoring process, social hierarchies can become further entrenched, the self-selection of groups has led to the poorest being marginalised and not being included in groups (Ghosh; 2013).

Microfinance in South Africa

Microfinance in South Africa has failed to live up to its promise. Microfinance activities began in earnest in SA following the demise of Apartheid. Yet, these activities have not resulted in any real development. In fact, these activities have created a debt trap for the poorest South Africans, many of whom borrowed money under the pretext of needing capital for business purposes, yet they then used these funds for consumption (Guardian;2013).

Lenders, had also contributed to this problem, by lending recklessly, without substantial regulation.

Thus, in SA, microfinance had become a predatory business. With large lenders chasing quick returns and development all but forgotten.

Conclusion

Microfinance is certainly not the panacea to the World’s developmental needs. It has the potential to be a tool of development, if it is understood to be such. Thus microfinance needs to be measured in terms of its cost-benefit ratio versus other developmental tools, understanding that the model will work best as a developmental tool if it is subsidised, and then the model with the best cost-benefit ratio should be chosen.

 However, once the profit motive becomes the overriding consideration, than the model opens itself up to substantial abuses and the potential to become destructive, and trap the poorest in a debilitating cycle of debt, indistinguishable from the predatory “loan shark”.

References

Ghosh, J (2013), Microfinance and the challenge of financial inclusion for development, Cambridge Journal of Economics

Meier G.M , Rauch J (2005) Leading Issues in Economic Development, Oxford University Press

http://www.theguardian.com/global-development-professionals-network/2013/nov/19/microcredit-south-africa-loans-disaster Accessed 30 August 2015

                

Money, credit and Macroeconomic (In)Stability

Introduction

It is of crucial importance to understand the sources of macroeconomic instability. When an economy is functioning well this leads to political, social stability. An economy that is unstable, that is characterised by low growth/ recession, unemployment, price instability, either due to hyperinflation/ deflation, is an economy that engenders both political and social instability. The recent economic woes faced by Greece, Zimbabwe, and Venezuela and the accompanying political and social turmoil found in these countries are illustrative of the need to understand and thus prevent or rectify macroeconomic instability.

The reasons for macroeconomic instability are myriad. Factor endowments, extreme or destructive weather conditions, unresolved structural defects are all possible reasons for instability.

Monetary policy (which essentially determines the amount of money created, credit provided in a fiat money economy, via the interest rate) is another great potential source of macroeconomic instability. When applied correctly monetary policy is a powerful tool, one that can restore stability to an economy, which can engender growth, employment and price stability. However, when misused monetary policy has the potential to further exacerbate any potential instability in an economy.

Neutrality of money

Before proceeding, it would be appropriate to discuss the neutrality of money. This is the core concept at hand. Money is considered neutral if any change in the quantity of money found in an economy only leads to changes in nominal variables, e.g. prices, wages and does not affect any real variables, e.g. employment and real GDP.

This concept has lead to substantial debate amongst economists, and different economic schools of thought hold differing views. The classical economists held that money was neutral, whilst Keynes rejected the neutrality of money in both the long and short run. The monetarists held, and this view is supported by many economists, that money is not neutral in the short run but only in the long run. (Snowdon: 2005)

It is because of this the short-run non-neutrality of money that the incorrect application of monetary policy has the capacity to create or further exacerbate macroeconomic instability. And in contrast, the appropriate application of monetary policy is a great stabiliser in an economy.

Macro and micro equilibrium

Macroeconomic studies and analysis deals with the general state of the economy. That is, the general price level, which is determined via an appropriately representative basket of prevalent goods as well as aggregate income. A state of macroeconomic equilibrium is attained when there is sufficient aggregate demand that allows firms to sell their aggregate output, utilising their full capacity (UNISA,2015b)  (this is in contrast to macroeconomic instability which is determined by the state of a number of factors including; unemployment, growth, price stability, inequality (World Bank)). The aggregate goods market equilibrium condition and aggregate monetary budget equation are utilised in this regard.

For any exchange of goods to take place in the current economic setup, money is needed to facilitate exchange.

The macroeconomic equilibrium condition (∑ P^s,yS^y_t= ∑ P^D,yD^y_t) shows this. This condition indicates that the supply price multiplied by the quantity of all recently produced goods is equal to the demand price multiplied by the quantity of all recently demanded goods, aggregated, at a certain moment in time. This implies that every supplier of a good is naturally then a demander of money, whilst every demander of a good is then a supplier of money. The logical outcomes derived from the above, is that for market coordination to occur the physical quantities which are demanded (say 3 bananas) must be supplied, but also that demanders of goods must possess the requisite amount of money to pay for the goods demanded (say R6 for 3 bananas). Thus monetary disturbances are transmitted to the goods market, from the demand side by changing the quantity of money held by demanders, hence changing planned demand.

Goods market equilibrium (∑ P^s,nS^y_t= ∑ P^D,nD^y_t)    consists of both macro and micro equilibrium. Microeconomic equilibrium occurs when supply is equal to demand in a specific market, or for a specific good. S^b =D^b (b=bicycles). The micro sector experiences disturbances in equilibrium due to real factors (changes in tastes, weather patterns and technology) whilst disturbances in the macro sector occur due to monetary disturbances.

The circulatory income spending stream

The circulatory income stream is an important tool in macro-monetary analysis as it demonstrates the dynamic processes which occur in an economy vis-a- vis the demanding and supplying of money.

Robertson’s (UNISA 2015b, quoting Robertson : 1940) budget equation (∑ P^s,yS^y_t-p +  ∑ M^s_t-p = ∑ P^D,yD^y_t  + ∑ M^D_t+1)   demonstrates the circular, dynamic nature of monetary exchange. Considering the current moment as _“t” then every current demander of money, was a supplier in the previous period, _“t-p’’.  Money creation also occurred in the same, prior period.

What this means is that the income and money creation which occurred in the past (for the economy as a whole) must be sufficient to enable current, planned spending as well as planned increases in passive money holding for the immediate future, _t+1.

This equation provides 2 important concepts; money creation is an injection into a circular income-spending stream and hoarding is a leakage from it.

Leakages and injections

Aggregate spending in an economy is determined by the aggregate income earned in that economy in the preceding period(s), the net effect of injections-leakages, is also a determinant of aggregate spending.

If the net effect of injections-leakages were zero than the economy would be in a stationary state (where goods roll over in the economy, and the same sum total of money merely oscillates between market participants). In this case the value of aggregate spending would be equal to the value of the prior aggregate income.  However, when injections are greater than leakages then aggregate spending will be greater than aggregate income, and if leakages are greater, then aggregate spending will be less, thus in this manner leakages and injections are the transmission mechanisms whereby spending, hence the real economy, is affected by money and quantitive changes thereof.

Passive money holding (hoarding) is a form of a leakage. This is money which is earned but then not re-spent.

Money creation which occurs as a result of commercial banks lending money to the non-bank public as well as the government. This is an injection. Also when banks purchase assets e.g. bonds from nonbanks, money is created and this is therefore an injection.

Leakages also occur as a result of money destruction. This occurs when nonbanks repay their debts to the banks. Also when nonbanks invest in bank non-monetary deposits, loans or equity.

Any increase in the volume of secondary financial assets traded by nonbanks will constitute a leakage.

A trade surplus on the Balance of Payments (BoP) constitutes an injection, while a deficit constitutes a leakage.

The Keynesian view and related difficulties

The ISLM theory, which is often the starting point for students studying macroeconomic analysis, is a representation of the ideas of Keynes.

The Keynesian version differs in that aggregate income results due to actual spending. Under the circulatory stream aggregate income leads to aggregate spending.  The Keynesian (IS) approach does not allow for leakages and injections. This creates a troubling problem, how are changes in income explained? The IS approach is to then explain changes in income as a result of changes in autonomous spending: autonomous consumption, investment and government expenditure. Another problem then becomes apparent, how are these changes in autonomous spending financed? The IS analysis is unable to answer this question. And financing is assumed to just occur, without any method being explained.

By not allowing for leakages and injections, a further difficulty is created, i.e. the treatment of savings and investments. Defining savings as unconsumed income (UNISA, 2015b), savings would then constitute a form of monetary finance. This only holds if savings are deposited into bank accounts. If unconsumed income (savings) is “stashed under the mattress”, then in no way does it become a form of monetary finance, and is in fact a passive money holding and thus a leakage. Keynes did not make this differentiation and treated all savings as passive money holding. A possible reason for this is that in Keynes’s time bank deposits typically earned very little interest. This is possibly why under his liquidity preference framework, people either choose to hold cash balances or invest in bonds. Thus, Keynes’s approach can be understood in the context of his time, when there would be little difference between “stashing under the mattress ” and depositing unconsumed income with a bank.

Keynes’s treatment of investment as an injection is also not always true. If investments are financed entirely from aggregate income then they are not injections at all. However, if investments are financed by borrowing from banks then due to the resultant money creation investments will be an injection, not directly, but rather due to money creation. Keynes generally held that investments are financed by money creation. (UNISA, 2015B).

Leakages and injections during different historical periods

Under an economic system where commodity money is used there are two possible forms of injections:

·         More of the commodity being found, e.g. a new gold mine is discovered

·         A surplus on a countries BoP

For a country trading in gold, a third form of an injection would be when gold which is not in the form of coinage is smelted and minted into gold coins.

Leakages would occur as result of a deficit on the BoP and if gold coins are removed from circulation, melted down and used in some other regard.

With the introduction of fractional reserve banking, money is created when banks borrow money, buy bills from nonbanks. Money is destroyed when nonbanks pay back their loans or purchase bills from banks.

Under a fiat banking system the primary injections are money creation by commercial banks, financial asset purchases by banks from nonbanks and a surplus on the BoP.

The primary leakages are the repayment of bank loans, financial asset sales to nonbanks and a deficit on the BoP.

Effects of improper monetary policy

When monetary policy is not applied appropriately this can result in hyperinflation. This occurs when there are several periods of rapid and increasing inflation. (inflationdata.com). This causes massive price instability, erodes savings, transfers wealth from wage earners to business owners. Hyperinflation occurs due to unrestrained money creation.

When the money stock in an economy does not increase adequately, there is a risk of deflation. This means that a reduction in the price level occurs, which implies that the real value of the money stock has increased. At first blush this would seem like a positive component. However, deflation has a secondary, insidious component and that is it causes the in the real value of bank indebtedness. This is a great problem, and counterintuitively the more people try to pay their debts off, the more money destruction occurs, which causes the value of the money stock to again increase and the real value of bank indebtedness to increase once again. A truly vicious cycle.

Macroeconomic disequilibrium and macroeconomic instability

Macroeconomic disequilibrium occurs when firms are not able to sell their aggregate output utilising their full capacity. This then leads firms to curtail production, which implies job losses. A result of unemployment is that aggregate spending decreases which means that even less of firms output would be purchased, creating and perpetuating a cycle of diminished production and unemployment.

Increasing unemployment creates a burden on the government by increasing the demand for welfare transfer payments and subsidies. These transfer payments are funded through taxation and government borrowing. Increased taxation makes firms less competitive, realtively, whilst increased borrowing increases the possibility of a deficit on the BoP.

Unemployment also leads to political and social instability. In this manner if macroeconomic disequilibria are not corrected they have the potential to create macroeconomic instability.

Current examples of macroeconomic instability

From 2000 to 2009 Zimbabwe experienced massive macroeconomic instability. Recessions, hyperinflation, mass unemployment were all experienced by Zimbabwe. This was due to the central bank increasing the money stock recklessly. The central bank did this due to it lacking the independence which would allow it to resist governmental pressure. As this independence was lacking the central bank was forced to “monetize the debt’’ of the government, which meant purchasing massive amounts of government bonds, hence creating massive amounts of money. As a result of this macroeconomic instability, political instability has also occurred with violence, rigged elections and a massive refugee crisis which has swamped neighbouring South Africa all occurring.

Another interesting case is that of Greece. Greece owes large debts. Were Greece a country that enjoys central bank autonomy she would simply “print her way out of trouble”. What this entails is a cutting of the interest rate which leads to greater money entering circulation which results in a depreciation of the currency allowing exports to increase and the economy to expand. Quantitive easing where liquidity is supplied by the central bank to financial institutions other than commercial banks is another method whereby central banks create liquidity (money) in an economy.

However Greece cannot do this as under the provisions of the Treaty of Maastricht it has ceded control of its monetary policy to the European Central Bank (ECB) . This has left Greece with austerity measures as the only solution. These measures are exceptionally unpopular and have resulted in great hardships being visited on the Greek people.

Thus macroeconomic instability has occurred, here too. With recessions, mass unemployment and austerity measures being the order of the day.

References

http://inflationdata.com/articles/hyperinflation/ accessed 21 June 2015

Snowdon, B. and Vane, H. (2005). Modern macroeconomics. Cheltenham, UK: E. Elgar.

UNISA 2015b. Tutorial Letter 103. ECS 4864. Pretoria UNISA

www1.worldbank.org/prem/lessons1990s/chaps/04-Ch04_kl.pdf Accessed 21 June 2015