Is microcredit a debt trap?

The act of taking out a loan implies an optimistic view of the future. Borrowers believe their future earnings will be sufficient to pay back the principal and the interest on the loan. Behavioural economics shows that people tend to be over-optimistic. If that optimism is misplaced, the borrower will either default on the loan or face the need to sell assets or cut consumption. Researchers have found that micro-borrowers often make sacrifices in their daily lives to repay loans on time. Cutting down on cigarettes or sweetened tea may not seem unreasonable but providing smaller meals for school-age children certainly does.

Default has been a defining factor in microfinance crises – for example in Bolivia in the late 1990s and in Bosnia-Herzego­vina and India at the end of the 2000s – and is currently being watched with concern in Mexico. Default means that microfinance institutions (MFIs) loans have gone bad – no further repayments are being made. If this happens on a large scale, default can destroy an entire system. The delivery of microcredit as a group loan – a practice inspired worldwide by the Grameen Bank model – incentivises both borrower group members and MFI loan officers to make ever new loans. It is thus a particularly susceptible system.

But default should not be equated with over-indebtedness. In the crises mentioned above, for instance, microcredit group members did not only refuse to make repayments because they were over-indebted but also because the prospects of new loans dwindled as defaulting borrowers caused more and more liquidity problems for the MFI.

Over-indebtedness was measured indirectly in the past, especially in qualitative studies. Roodman (2012) provides an excellent overview of the literature. There are a number of new studies addressing the issue of over-indebtedness.

Devastating cycle of rescheduling

In one ethnographic study, Mader (2015) shows how Vietnamese and Indian households are burdened by over-indebtedness. In other studies, borrowers report “being unhappier than people with no loans” (Mader 2013). Those borrowers are mostly clients of the big Indian microfinance providers using the group-loan model. Mader argues that those providers push their clients into a devastating cycle of rescheduling, in which one loan is used to repay another.

Rescheduling is indeed common practice among micro-borrowers. Mader is one of a number of authors documenting the fact that loans are frequently used to pay off other loans. That said, the modern microfinance movement also claims that its group loans end dependence on loan sharks. In such cases, rescheduling goes hand in hand with lower interest payments. However, figures from India cast doubt on the formal MFI claim that loan sharks are being systematically dislodged. Evidence suggests that loan-shark business flourishes alongside the MFIs.

Schicks (2013) developed an innovative approach that measures over-indebtedness in terms of sacrifices. The author makes a distinction between structural sacrifices with a long-term impact – such as the sale of assets or rescheduling of debts – and non-structural but unaccept­able sacrifices such as less food, a poorer diet and lower expenditures on education and preventive health care. Households making more than three undue sacrifices during the evaluation period were classed as over-indebted.

In a quantitative household survey of more than 500 microcredit clients in the Ghanaian capital of Accra, nearly a third of respondents were classed as over-indebted (Schicks 2013). KfW Entwicklungsbank, which refinances many MFIs, also initiated a study on over-indebtedness in Uganda. While Schicks focused exclusively on active microcredit clients of formal MF providers, the KfW study covered borrowers involved with various MFIs. This allowed to relate the over-indebtedness measured to the sources of loans.

The results revealed that households with only formal loans actually made fewer sacrifices than those who had taken out no loans at all. Households with loans from various sources – not just formal but also informal or semi-formal MFIs – made significantly more sacrifices. The most sacrifices were made by households with loans from semi-formal sources.

Sacrifice the same as over-indebtedness?

Not every sacrifice is a sign of over-indebtedness. On the contrary, it is to be expected that borrowers will make sacrifices now and again if their income fluctuates and a loan payment is due. As the chart shows, even households with no loans occasionally make sacrifices termed distress by KfW (2015). Nevertheless, sacrifices are a plausible indicator of over-indebtedness. Households with loans from more than one source make more sacrifices on average than those with loans from only one source. Semi-formal and informal loan sources may thus cause more distress than formal ones because formal providers in Uganda report to the Credit Reference Bureau. This means that the size of the loan is adjusted to suit the borrower’s ability to pay, which is not the case with semi-formal and informal providers. It is intuitively logical that households which take out a poorly vetted loan in addition to a carefully calculated formal one experience corresponding distress.

Organisations like KfW and GIZ, which work on the “institutional setting” of microfinance markets, can consider their work justified by the latest findings about over-indebtedness. Institutional setting is the interaction between regulation and organisation. If MFIs grow fast and have little incentive to conduct a robust assessment of the impacts of their lending activities or to extend their product range beyond microcredit and instead adopt a casual sense of accountability, over-indebtedness is virtually inevitable. Where the impacts are accurately assessed and appropriate regulators – such as credit reference bureaus – are present, access to microcredit makes a solid contribution to human development.

Oliver Schmidt has worked in financial sector development in India and Uganda since 2005. Since the end of 2016 he has been a freelance consultant, among other things helping the Ugandan NGO New Mindset Mentoring Institute of Africa (NEMMIA) create rural savings groups.
oliver@iqpconsult.de

Link
Extended version of this article in German, with a detailed description of the various methods for measuring and studying over-indebtedness:
http://www.researchgate.net/publication/315691028_Mikrofinanz_ohne_Hype

References
KfW Entwicklungsbank, 2015: Financial struggling in Uganda – Who struggles more and why? KfW Evaluation Update No. 2.
https://www.kfw-entwicklungsbank.de/PDF/Evaluierung/Themenbezogene-Evaluierungen/Nr2_Financial_Struggling_in_Uganda.pdf
Mader, P., 2013: Scheitern auf Raten. In: Max Planck Forschung 3/2013, pp. 12-17 (in German only).
https://www.mpg.de/7540958/MPF_2013_3.pdf
Mader, P., 2015: The political economy of microfinance – Financializing poverty. London et al: Palgrave MacMillan.
Roodman, D., 2012: Due diligence – An impertinent inquiry into microfinance. Brookings Institution Press.
Schicks, J., 2013: The sacrifices of micro-borrowers in Ghana – A customer protection perspective on measuring over-indebtedness. Journal of Development Studies, Vol. 49(9).