How Microloans can Change the Third World Economy

Microloans Create Self Employment and Promote Entrepreneurship among the Poorest

A very large part of human population still awaits the benefits of global economic growth in the Third World, including in emerging economic giants like China and India. In some of these countries, microloans have emerged as the major solution for encouraging entrepreneurship among them. They serve to fill a vacuum that traditional means of investment have failed to fill.

Microloans fill the biggest gap in the economies of third world - they provide small amounts of capital right in the hands of willing entrepreneurs. By doing so they make the most efficient use of that capital, at the least managerial and administrative cost.

Why Microloans?

In most third world economies, which are inherently labor surplus and capital deficient, there is enormous scope of decentralized small scale enterprise, like food processing, handicrafts, mechanization of diary or poultry farming, fisheries, garment fabrication etc. All these enterprises are labor intensive, but still need a small amount of working capital without which they cannot be operated in a viable manner. Most people, especially the most backward rural areas, have no capital of their own, nothing to offer as security, and are not capable of satisfying the criteria of credit worthiness required by financial institutions. For these people, microloans are the only opportunity that they can get.

Most microloan programs follow a community based model of operation. Since the amounts disbursed are small, and credit ratings of target population poor, any institutionalized operation will not be viable simply because of disproportionately high over-head costs. Thus, instead of operating it through formal institutions, microloan programs are usually operated through the participation of local people only.

Community based operations add another vital dimension to these microloan programs. Most third world rural societies have strong social bonds, and social and peer pressure has a far stronger and immediate impact than the enforcement of law - for which the agencies are usually far off, and cost of enforcement disproportionately high. By having community pressure to pay back the debt - so that it can be used by other members of community - the probability of timely debt repayments is substantially improved. In addition, the information about the overall attitude and discipline of debt seekers is much more easily available to the local community, who are in a far better position than any financial institution to select candidates with greatest likelihood of honoring their repayment commitments.

Microloans  Vs. Mega Investments

Microloans are often weighed against mega investments, in terms of their overall returns. Interestingly, developed countries have little role for microloans, and yet microloans are advocated in developing countries. The reason again lies in the fact that in developed countries, labor costs are much higher and availability of labor scarce, so it makes sense to invest in mechanisation of production. On the other hand, in developing countries the cost of labor is much smaller - in fact, since the unemployment rate is high and microloans help bring some unemployed workers in the economy, the Opportunity Cost  of that labor is Nil.

In simpler words, in developed countries the same investment would shift labor from one activity to another and hence, increase in production in one area will be balanced by fall of production in another. On the other hand, in developing countries, microloans help increase overall production by bringing new (yet unemployed) labor into economy.

One could argue that such additional labor could also be brought into productive work force by mega investments. That does not really happen, because most mega investments create mechanised systems that do not contribute substantially to creation of jobs. Thus, compared to large investments, microloans create more self-employed jobs, and boost the economy.

Microloans are Financially Viable Investments

It is often thought that microloans are without any interest. Actually, such a statement is only partially correct. The main financing agency, whether it is Government, a financial institute or a charitable agency, usually offers the initial corpus to the community either free of interest, or at a very nominal interest rate. The community, in turn, does charge some reasonable rate of interest from the actual users of the funds. Most often this rate of interest is not very different from the organised market interest rate, but it is provided to candidates to whom either market will not provide loans or it would be provided only at a huge risk premium that they would be unable to bear and at which it would not be financially viable for them to start an enterprise.    

Microloans have a very important role to play in the third world economies. If used appropriately, they can make a huge difference to the life and earning of the people, as has been the experiences in many countries like Bangladesh, India, Cambodia and others. The Grameen Bank in Bangladesh is now recognized throughout the world. In addition to providing earning opportunities to the underprivileged, such programs have also contributed immensely by empowering them and training them in community based projects. As they grow further, their contributions can become even more appreciable.