Capital Markets

Microcredit: Trickle-up Economics

"The poor are good credit risks," says one lender. "They don't normally have access to funding, and they protect it carefully."
Marie LeoneOctober 20, 2005

To track their progress, most global lenders use well-known key performance indicators like customer profitability or transaction-reserve ratios. For their part, however, microcredit providers employ a set of gauges much less familiar in the banking world: how many clients have moved from shacks to concrete-block homes; how many can feed themselves and their families; and how many have children that are properly clothed and attending school.

The measurement of success is so decidedly different for microcredit lenders because their clients are worlds away from those of traditional commercial banks. The recipients of such loans and grants are among the poorest people on earth: Africans, Asians, Latin Americans, and Eastern Europeans who live on less than a dollar a day. In such circumstances, a little goes a long way. Indeed, a loan of between $50 and $200 to start a business can help many clients work their way out of poverty, says Larry Reed, chief executive officer of Opportunity International, a microcredit lender based in Oakbrook, Illinois.

Advocates of microcredit, also called microfinancing, contend that it’s a modern-day example of the old Chinese proverb, “Give a man a fish, and you feed him for a day. Teach a man to fish, and you feed him for life.” The concept is to provide seed capital, in most cases less than $200, to entrepreneurs too poor to qualify for traditional bank loans. The expected result for the businessperson’s family is a self-sustaining income.

It may be unfathomable for Americans to imagine that a $100 loan could jumpstart anything more than a lemonade stand. But the standard of living is so low in the poor communities of countries like Malawi, Uganda, Colombia, the Philippines, and Romania, that equipment, tools, and packaging can be bought for a few dollars. Raw materials and livestock don’t cost much more.

Consider the Monger Group, a business started by a few Tanzanian entrepreneurs with a $100 grant from the Village Enterprise Fund, a microcredit lender and grant maker. The group, which used the cash to buy an anvil, crafts farm tools out of spare truck parts. Business is booming, Village Enterprise officials report, noting that the company has begun exporting tools to Zambia and the Congo.

Then there’s Aurora Matias of the Philippines, who once sold slices of bread and slivers of soap in a Manila neighborhood where people couldn’t afford to buy entire loaves and bars. Business was brisk, but Matias never turned enough profit to keep her shelves fully stocked. Using a small loan of about $100 from Opportunity International, she bought bottles, labels, and large quantities of bleach, fish, and soy sauce. By buying in bulk and reselling the products wholesale, her business gradually expanded. Now Matias sells to more than 50 stores and employs two full-time and five part-time workers.

Overall, microcredit lenders fund a sizable range of businesses. Some, for instance, sell vegetables and grain, used clothing, or charcoal for cooking. Others raise animals, produce bricks, or make garments.

Creditors are reassured by how prudent the entrepreneurs often are. “The poor are good credit risks,” says Opportunity International’s Reed. “They don’t normally have access to funding, and they protect it carefully.”

Further, their businesses tend to last. In fact, adds Brian Lehnen, Village Enterprise’s executive director, over 88 percent of the 9,000 businesses started with his organization’s funds have remained in operation for at least one year; 75 percent have continued for four years or longer.

That success rate is remarkable, considering that half of the self-employed startups in the United States fail in the first year and 95 percent go out of business within five years, according to the U.S. Small Business Administration.

Non-profits and the Poor

According to the Microcredit Summit Campaign, an international organization launched in 1997 to promote the cause, 55 million extremely poor families were being reached by microcredit at the end of 2003. Most of the operations that offer it are non-profits, including some that are faith-based. Frequently, the lenders are funded by donations; some are financed by the World Bank.

The notion of microcredit reportedly was shaped by Muhammad Yunus, a U.S.-educated professor of economics who set out to fight poverty in 1974 when widespread famine struck his native Bangladesh. He loaned $27 to a woman, who started a bamboo-furniture-making business that lasted for many years.

The business’s sustained income, enabling the woman and her family to survive, inspired Yunus to formalize the lending process. He eventually founded the Grameen Bank, which today boasts 1,267 branches in Bangladesh that lend $3 billion in microcredit financing to 2.4 million clients.

Opportunity International, a faith-based organization, casts its lending net a good deal wider. It operates in 27 countries via a network of 42 country partners. The partners are individuals that supervise the lending on a countrywide basis. Part of their responsibility is to recruit community professionals — often religious workers and educators — as loan officers. Using their grasp of the local cultures and economic challenges, the loan officers work with would-be entrepreneurs to refine their business ideas, develop budgets, and apply for loans. Once funds are approved, loan officers train the new owners in productive business practices.

In all, Opportunity International arranges for more than 1 million small business loans a year. In 2004, the lender distributed $242 million worth of collateral-free financing, backed only by its clients’ stellar credit history. Many borrowers average repayment rates of 98 percent, with some regions maintaining an astonishing 100 percent payback rate.

The terms of microcredit loans tend to be straightforward. Opportunity International, for instance, usually provides credit at market-based interest rates on four-month to six-month terms. The lender uses the interest to cover the operating costs of partners and loan officers. First-time loans often require mandatory small-business training.

The training pays off. Take the example of Beatrice Kitaara, an entrepreneur from Uganda who has learned to budget her money and use it more productively to expand her agricultural business. A client of Opportunity International, she used an initial loan of $115, and a second of $170, to set up shop selling vegetables, ground nuts and grains, and milk, while her husband worked on a farm. They use the profits to feed and school their nine children, who are between the ages of six months and 18 years old.

“My family’s health has improved because their nutrition has improved,” remarks Kitaara, who says she hopes to further expand the business by adding to her stable of cows. Likewise, Susan Okepa — another entrepreneur from Uganda, and a client of Village Enterprise — says that growing and selling vegetables has provided her family with “food, pigs and goats, a new brick house, and an [account] at the Women’s Savings Bank in Tororo.”

Very few clients renege on their business-plan promises, says Lehnen, who operates Village Enterprise out of San Carlos, California. Although he says there are many barriers to entry in starting a business in poor communities — lack of money and business know-how, to name two — there’s little competition. That’s one reason that businesses propped up with microcredit financing succeed.

Another secret of their success is the way programs are structured. For example, Village Enterprises bases its grant repayments on an incentive system. Half of the grant total — which averages between $100 and $150 — is released to clients for the purpose of demonstrating their ideas’ viability. Once the business is up and running, the balance is released.

Village Enterprises also provides larger loans — up to $15,000 to groups of about 25 — for community projects. The projects have included trucking business, maize mills, and commercial bakeries.

Opportunity International’s Reed says his organization’s most successful structures are groups of 20 to 30 local small-business people called “trust banks.” The groups usually consist of women because their repayment rate is better than that of men, and they tend to focus more on the community and children, according to Reed. The clients elect leaders and apply for a group loan that’s collectively guaranteed by trust-bank members. The funds are distributed according to individual business-plan needs, and if one client defaults on payment, the others in the trust are obligated to repay the debt.

The size of trust-bank credit offerings varies from country to country, but first-time loans can be as small as $50 and usually top out at $125. Groups can apply for future loans after paying off existing balances, and members can graduate to larger individual loans with longer terms.

In the Clear

As it is for virtually all lenders, financial reporting transparency among borrowers is a major issue for microcredit organizations, which must show existing and potential donors how their money is being spent.

Village Enterprise does most of this disclosure in its annual report, which covers general accounting information filed with the Internal Revenue Service as well as more-specific data about where funds are being spent and how the grants and loans are fostering changes in people’s lives. Much of the non-financial reporting is collected by Lehnen, who has visited with 600 of the organization’s 1,800 clients so far. Village Enterprise serves the contiguous countries of Kenya, Uganda, and Tanzania.

To report financial results on a quarterly basis, Lehnen’s staff of three full-time employees and two interns use Quicken accounting software. Most of the financial tracking involves monitoring the 100 to 200 grant applications that each country’s office submits every year, and distributing funds to the approved projects.

Opportunity International requires more muscle in it financial reporting because the operation has blossomed so quickly. Indeed, the lender’s loan portfolio has expanded at a compounded annual growth rate of 36 percent over the past five years. To help cope with that rapid expansion, last year services manager Tim Head rolled out a Web-based accounting software system donated by Hyperion Solutions Corp. (AnswerThink Inc. donated information-technology consulting services as well.)

Previously, Head gathered financial data by exchanging Excel spreadsheets with country partners, today he uses the Hyperion software, which he also uses to monitor such metrics as the number of loans offered, the number of clients, and repayment rates. He analyzes the results to help CEO Reed and Opportunity International’s board set broad development initiatives. One goal: serve 2 million clients by 2010.

On a tactical level, Head tracks late payments on a quarterly and monthly basis, creating an early warning system for regional loan portfolios at risk. He also distributes loan-risk tables to country partners, enabling him to share best practices with colleagues halfway around the world.

Indeed, one of Head’s tables highlighted the organization’s Philippine operation, where the partner was maintaining a zero percent default rate among the country’s 300 clients. His secret? The partner paid out bonuses to local loan officers who maintained a zero default rating. Part of his method was to urge loan officers to intervene quickly, before repayment snags turned into defaults.

Soon, Head was sharing the bonus-plan idea with other country partners. Within a year, the country partner in Ghana cut his default rates from 20 percent to 2 percent, and a partner in Zimbabwe with a high default rate cut non-payments enough to pull even with Opportunity International’s other African operations.

More broadly, financial transparency helps officials at Opportunity International advance their theory of “trickle-up economics.” Rather than waiting for big changes to eventually help the poor, it’s better to help teach them to fish, because the return on these tiny investments can be immense.