Op-Ed: Microfinance revisited and its role in reaching the missing middle

Two weeks ago I wrote about James Surowiecki’s article in the New Yorker that brought forward the inherent limitations of microfinance to actually generate a substantial number of jobs in a developing country. Since then it seems as if I was not the only one (surprise surprise) to take notice of Surowieki’s conclusions and it has even brought pioneers like Acumen Fund‘s CEO Jacqueline Novogratz into the argumentative fray.

Novogratz gave some credit to Surowiecki’s argument that not everyone in society is an entrepreneur and that in fact most people simply want a predictable, stable job with defined roles. Novogratz, however, distinguished her stance through her anectdotal experience with women’s access to credit and how throughout her experience they have overwhelmingly been favorable towards it. She says that this desire for credit provides the rest of us with critical lessons on how to address poverty.

However, the desire for credit on its own in no way makes someone an entrepreneur. Every teenager in America has an affinity for credit, but just because they are willing to spend that money somewhere does not make them some sort of innovator. Likewise, Surowieki’s argument highlights that for the most part microloans are not utilized for business expansion, but rather they help tide businesses over during rougher times, a la a bridge financing round. These funds like simple credit cards are used to cover funds that someone has already spent before — not towards future capital investments. It is that ability to reinvest ones funds towards scalability and expansion that is truly entrepreneurial.

Novogratz to a certain extent recognizes this limitation and reframes microfinance as one tool of many to help the poor.

But we’ve learned how to deliver at least one product to the poor, and we have an unprecedented opportunity not only to build larger businesses that employ people but also to deliver other critical products — healthcare, clean water, housing and alternative energy — to the poor in ways they can access and afford.

In fact, Acumen’s primary focus is specifically to find those social ventures that do exhibit potential economies of scale and to provide them with the capital they need to grow and actually become a viable business that hits the missing middle. One example is LifeSpring Hospitals, whom Acumen recently provided seed capital to expand its hospital network. When we speak of the missing middle here, we are primarily looking to those businesses that the developed world take for granted, like supermarkets, clothing stores, etc. — the types of businesses that employ numerous people and can sometimes leverage economies of scale to reach more customers.

But this funding gap can be difficult to navigate and assess. What sort of criteria must be used to sift out those enterprises most suited for scaling up via social venture capital infusions? What are the metrics that must be applied to reach this conclusion? Acumen has developed an in house metric called BACO, or the best alternative charitable option. This metric operates as a comparative tool to assess which ventures are most likely to be a successful small or medium size enterprise or SMEs. Moving one level up, Xigi.net has developed a social capital index that is intended to monitor and assess the performance of funds like Acumen themselves.

Such measurement tools are crucial as money has begun to flow into the SME space. One effort that has received particular attention is the $17 million dollar SME fund that Google.org with others has launched targeting India. But where will this money go, and how can we be sure it will not be wasted? It is here, where I believe that microfinance instiutions and their clients provide the greatest value to the development community. Beyond the obvious benefits earned by the client herself, microborrowers also serve in effect as beta testers for new and creative ways to address complex problems. Metrics like BACO and Xigi.net’s SCI will assist in this effort, but in the end we will have to accept that there will be times when an investment may pressure a microbusiness to try to expand only to result in failure. While it may seem callous to view individuals in this light, I do not see another alternative to an efficient yet organic mode of development.

The shift away from pure debt financing to capital investments, as evidenced by Google.org’s new fund, will help this process as failed attempts to expand will not result in the financial ruin of that individual. With venture capital like infusions, the possibility of failure becomes ingrained in the initial investing analysis. A post on Nextbillion.net by Nitin Rao speaks to this. Rao argues that it is unfair to state that microfinance does not lead to business expansion, since the present size of the MFIs does not lend them to being accesses to capital, but instead specifically to the discrete poverty alleviation of that specific borrower.

According to a study by SIDBI (Small Industries Development Bank of India), loans from MFIs/group funds are used mostly for productive purposes (as high as 80% in the Grameen and Individual model and 60% for SHG members). With over 90% MFIs serving less than 10,000 clients, it appears likely that larger microfinance institutions will lend for productive purposes – and smaller SHGs will be relatively flexible about the use of capital. When I wrote to SKS, they insisted that the MFI only lends for income generation and by the loan utilization check verifies it too.

But this again speaks to my issue that microfinance is good at alleviating poverty for those individuals involved but at this juncture it is uncertain that it can provide more. Most people invested in addressing development did not go into it with the utlimate goal of simply elminating poverty. No, our goals are much loftier than that as many of us want to figure out ways to enable entire communities and moreover nations to raise their aggregate standards of living to that where they are competitive players in the global economy.

That is not to say that microfinance is not a viable or amazing tool at society’s disposal. But it does bring to light the fact of the dangers of having an overly rosy perspective of it. One area where microfinance can and should have a significant role, however, is in its integration with the traditional banking sector. One of the most difficult aspects of the missing middle challenge is finding these potential entrpreneurs in the first place. A great way to do that is to tap into the one commonality that every social entrepreneur shares — the need for funding. Suggestions have been made to better coordinate between MFIs and traditional banks to empower rural individuals and provide them access to credit. Amdist the recent loan waiver for farmers controversy, the CFO of SKS Microfinance had the following to offer (From VC Circle):

In an interview to VC Circle, S Dilliraj, CFO of India’s leading microfinance institution, says that “farmers need income for survival and not debt relief”. According to him, the long-term solution to this problem could be closer collaboration and synergy between banks and MFIs for rural lending. And also take the local moneylender along instead of banishing him from the system.

A corollary to this would be the development of a financial network to identify and communicate with potential entrepreneurs throughout the country. This is not to say that microfinance should not play other roles, but in my opinion we need to look for ways it can evolve as an institution and practice. The future of development, particularly in India with its massive population and innovation hubs, is in the small and medium size businesses. Harnessing microfinance to get us there seems like a ‘small’ step along the process, but it is one that may result in macro-effects.