How to make microcredit work

Simple changes to contract design could be a significant way of enhancing the effectiveness of microcredit, suggests a new review.

After much initial hype, the effectiveness of microfinance or microcredit to fight global poverty has come under question in recent years with a number of studies showing little or limited impact of microcredit on household welfare. In a recent review article published in Ideas for India, a policy research portal, Mushfiq Mobarak of Yale University, and Vikas Dimble of Tata Centre for Development point out that the shortcoming of microcredit is not the programme’s execution, but rather the structure of the microcredit model. According to them, modifying and expanding the model could improve outcomes for the poor.

Since the IL&FS defaults, it can be noted that NBFCs and housing finance companies (HFCs) were facing a crisis of confidence, sending call money rates higher and overall liquidity tight. (Mint photo)

For instance, they point out that many microcredit programmes require that repayment starts almost immediately and follow a strict weekly schedule, which can make it difficult for borrowers to repay the loan since returns from productive investments can take time to be realised. They suggest introducing flexibility in repayment schedules can increase business investments and profits. They point to a study which showed that simply switching from a weekly repayment schedule to a monthly one led to significant improvements in household income for the recipients without any increase in defaults.

One reason for the strict requirement of repayments is the lack of information about the creditworthiness of clients. To address this, the authors argue that community information can be harnessed to better target microcredit lending to those who will make the best use of it. They refer to a study conducted in Maharashtra, in which the researchers asked entrepreneurs to rank their peers on various metrics of entrepreneurial characteristics. The study found that the community was able to accurately their peers with the top-ranked entrepreneurs earning significantly more returns.

The authors also suggest that the scope of the microcredit policy can be expanded to move beyond entrepreneurship. They suggest that loans should also be offered to those who are looking for jobs or for smoothing consumption during difficult difficult periods.