The following thesis is based on the abstract exploration of microfinance as a poverty-reducing measure. Poverty, by definition, is often assessed as the lack of income and consumption by poor households and financial services often neglect these households due to risks of low repayment and financial management. However, microfinance institutions have given rise to a new meaning for poverty reduction and development. Poverty should be defined as the lack of essential individual freedoms for the pursuit of a life with reason to value, according to the capability approach. Empirical evidence is combined with the capability approach to define the impact of modern microfinance institutions on poverty. Today, these institutions boasts goals of reducing poverty by providing credit to the poor, but the problem is embedded at a deeper level for poor households. At a level at which the question of ability to convert resources in capabilities is examined and only then can the impact of microfinance on poverty reduction be measured. Evidence that micro loans reduce poverty may be weak, but other services such as saving and health insurance may help the poor start a life worth valuing, and ultimately helping to eradicate poverty in the long run. The question then is not can microfinance increase poor households’ income consumption, but rather whether microfinance can support poor households with the basic capabilities they need to lift them out of poverty with a life worth reason to value.

Microfinance, poverty and development of capabilities

Harvard Extension School

SSCI – 100B

Professor S. Harris

December 18, 2012

Nour Halabi

To alleviate poverty, policy makers increasingly rely on theories of social

capital to fashion development interventions that mobilize local social networks in

third world countries. The potential of such a theory lies in its recognition of the

social dimensions of economic growth and the importance of government

intervention. This recognition has inspired some innovative approaches to

development, such as the now-popular microfinance model. In assessing the

implications of these recent developments for economic objectives of social

transformation, this paper evaluates prevailing ideas about poverty and the

impact of microfinance on the reduction of poverty. The paper concludes by

bringing these critical insights to bear on possibilities for designing microfinance

programs aimed to reduce poverty by enabling the poor access to basic

capabilities; rather than to eradicate poverty as defined by being of ‘low-income.’

To practice a kind of development more generally could engage an impoverished

society’s solidarity to challenge dominant economic ideologies and lead people to

live a life they have reason to value.

The most common approach to identifying the poor is through evaluating a

set of basic needs that humans need to sustain a fulfilling life and recognizing

that someone is poor if these needs are unmet. The ideology of this approach

attempts to define what absolute minimum resources people need for long-term

physical well-being, which can be defined in terms of consumption goods like

food, housing, schools, and healthcare. To assess who is living below the

threshold of poverty, it is possible to use the income method to calculate the

minimum income at which all the basic needs are satisfied in terms of the

consumption of food, water, clothing and housing.1

Another method would be to evaluate the set of people whose actual

consumption baskets leave basic needs unsatisfied. But if basic needs can be

defined as needs for commodities, then it may mean that these commodities are

no more than a means to ends. So even the relationship between commodities

and capabilities differ between people and societies. In other words, there is a

difference between meeting a basic need by using some commodity and having

that commodity. Thus, the purpose of meeting the basic needs requirement is not

so people can possess commodities, but rather to help people succeed in doing

and being.

Does is follow to define poverty as people living below some measure of

‘consumption’ income? Poverty cannot be defined as income poverty because

there is no detail as to how income is allocated in a family.2 Also the relationship

between capability and income is varied for different societies, families and

individuals. So focusing on income might not shed light on the ability to convert

income into capability since it ignores factors that promote an individuals well-

being. And if the right approach to evaluating a person’s well being is to focus on

their capabilities and functioning, then poverty should be defined in terms of the

deprivation of basic capabilities which include income, education and health.

Without such basic capabilities, people “can barely initiate any move toward the

life they have reason to value.”3 Thus, when poverty is defined as the deprivation

1 Pradhan 468.2 Laderchi et al. 2003.3 Sen Resources, Values and Development 10.

to basic capabilities to live a valuable life and not as a lack of enough income,

poverty becomes relative in the space of commodities. As Adam Smith once

discussed the concept of necessities to make clear a distinction between

absolute and relative poverty, he said:

“By necessaries I understand not only the commodities which are indispensably necessary for the support of life, but what ever the custom of the country renders it indecent for creditable people, even the lowest order, to be without…Custom…has rendered leather shoes a necessary of life in England. The poorest creditable person of either sex would be ashamed to appear in public without them.” 4

So as to avoid shame, an Englishman in the 18th century would have had

to have leather shoes. Considering the expensiveness of more and more

commodities, it still holds that the commodity requirement of the same capability,

avoiding this type of shame, would increase. In terms of the commodity space,

escaping poverty to avoid shame would require the collection of commodities in

order for someone to be able to participate in society and fulfill some measure of

basic capabilities. In other words, even when an individual’s absolute income is

high in terms of world standards, being relatively poor in a rich country may serve

as an immense capability handicap.

While it is commonly understood that the poverty line is set in terms of

income shortage, it may be that the poverty line should be defined as the level

below which an individual cannot meet nutritional requirements, participate in

communal activities or appear in public without feeling shame! However, some

capabilities like being well nourished may have more or less similar demands on

4 Sen Resources, Values and Development 10.

commodities irrespective of the average living standard in which a person lives;

other capabilities such as to be free from public shame or to visit friends may

require more real income and wealth in a developed country than a developing

country.

It follows then if right approach to evaluating a person’s well-being is in

terms of their actual opportunities and capacities to do that which they have

reason to value in their life, then development should be defined as the

expansion of those capabilities for all peoples to enjoy. Historically, the

connotation associated with development was the increase in GNP per capita,

which exacerbated distributional inequality by failing to disaggregate and

consider separate dimension important to development such as health and

education.

According to a study conducted by the United Nations, more than 840

million people suffer from hunger globally, and over 100 million do not have

housing while one-sixth of the world’s population is illiterate. According to the

United Nations Children’s Fund (UNICEFA), approximately 148 million children

under the age of 5 in developing countries are underweight; 22 million infants are

not protected from vaccine-preventable diseases; 8 million children died before

the age of 5 in 2009; 2 million children under 15 years are infected with HIV;

nearly half a million women die each year from causes relating to pregnancy and

childbirth. About 22,000 children die from poverty and nearly a billion children

were illiterate entering the 21st century.5 The reports can only show a fraction of

the reality of people suffering from poverty. While there isn’t a concrete and

5 World Health Report 2005.

effective approach to eradicating poverty, microfinance plays an important role in

alleviating the problem of poverty.

Microfinance is a practice that involves the provision of small loans to

people that lack conventional collateral and financial services which vary from

micro savings to micro insurance. And huge attention has been gained in the

industry over the last 30 years. People with decent work and decent pay take

their situation for granted. But for the 1.4 billion people living on less than $1.25 a

day, access to financial services are a luxury. Poor households are excluded

from formal financial services due to collateral requirements, complicated

application procedures, high interest rates, and the complicated inequality issues

with admissions processes. So microfinance institutions are modeled to operate

with programs that prove that lending to the poor without collateral is feasible and

repayment rates can be sustained when the programs are adequately designed.

If well being can be evaluated in terms of capability and functioning, then

poverty should be seen as the absolute deprivation of basic capabilities and

development to be understood as the process of realizing basic capabilities and

hence the impact of microfinance on poverty reduction cannot be measured only

by income but by basic capabilities. So the question is not whether microfinance

can increase or decrease a poor man’s freedom, but can microfinance increase

or decrease a poor man’s basic capabilities?

Tracing back to the 18th century when lawyer and political philosopher

Lysander Spooner suggested giving small loans to farmers and entrepreneurs to

help the poor out of poverty, microfinance again took a world stage at the end of

World War II. Where it once meant only microcredit, or the extension of small

loans to poor people for income-generating activities, microfinance refers to

offering poor people with basic financial services such as loans, savings, money

transfer services and micro insurance. Nobel Laureate and Founder of Grameen

Bank, Muhammad Yunus and other organizations such as ACCION International

and SEWA BANK formed the most notable microfinance institution during the

1970s. Modern microfinance institutions came into existence because of the

failure of agricultural credit, formal financial institution’s denial of lending to the

poor, and the ineffectiveness of informal financial providers. These issues built

the foundation for microcredit. And the products available from microfinance have

evolved from simple microloans to micro savings,

Two paradigm shifts correspond with the recent development trends in

microfinance products. During the period between the 1960s and the 1980s,

microfinance focused on offering credit to agricultural entrepreneurs by

governments and donors. During the second half of the 1980s, there was a

paradigm shift from subsidized credit to financial sustainability of microfinance

institutions.6 Since government subsidized credit focused mainly on the ability

and willingness of poor farmers to pay for financial services, the shift focused on

building cost-efficient institutions to reduce risks and strategic defaults associated

with lending to the poor.7

And the second paradigm shift began in the middle of 2000. During this

shift, “access to formal financial services including savings, credit insurance and

6 Adams 31.7 Zeller ‘Rural finance and Poverty alleviation’ 1998

payments through a formal financial intermediary, at an affordable cost” defined

the principle that microfinance institutions would focus on financial inclusion. This

would translate into meaning that microfinance institutions would offer financial

providers with a comparative advantage to serve the poor and low-income

households to assist in the development of micro and small enterprises.

Most microfinance institutions only offer one service, loan and recovery,

but in the second paradigm shift, these products developed into all kinds of

financial services due to increasing competition and withdrawal rates. 8 Because

of increasing competition, clients would not only take out multiple loans at a time,

but also risk defaulting on their microcredit. Hence there was a need to focus on

the relationship between clients and products, and develop products that match

the needs of clients. So microfinance moved from concentrating on enterprise

investment to household money management.

Microloans are no longer limited to enterprise investment only today. The

poor are allowed to have a savings account and take out loans for other

purposes to sustain a life they have reason to value and live with basic

capabilities available to them.9 Financial products available to the non-poor

include: microloans for enterprise purposes which remain the dominant product

provided by microfinance institutions; micro savings which allow access to saving

services that make the poor less vulnerable to events requiring large sums of

money such as emergencies, investment opportunities, and life-cycle event; and

micro insurance which protects low-income people from peril in exchange for

8 Cohen 343.9 Dunn 2002.

regular monetary payments which mirror the cost of risk involved, similar to what

insurance is for the non-poor.10

As the objective of microfinance institutions was to lift poor households out

of poverty by offering small loans, the question of poverty reduction cannot be

answered simply by supplying the poor with money. As discussed, poverty

means much more than simply a lack of income. Thus microfinance institutions

can help reduce poverty if poverty is defined as something more than a lack of

income, but rather a lack of basic capabilities for the poor. The goal must be to

expand from poverty reduction to building a system in which low-income

households have access to financial resources and feel socially empowerment.

Microfinance was founded on the principle of helping eradicate poverty. In

terms of the programs available to the poor, this means raising income levels and

providing financial excluded people with financial and non-financial services. Kofi

Annan, the former Secretary General of the UN, stated during a Microfinance

Symposium in 2005:

“...Microfinance is gaining general acceptance. A small loan, a savings account, an affordable way to send a pay cheque home, can make all the difference to a low-income family, or to a small-scale enterprise. With access to microfinance, people can earn more and better protect themselves against unexpected losses and setbacks. And with the ability to collateralize their assets, they can move beyond day-to-day survival, towards planning their future. That means they can invest in better nutrition, housing, health, and education for their children. They can create productive business, and recover quickly in the aftermath of natural disasters. In short, they can take real strides towards breaking the vicious cycle of poverty and vulnerability...Microfinance is a way to extend the same rights and similar services to low-income households that are available to everyone else. It protects people against shocks, and allows

10 Rutherford 3.

the majority of the population to become part of a country’s economic activity”11.

When Kofi Annan made this address to the UN, he addressed the ‘poor’ as the

low-income households. This draws upon the dominant connotation with

microfinance in that it defines poverty as a shortfall in consumption below a

poverty line.12 In the field of microfinance, the poverty line is equal to one US

dollar or less. Muhammad Yunus explains:

“There are almost as many definitions of poverty as there are individuals and groups studying the problem. A recent World Bank study mentions thirty-three different poverty lines developed and used by particular countries in addressing the needs of their own poor people... Whenever I refer to poverty with no more specific explanation, this dollar-a-day definition may be assumed.”13

Annan also states that to break the vicious cycle of poverty and

vulnerability, microfinance is the key. This is the dominant role of microfinance in

the industry but although the experts cannot deny that other social interventions

such as employment, education, and healthcare are necessary in order to

alleviate poverty, they argue that the access to financial services is the

foundation for making other social interventions become sustainable.

“No single intervention can defeat poverty. Poor people need employment, schooling, and health care. Some of the poorest require immediate income transfers or relief to survive. Access to financial services forms a fundamental basis on which many of other essential interventions depend.

11 http://www.un.org/News/Press/docs/2005/sgsm10151.doc.htm.

12 Hulme 1996.13 Yunus 27.

Moreover, improvements in health care, nutritional advice, and education can be sustained only when households have increased earnings and greater control over financial resources.”14

In other words, the right approach to tackling poverty may be seen as

giving the poor access to microfinance. As stated, it has been said that the

primary object of microfinance is to reduce poverty. As perceived, microfinance

aims to lift the poor out of poverty by funding micro-enterprises and providing the

poor with income to consume. The many accounts and stories of microfinance

will point out how the poor have been able to use those tiny loans to start or

expand their businesses, and realize notable gains not only in income and

consumption, but it has granted them access to basic capabilities that include

health, education, and social empowerment. Additionally, microfinance

advocates use these compelling stories as evidence to gain support from

international donors and investors. Muhammad Yunus makes an argument that

microfinance plays a significant role in the lives of poor people by reducing

poverty and enhancing peace.

The question remaining is whether these cases justify microfinance as a

means to reduce poverty? I examine microfinance in terms of whether it

increases or decreases people’s substantial freedoms in terms of increasing their

income, education, and health. Although microfinance may be contributing to

reducing poverty in terms of allowing for consumption by poor people and

potentially increasing basic capabilities such as education and health, the current

evidence and literature suggests that there may be no automatic positive link

14 Littlefield 7.

between the reduction of poverty due strictly to microfinance. Microfinance may

be a means to consumption smoothing and income, but this does not mean it

expands the “freedom” the poor seek.

As mentioned before, the adequate definition of poverty is the first step in

assessing not only who the poor are, but also in the assessment of the effects of

microfinance on the poor. Experts and specialists in the industry agree that

poverty can be defined as a shortfall of consumption for the poor based on some

poverty line, specifically to those whose daily consumption is one dollar or less.

But why is poverty defined as income? While the concept of poverty may have an

irreducible economic connotation, it goes further as to suggest that ‘poverty’ not

only means a poor person’s inadequate personal income, but also suggests that

they lack sufficient ‘command over publicly provided goods and services’ and

have “inadequate access to communally owned and managed resources.” So the

concept of poverty is not limited to terms of income but rather the broader

concept of “‘inadequate command over economic resources.”15

Moreover, if poverty is defined as one’s command over economic

resources, it does not necessarily follow that the primacy of economic concerns

are the causation of poverty and hence microfinance may not actually reduce

‘poverty.’ For example, what if someone were to be denied access to healthcare

based on gender or ethnicity? One may argue that this person does not have

command over their economic resources but the real cause may lie in the social

biases that allow such person to be treated unfairly. The mistake would be to

think that this person could access healthcare and have greater control over their

15 Hunt 8.

economic resources if income is increased. So even adequate control over

economic resources may not translate into the one step solution to solving

poverty. Also, not every individual has the same ability to convert economic

resources into capabilities to sustain a life they value. For example, people with

different biological characteristics such as pregnant women or the elderly may

require different resources such as food or healthcare to achieve the same

degree of freedom to live a healthy life. Thus, it then becomes important to

realize that the “degree of command over resources that may be adequate for

one person may not be adequate for another.”16

So it follows that poverty is not best defined as the lack of income. The

better way to define poverty is to say that it is the absence or inadequate

realization of certain basic capabilities or substantial freedoms. The essence of

development aims to increase a person’s capabilities and freedoms, and poverty

is an infamous form of unfreedom. So rather than focus on poverty reduction on

the basis of income, the question is: does microfinance increase or decrease

poor peoples substantial freedoms, or their basic capabilities? To assess this

question, a review of the impact of microfinance on poverty reduction must be

measured by basic capabilities, which include income, education, health and

social empowerment. As will be derived, microfinance is a relative failure to

poverty reduction, as it does not substantially expand the basic capabilities in

question.

In the context of microfinance institutions, the most common product

offered to the poor is micro-credit. The principle behind this is that if poor people

16 Hunt 9.

are granted credit to invest in their micro-loans into income-generating activities

such as starting a small business, then their incomes will increase which enables

them to increase their ability to control their economic resources and financial

circumstances. But is micro-credit increasing the incomes of poor people?

Economists David Hulme and Paul Mosley cite in one of the earliest studies on

the subject, that there is a positive impact on the incomes of the poor receiving

micro-loans (1988 – 1992) producing results that show an average increase over

the control groups ranging from 10 – 12% in Indonesia, to about 30% in

Bangladesh and India.17 But the results also indicate that the incomes of the non-

poor borrowers increase the most as opposed to the gains of for the poorer

borrowers whose gains are minor.

Hulme and Mosley explain that the core poor may be too risk-averse to

borrow and invest in their future and are granted with very limited benefits from

microcredit. Another study on Bangladesh concludes that microfinance may have

a significant consumption benefits when women are the program participants and

are part of poor households with daily consumptions of less than one dollar. In

the study, household consumption increases by 18 taka for every one hundred

taka lent to women of these households as compared to an increase of 11 taka

when managed by men. Microfinance may contribute to helping poor women out

of poverty.18 Numerous other studies in Uganda, Peru, Bolivia, Nigeria, Malawi,

Haiti and Kenya show that microfinance may have a positive impact on micro-

entrepreneurs’ incomes. So it may be tempting to accept that, based on such

17 Hulme Table 8.1.18 Khandker 2003.

findings, microfinance, especially micro-credit, might increase the poor

borrowers’ incomes.

However, such studies may suffer from selection bias. A study in MIT on

the economics of microfinance shows:

“The challenges in evaluation arise because no microfinance program lends to random citizens. Instead, lenders carefully select areas in which to work and clients to whom to lend...Often, though, what makes clients different is not measured - borrowers may, for example, have a more entrepreneurial spirit, enjoy better business connections, or be more focused than non-participants.”19

Thus, in evaluating the effect of microfinance on the incomes of poverty-

stricken borrowers, a simple comparison between borrowers and non-borrowers

cannot be made without taking into account other factors before concluding that

microfinance can increase poor borrowers’ income and reduce poverty. What if

those who apply for micro-loans are richer and have entrepreneurial aspirations

compared to those that do not? The comparisons in this case would exaggerate

the effect of these microcredit programs. So to measure the precise impact of

microfinance on poor borrowers’ income, the effects of the program needs entail

randomly determined participation. Only one study applied this idea. The

assessment of microfinance was introduced to two random, equally suitable

selected poor neighborhoods in India. An experiment where 52 randomly chosen

slums in the city of Hyderabad were granted access to microfinance while 52

other slums that were equal in characteristic were denied access to microfinance

showed that micro-credit had no significant impact on boor borrowers’ incomes

19 Armendáriz 312.

and consumption in the 12 – 18 month timeframe. According to the study,

microfinance may not even be the best financial service for the poor as only 20

percent of the micro-loans led to the creation of new business and concluded that

providing the poor households with savings accounts may be more helpful in the

long term.20

Moreover, there is a dark side to microfinance. When the poor borrower

takes out a micro-loan, the borrower is essentially in debt. A poor borrower could

actually be made worse off in the long run since it may be more difficult to pay

back the loan as opposed to not taking it out in the first place. For example, what

if a poor woman has a baby daughter who becomes medically ill and needs

medical treatment immediately. Taking out a micro-loan and sending the child to

the hospital means that she will have to pay back a loan that she may not be

capable of doing. In order to pay back the loan, if she does not have a business

going due to the lack of income and the loan money paid to the hospital, she

would have to sell her cows or goats, or in other words, she is forced to give up

her productive assets. Ultimately, she will fall into a debt trap. It is not be

understood that if one cannot pay back a loan then one should not save the life

of a family member, but the point is that micro-credit may not always help the

poor in the long-run.

Many microfinance institutions show a history of high repayment rates. But

the issue of indebtedness has submerged as one of the main issues in the

microfinance field. Hulme points out that poor borrowers can face serious

consequences for failure to pay back loans:

20 Banerjee 21.

“[I]n Bangladesh, MFI [microfinance institution] debtors have been arrested by the police, are threatened with physical violence, and the press regularly report female suicides resulting from problems of repaying loans.”21

And similarly, a one-year study in Bangladesh shows that it is not uncommon for

women to default on their loans only to be forced to give up poultry, rice, grains

and houses in order to repay the loan:

“I saw that credit-related strife amongst members and their families were routine occurrences. Women would march off together to scold the defaulting woman, shame her or her husband in a public place, and when she could not pay the full amount of the installment, go through her possessions and take away whatever they could sell to recover the defaulted sum...This ranged from taking away her gold nose-ring (a symbol of marital status for rural women, and removing it symbolically marks the “divorcing/widowing” of a woman) to cows and chicks, to trees that had been planted to be sold as timber, and to collecting rice and grains that the family had accumulated as food, very often leaving the family with no food whatsoever...In instances where everything has been repossessed because of a large default, members would sell off the defaulting member’s house.”22

Not only is the consequences of default a criticism of microfinance, but

also the increased competition between microfinance institutions that has led to

irresponsible lending schemes which has caused more people to become over-

indebted. Paul Mosley, in a study of microfinance institutions in Bolivia between

1998 and 2004, found that because of new market entrants in an already over-

exposed informal credit market, there was an increase in over-indebtedness for

21 Hulme 20.22 Karim 18.

the poor.23 An article in the Wall Street Journal finds that even in India, India

households are ‘carpet-bombed’ with loans causing many poor households to

become over-indebted because of borrowing money from too many microfinance

institutions. And in result of the increase of these institutions, outstanding loans

grew 72 percent in the year ending March 31, 2008.24

So microcredit may actually be a double-edged sword. While micro-credit

may help in potentially increasing people’s freedom as in their capabilities and

opportunities, it can also make them indebted, which would decrease their

freedom. When the poor take out a micro-loan, they are obligated to pay it in the

future. But the determinants of people’s abilities to pay are complicated and

involved not only their entrepreneurial skills and knowledge to pay back a loan,

but also their environmental and economic factors which include local low wages,

poor developed markets, sickness, floods, drought, theft, etc. It is not surprising

then to understand why the poorest clients of microfinance do not only lack

money, but lack the basic capabilities and capacities to turn their investments

into successful businesses.25 The poor already suffer from fragile financial

structures so micro-credit would inflict a heavier negative impact on their freedom

than increasing their income. And if they cannot pay back a loan, then their

freedom is seriously reduced.

The question may then be how best to help the poorest households pay

23 Marconi 724 Gokhale 13.

25 Hulme 15.

back loans. One idea is to provide clients with micro-savings. Micro-savings can

make poor people less vulnerable to specific perils and various needs. Moreover,

micro-savings would not inflict serious punishments to those that default on

loans. So if the poor borrower’s purpose for using micro-loans is to meet their

minimum consumption or address specific perils, and not to invest in new

business ventures, then micro-savings is a more useful alternative to micro-credit

even though it takes longer to get than micro-credit.

Furthermore, micro-savings would not only allow poor borrowers to meet

minimum consumption needs, but it would also offer more room for development

in terms of businesses. For example, in a study on the Bank Rakyat in Indonesia,

90 percent of clients save but do not borrow.26 In another similar study, micro-

savings have long-term effects on asset growth in Thailand.27 And finally, the

most solid evident that the most powerful element in microfinance is micro-

saving, not micro-credit, was found in in Kenya in 2008. In the experiment, fees

were paid by the researchers to open bank accounts for micro-entrepreneurs

such as bicycle taxi drivers, barbers, market vendors, etc. The bank accounts

were interest-free and had substantial withdrawal fees; so the de facto interest

rate on savings was negative. Theoretically, the demand for such accounts

should be zero if poor households do not face savings constraints. But the

experiment found that for most female entrepreneurs, there is a significant

savings constraint that they face and would need to open such savings accounts.

And in addition, the female entrepreneurs opening up such accounts realized

26 Johnston 53.27 Kaboski 27.

substantial gains. These entrepreneurs were investing 40 percent more in their

businesses within six months of opening these accounts, which led to higher

expenditure and income levels. To conclude, the experiment results show that

the largest obstacle in starting a micro-enterprise is not the constraint of micro-

loans, but micro-savings.28

However, since business involves risks and requires certain skills, the

other method to helping poor borrowers pay back loans is to help build-up their

business capacities so they know how to manage and run their business. In

conclusion, microfinance cannot be said increase the consumption and incomes

of poor borrowers, but rather can be argued to prove as a potentially helpful

model in creasing the poor’s financial capital and dealing with life’s

contingencies. Micro-savings might help the poor meet their daily minimum

consumption needs and spur the development of their micro-enterprise but the

result will depend on their abilities to start and expand businesses to pay back

loans. And hence, although microfinance will not directly increase incomes for

the poor with entrepreneurial aspirations, it does manage to help them cover

start-up costs. “By being willing to take a risk on entrepreneurial sorts who lack

any other way to start a business, micro-credit may help reduce poverty in the

long run, even if its short-run effects are negligible.” 29 If the entrepreneurial poor

are able to create their businesses, this would in turn make commercial banks

more willing to be involved in informal credit markets, allowing the

28 Dupas 2008.29 Fisher 2009.

entrepreneurial poor access to larger loans.

So is microfinance contributing to the poor’s basic capabilities? As

discussed, microfinance aims at the objective of reducing poverty, but as defined,

poverty is not defined in the context of lacking income, but rather the basic

capabilities that allow a person to sustain a life they have reason to value.

Hence, before investigating how microfinance might contribute to basic

capabilities, let me clarify which capabilities are basic. Although it may be wisest

to allow people select basic capabilities based on what they value most through

possible questionnaires, democratic debate or public reasoning, the reality is that

no developing country has let citizens choose what basic capabilities they are

liable to. This is not to say that people living in developing countries will not be

able to voice their opinion as to what basic capabilities are entitled to them, but

rather to mention that even the question of the selection of basic capabilities may

poses difficulty in measuring the impact of microfinance on basic capabilities.

Basic capabilities must carry a common denominator to all people alike so as to

say:

“The substantive freedoms include elementary capabilities like being able to avoid such deprivation as starvation, under-nourishment, escapable morbidity and premature mortality, as well as the freedoms that are associated with being literate and numerate, enjoying political participation and uncensored speech and so on.”30

Education carries a significant responsibility in the role of human and

30 Sen 1999: 36.

economic development. Recent theoretical models yield a positive correlation

between GDP growth and schooling rates. For example, increased enrollment in

school in 1960 for an additional year was associated with 30 percent increase in

growth over the period from 1960 to 1990. The World Bank emphasizes that:

“Education is the foundation of all societies and globally competitive economies. It is the basis for reducing poverty and inequality, improving health, enabling the use of new technologies, and creating and spreading knowledge. In an increasingly complex, knowledge-dependent world, primary education, as the gateway to higher levels of education, must be the first priority.” 31

Education in turn would expand a person’s freedom in terms of allowing

them to create choices and opportunities that help empower them. There is a

global mutual understanding that education should be at the forefront to universal

basic needs:

“The capability to be educated is basic, since the absence or lack of education would essentially harm and disadvantage the individual...Education is basic also in the sense of being a fundamental capability, and foundational to other capabilities as well as future ones...The broadening of capabilities entailed by education extends to the advancement of complex capabilities, since while promoting reflection, understanding, information and awareness of one’s capabilities, education promotes at the same time the possibility of formulating exactly the value and beings and doings that the individual has reasons to value. On the other hand, the expansion of capabilities entailed by education extends to choices of occupations and certain levels of social and political participation...These considerations lead to an understanding of education as a fundamental capability, which includes basic capabilities, in terms of those enabling beings and doings that are fundamental in meeting the basic need to be educated but equally foundational to the promotion and expansion of higher, more complex capabilities.”32

31 Bils 1107.32 Terzi 9.

So if it holds that education is a bridge between poverty reduction and

economic growth, what is the link between microfinance and education? If it is

universally understood that education should be at the forefront of everybody’s

needs, then what are the deterrents that cause poor people not to send their

children to school? There are barriers to education such as: income barriers in

which a household cannot afford the costs of schooling; child labor barriers in

which the benefit from wages earned by a child affects schooling decisions; risk

management barriers in which the inability to control for life’s contingencies and

perils makes school attendance of a child vulnerable in times of income shocks;

gender barriers in which the gender of the household’s decision maker influences

the household’s schooling decisions; and education barriers in which the parent’s

own level of education influences the perceived value of education. Hence, there

can be a linkage drawn between these educational barriers and microfinance in

which we can investigate what real effects microfinance might have on

education, if any.

If in theory microfinance can lift poor households’ incomes enough to allow

them to send children to school, then women may be able to spend more than

men on child health and education. Yet since microfinance institutions can only

provide microcredit, it is not even enough to increase poor households’ incomes

over the span of a year to 18 months, and would probably not be effective

enough to deliver capabilities such as education, according to empirical studies.33

33 Karlan 440.

The studies show that poor households do not care enough about their children’s

education, as the utility is not higher than if they were to use the money for other

needs. So it goes to say that microfinance may not prove to have a positive

impact on education in the long run. That is because poor households do not

give priority to education when they are granted micro-loans because although

education proves profitable on a macro level in society, poor households are

uncertain as to whether their investment on education will give them positive

results. To encourage investment in education, some microfinance institutions

offer loans for education at far lower interest rates than loans for micro-enterprise

(XacBank, Vittana, Qifang, Grameen Bank). And these lower loans for students

only target students who wish to pursue higher education because the loan

repayments are relatively more enforceable. As the CEO of XacBank, Mr. Hutagt,

“students come from remote villages, no one knows them, and they have no

reputation to lose”. And since the student loans are longer term (up to five years)

as opposed to one-year loans for microfinance business loans, microfinance

institutions are reluctant to risk the money in offering student loans.34

So if the loans are difficult to achieve, this only adds to reasons a family

would not send their children to school. Moreover, the family would value a loan

to protect from adverse economic shocks more than an educational loan for their

children, which would make the parents keep their children at home. Instead of

sending the children to school, children engage in child labor which, according to

the United Nations Children’s Fund (UNICEF), is defined as children who work

34 Bishop 2010.

more hours than a minimum number of hours and in jobs that harms or abuses

them. In a study on agriculture, a 10 percent decline in agricultural income

translated into a decrease in school attendance by five days in a sample of six

Indian villages.35 The question is then does microfinance help take children out of

work and grant them the capability of pursuing an education?

The results of many studies show mixed results. Some studies show that

microfinance does help poor households enter their children into schools and

decrease child labor. For example, in the same study by Jacoby in 1994 in Peru,

the lack of access to credit is the leading factor for poor households to withdraw

their children from schools and make them work. Studies in Nepal show an

increase in school enrollment rates and a decrease in child labor.36 In

Guatemala, access to credit decreases the chance of pulling children from

schools and into work for poor households’ business purposes.37

However it would seem more common for microfinance to increase child

labor when poor households engage in micro-entrepreneurial activities.38 A study

in Malawi shows relationship between child labor and micro-enterprise, which

portrays that during peak labor demand, poor households have less access to

micro-credit, which therefore results in an increase in child labor.39 Furthermore, if

the mother works, the children’s chances of working increase by 43 percent

35 Jacoby 322.36 Ersado 463.37 Wydick 861.38 Patrinos 433.39 Hazaruja 2007.

according to a study in Mexico.40 Even children from ‘better-off’ households have

the same chance of engaging in child labor as those from poorer households

according to the same study. In Indonesia, engaging in micro-enterprise activities

neither eliminates child labor nor promotes education in rural areas.41 Thus there

may be evidence that microfinance increases a child’s chances of being

educated, but at the same time, it also gives rise to a side effect, which is a new

demand for child labor. The children in essence may have to forgo an education

to help with micro-enterprise or take care of the home. It may be more likely to

imply that microfinance has positive effects on education when household

“income is above a certain threshold.”42 In other words, although poor

households are aware of some advantage to sending their children to school,

they will only do so when their income is above a certain threshold. As Vanroose

states, “the level of income increase resulting from micro-loans may not be

sufficient to make a real difference.”43 In conclusion, there is not automatic link

between microfinance and the reduction of child labor due to the benefits of

education. The impact that microfinance can have on the children of poor

households remains largely on the income level of borrowers.

However, in the field of microfinance, women prove to show higher rates

of repayment and therefore may be more inclined to invest earnings from micro-

enterprise in health and education for the entire household. So in effect, if the

access to microfinance for women was improved, their influence in family

40 Basu 158.41 Yamauchi 38.42 Becchetti 10.43 Vanroose 21.

decisions about education would improve and thereby increase the children’s

chances of gaining an education. But although women are aware of the

disadvantages to not sending their children to school, there is no evidence as to

the link between womens’ access to microfinance and demand for education.44

There is also an issue of gender equality in education. In 1995, of the

worlds 960 million illiterate adults, two-thirds consisted of women according to a

study by the United Nations Entity for Gender Equality and Empowerment of

Women (UN WOMEN). And only 5 percent of women had secondary education.

So by virtue of these statistics, it would follow that even if children of poor

households had a chance to pursue an education, it would probably be the boys

who have priority. But there is no study that shows the connection between

microfinance and education gender inequality.

Rather, what is known is that there is a positive correlation between

parents’ educational levels and their children’s chance of gaining an education.45

A journalist of The New York Times, Nicholas D. Kristof portrays how the

educational level of parents will affect their decision to grant their children access

to schooling. On a trip to central Africa, Kristof met with the parents of a boy who

was being expelled for not making tuition payments as his parents were

struggling to pay off the rent. The family was extremely poor and sold straw

stools at one dollar each and had racked up an 8-month outstanding rent bill. He

also found that the family spent 10 dollars on a cell phone per month and 12

44 Maldano 2003.45 Lillard 1131.

dollars on alcohol per month. When Kristof asked the father why he prioritizes

alcohol over an education for his kids, the father had only a pained expression on

his face. And this was not unusual behavior in the community. But Kristof argues,

“if the poorest families can spend as much money educating their children as

they do on wine, cigarettes and prostitutes, their children would have brighter

futures.”46 The account by Kristof also points out that there are factors that

influence the parents’ decision about sending the children to school that their

own level of education, but also it is also affected by their social, religious, and

cultural factors.47

So in effect, will microfinance change parents’ preference about

schooling? Not necessarily, but it could in the long run. And since microfinance

services are offered by microfinance institutions and the borrowers meet with

these institutions, then the institutions must hold the responsibility to change the

clients’ perceptions of the value of schooling. Microfinance institutions would be

at an advantage to offer clients information about child education, helping more

poor households see the importance of sending their children to school.

The evidence that microfinance has positive effects on increasing school

enrollment rates is compelling although the question of how it influences those

rates might be complicated. There exists a difference in having higher school

enrollment rates and the actual results of education on academic performance.

So even though microfinance might allow for the access to schooling for children

46 Kristof 2010.47 Klasen 43.

of poor households, having higher school enrollment rates doesn’t necessarily

dictate the effectiveness of yielding higher academic achievement for these

children. The project of Conditional Cash Transfers, which is funded by the World

Bank, displays a scheme, which “transfers cash, generally to poor households,

on the condition that those households make prespecified investment in the

human capital of their children.” Such a scheme means sending children to

school and to a clinic for regular physical examinations. The CCTS targets the

poorest households and has been successful in increasing enrollment rates but

shows that even increased school enrollment will not translate to higher

academic performance per say.48 Thus, sending children to school is only half the

solution for the promotion of education, as there is no guarantee that schools will

operate effectively enough to always yield to a better future and thus allow for

purposeful investment in a basic capability as education. Not all schools operate

well. Microfinance does not solve that problem. The question of educational

quality is for governments to solve and apply themselves.

Well then, if microfinance can improve educational skills of the poor, this

will contribute to the development of the institutions themselves, as the poor will

be more knowledgeable on the financial facilities available to them. Thus,

another capability microfinance institutions should, in theory, be able to build

upon, is the health of the poor. According to the World Health Organization

(WHO), a survey conducted in 2005 indicated that about 25 million households,

which translates into more than approximately 100 million people, are forced into

48 Filmer 2006.

poverty due to illness because they cannot satisfy their requirement for basic

healthcare49. Moreover, 1.02 billion people living in developing countries are

malnourished. With the lack of basic healthcare and clinical infrastructure in

remote and rural areas, the impoverished are only pushed further into a

deteriorating state of health. The Grameen Bank notes that within their micro-

credit program, “of the 42% that fail to improve their socio-economic condition,

60% experienced a serious illness within the family that drained family

resources.”50 This would indicate that access to healthcare must be a key factor

that helps in the reduction of poverty since being healthy almost directly

determines the success rate for economic and social development. If the

objective of microfinance is to reduce poverty by increasing the availability to

basic capabilities, then the question is whether microfinance is promoting

healthcare?

There is reason to believe that microfinance helps promote the nutrional

status, food security and basic health knowledge for women and children of poor

households. In Bangladesh, China, and Madagascar, studies prove that

microfinance programs do increase the calorific intake for poor households.51

And microfinance does also increase the food consumption of these

households.52 In Ghana and Ethiopia, microfinance programs report a positive

effect on food security for poor households.53 But the effect of microfinance

49 World Health Report 2005

50 Ahmed 3251 Zeller 1998.52 Khandker 1995.53 McNelly 2003.

cannot simply be addressed by studies using experimental methodologies; rather

there must be a study of country specific programs, which evaluate factors such

as geographical proximity to microfinance institutions and the country-specific

governmental attitude towards microfinance programs.54

In terms of public health, microfinance has had positive results as it has

helped educate its borrowers on their basic health knowledge. For instance, in

Bolivia and Ghana, microfinance programs helped facilitate basic health

education which promoted better breast-feeding practices.55 The objective of

such microfinance institutions is to deliver products along with a basic health

education that proved to improve sanitation related behaviors for the borrowers.

There proves to be a big difference between the group that is only receiving

micro-credit, the group that is only receiving health education and the group that

participates in both as a part of their micro-credit program. In the Dominican

Republic, such a study was undergone and the group that participated in the

health education only showed a 29 percent decline in diarrhea. And the group

receiving both health education and micro-credit realized a 43 percent decline in

the incidence of diarrhea.56

Microfinance institutions provide basic health education, but also products

such as mosquito nets and insecticide-treated bed nets (ITNs). In Bangladesh,

members of the Grameen Bank reported higher rates of contraceptive use.57 The

54 Gertler 262.55 McNelly 2003.56 World Health Report 2005.57 Schuler 68.

idea is that by combining microfinance and health education, the microfinance

program offers clients the education needed to practice better sanitary behaviors,

prenatal health, prevention to malaria, dengue fever, common childhood illness,

and the dangers of HIV/AIDS. Microfinance paves the road to combat HIV/AIDS

in Africa where microfinance institutions provide clients with gender and HIV

training courses resulting in a reduction of the virus for women under the age of

35 years. In other words, the availability of microfinance programs which educate

clients on issues such as HIV/AIDS allows young women to be aware of such

illnesses and practice safe sex, voluntary counseling and test for HIV reducing

the rate of sexually transmitted diseases.58 In conclusion, microfinance

programs, which offer health education, improve reproductive health,

breastfeeding, HIV/AIDS prevention and malaria problems for clients. Moreover,

microfinance may be at the foundation of improving national health systems.

More than simply offering an education to health services for the poor,

microfinance institutions can offer clients insurance for their health and therefore

reduce poverty. Institutions such as Grameen Bank and BRAC are already

testing different products that would enable the poor to access micro health

insurance. A number of institutions have even partnered with different insurance

providers to create a self-financing micro health insurance scheme. The

Women’s World Banking (WWB) in November 2009, partnered with Zurich

Financial Services Group to launch a micro health insurance program called

Caregiver which encompasses basic coverage for loss of income, childcare,

58 Costigan 2002.

transportation, and a portion of medical cost to poor households across Africa,

the Middle East, Asia and Latin America. There may be a strong supporting case

for the correlation between offering micro health insurance and improving

household income, food sufficiency and ownership of non-land assets.59

Microfinance is capable of improving public health both locally and

nationally as well as health outcomes for women and children of poor households

by offering microfinance services embedded with health education and offering

micro health insurance. Able to target poor households and run businesses in

rural areas, microfinance can facilitate health services to the poor. The reason

microfinance institutions should offer health services to clients is because a

fundamental and natural extension of the objective of microfinance is to reduce

poverty. In order to reduce poverty, not only must the question of poor

households’ incomes be addressed but also to realize that these households are

healthy enough to convert economic resources and income into their well-being.

With microfinance institutions improving the health of the poor, it would generate

the ability for the poor to do things they neither have reason to value and not be

clouded by diseases such as malaria and HIV/AIDS nor plagued by the

misfortune of malnutrition. By offering health services, microfinance institutions

would be helping to generate a self-sufficient prophecy for themselves as well

since their clients would be more capable of repaying loans and hence

maintaining the financial sustainability goals of these institutions.

However, even though studies show that microfinance institutions can

59 Hamid 71.

provide health services to the poor, the costs on microfinance institutions too do

so are heavy and hence the governments of the countries in question should

subsidize or partner with these institutions. There is a growing model that follows

this path in which several NGOs are already involved in, such as Freedom from

Hunger and the Women’s World Banking.

In conclusion, whether microfinance can increase or decrease poor

people’s basic capabilities has been the focus of the thesis. The effects of

microfinance on poverty can be summarized as follows. There is little solid

evidence that microloans increase the consumption and incomes of poor

borrowers. Moreover, microloans may actually decrease people’s freedom since

any repossession would exert negative pressures on clients who already suffer

from fragile financial structures. And although microfinance may not increase the

entrepreneurial poor’s income directly, it’s positive effect is that it may help them

start small businesses in the short run. It follows then that the poorest clients

would benefit less from microfinance because they are not as capable of starting

businesses to even pay back loans. Therefore, to better address this situation,

microfinance institutions can offer programs embedded with business-capacity

building programs or offer clients micro savings and micro insurance services.

Simply education is the key goal of microfinance when the question of

impact is assessed for the poor’s basic capabilities. Microfinance is not strong in

poverty reduction by measure of reducing the income gap, but rather is beneficial

in helping educating the poor. Microfinance has a positive effect on school

enrollment rates, as it helps remove risk management held by financial

institutions and changes parents’ perceptions on the value of education. But

microfinance does not increase school enrollment rates by increasing poor

households’ income levels to cover costs of schooling; sometimes, microfinance

may even create a new demand for child labor.

However, microfinance programs embedded with health programs have

proven effective in improving health, breastfeeding, child diarrhea, HIV/AIDS

prevention and Malaria. As well as educating individuals on individual health,

microfinance contributes to public health systems at a national level. Simply

based on the educational programs of microfinance institutions, microfinance

may increase the participation of women in society to make decisions within the

family such as birth control, family planning, children’s schooling and marriage,

and buying and selling properties. In general, microfinance can increase the level

of self-confidence people feel in society and decrease violence.

Based on a qualitative analysis of microfinance and its potential to reduce

poverty when poverty is define as the lack of basic needs, there is still no

automatic positive link between microfinance and poverty reduction. Microfinance

does not necessarily expand these ‘substantial freedoms.’ Perhaps the better

design for microfinance institutions is not to focus only on providing clients with

microloans but also with micro savings and micro insurance. Furthermore,

microfinance institutions should provide clients with non-financial services such

as basic business education, health services, and political empowerment

courses. This does not mean that microfinance should stop granting poor people

microloans, but rather that the industry should deemphasize microcredit, for it

may more negatively impact people’s substantial freedoms in the long run, as

opposed to micro savings and micro insurance.

In concluding, any social policies and arrangement relevant to

development and poverty reduction should be assessed in terms of its impact on

an individual’s ability to convert resources into well-being or substantial freedoms

people have reason to value. Basic capabilities do not refer to wide-ranging

freedoms any person may choose, but rather to an individual’s real freedom for

doing that which is considered necessary for survival and to avoid serious

deprivations so that they may move over a threshold of well-being. In the current

situation of developing countries, poverty and development are understood to

focus on more than income and various physical and mental conditions of

people, but more to basic social norms, political institutions and arrangements

that carry significance in everyday life and plans. Income or commodities are only

instrumentally important when measured in terms of their contributions to a good

quality of life. The end of economics and politics is the common promotion of

individual freedoms: the capabilities or real opportunities to pursue the things in

life one has reason to value.

While microfinance has been touted by many as a poverty-reducing

measure, empirical evidence is combined with principles of the capability

approach to deem microfinance a relative failure as a poverty-reducing effort.

Microfinance does not substantially expand people’s freedoms to do things they

have reason to value. The evidence that micro-loans reduce poverty is week,

while other services sometimes associated with microfinance like savings and

insurance may help. In terms of its significance locally to peoples freedom,

microfinance is the best model of an institution that does help promote freedom

and hence poverty should be defined as basic capabilities to move forward with

the design of more well-equipped microfinance institutions which will reduce

poverty in the future.

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