It’s a question that comes up at nearly dinner discussion of microfinance: why are the interest rates so high, and how can poor clients afford them? So, you have the answer – interest rates are high because operating in difficult environments is costly, and because those costs have to be recouped from small loans. After a few examples (it costs the same $10 to make a $100 and a $1000 loan…), you eventually set your questioner at ease that most MFIs might not be ripping off the poor after all. But after all that, you’ve largely forgotten then main point of the question – how can the poor afford it?
After reading yet another article questioning the affordability of microfinance loans, it occurred to me: microfinance clients face the same economics as the MFIs. Consider your typical market trader. She buys stock to resell. The cost of the stock, together with some fixed assets, constitutes her investment capital. What are her returns? I propose that they must be high as a matter of principle.
Consider the context of her operations – security is a never ending concern, and her stock is often at risk of being stolen or damaged. Moreover, the larger the investment, the greater the risk of theft. As a risk-averse entrepreneur, she would prefer to invest only the amount needed to stock her shelves. And even if she were more willing to take risks, where would she get the capital needed to buy excess stock and afford measures sufficient to secure her investment?
So, the stock she buys is small. But her sales are smaller still – how many times have you seen small vendors open up a pack of cigarettes to sell a single one at a time? The economics for her follow the same formulae as the economics for MFIs – the smaller the item, the higher the markup rate, even if in absolute terms, the amount remains affordable to her clients. The markup on those individual cigarettes must be very high indeed! Combined with the advantage of being located in the client's own neighborhood, this business model allows microentrepreneurs to compete with larger retailers that are unable to sell in such tiny quantities and still cover their costs.
There are a handful of studies showing very high returns (anywhere from 50% to over 300% annually) for microentrepeneurs. However, it helps to place them in the context of microenterprise economics – as with MFIs, the smaller the enterprise, the higher the returns it requires to sustain itself. And for those entrepreneurs who succeed in growing into something larger, those returns will shrink accordingly.
So next time you are asked how the poor can afford such high-priced loans, you may want to mention that returns for poor microenterpreneurs can and do far exceed those of larger retailers, as well as the seemingly high interest rates they pay on their loans. But it also helps to recall that such high returns are a sign of poverty, not a path out of it.