In 1976, a professor of economics in Bangladesh resolved to prove that his nation's poor can borrow and use resources productively. Muhammad Yunus's Grameen ("Village") Bank has since extended nearly $100 million in loans averaging $67 apiece, with an astounding repayment rate of 98 percent. The Grameen Bank has attracted international acclaim, including a recent "60 Minutes" feature.
In 1986, Peruvian economist Hernando de Soto published a book about the "Kafkaesque trap" of red tape that drives hundreds of thousands of entrepreneurs into Peru's unregistered, or black-market, economy. El Otro Sendero (The Other Path)—widely read in Peru and throughout Latin America—explains these "informal" entrepreneurs as individuals "confronting the mercantilist state instead of succumbing to it."
Both Yunus and de Soto are revolutionaries. Both are pioneers of method. Each has developed a veritable cult following in the United States, particularly among the "development set"—a well-knit brotherhood of businesses, consultants, and church-affiliated groups that make a living by carrying out aid projects for the U.S. Agency for International Development. These "Lords of Poverty," as British writer Graham Hancock dubbed them in a 1989 book by that name, have parlayed the work of Yunus and de Soto into the newest foreign-aid rage—"microenterprise lending." Their argument goes: De Soto and Yunus are right; underdeveloped nations' great untapped potential is their economically unenfranchised poor; all these poor people need is affordable credit.
Like foreign-aid fads before it, however, microenterprise lending targets a symptom of statist economies rather than the cause. And as informal economies continue to swell across the globe, Congress is splitting hairs in inconsequential debate over how to define a "micro loan" and a "microenterpriser."
In 1987, Reps. Edward Feighan (D–Ohio) and Benjamin Gilman (R–N.Y.) introduced two similar bills directing AID to devote substantial sums to giving loans to microentrepreneurs. In congressional hearings, Gilman told his colleagues that "the informal economy employs some 30 to 70 percent of the labor force in developing nations. Informal sector enterprises…include the hawkers and the street vendors selling goods and clothing and services and food in both urban and rural sectors…[who cannot obtain] assistance from existing formalized credit channels."
RESULTS Inc., a self-described grassroots foreign-aid lobby, largely drafted the Feighan bill. In supporting testimony, the group emphasized the critical feature of targeting "the very poorest people by requiring [that borrowers have] a maximum per-capita income of $250 per year" and that loans to individuals be for "a maximum of $150."
Although neither the Feighan nor the Gilman bill passed as a freestanding measure, later legislation did earmark money for microenterprise lending. AID was required to spend $50 million a year on "microenterprise credit and other assistance" during fiscal year 1988 and at least $75 million in fiscal year 1989 and 1990. Accompanying report language recommended that loans to individuals not exceed $300 "unless necessary to fulfill the needs of the program."
Now AID is under attack for not fulfilling that mandate. In a November 1989 report, RESULTS criticized the agency for "assisting people 'a few rungs up' from the very poor." The group charged that "AID's overall development strategy of defining development principally in terms of economic growth and employment generation has led the Agency to target its microenterprise programs to relatively larger and more established microbusinesses. While this strategy may create wage employment, it does not necessarily improve the poverty situation." Based upon RESULTS findings, Reps. Feighan and Gilman, together with Sen. Dennis DeConcini (D–Ariz.), have called for a General Accounting Office review of whether AID's microenterprise lending has targeted the absolute lowest rungs of the poor.
AID defends its actions, according to the RESULTS report, by maintaining that "there are no viable institutional channels capable of making and recovering loans of less than $300.…Therefore, costs cannot be recovered on a sustainable basis for this level of funding." Indeed, the Grameen Bank itself is not self-sustaining, but heavily dependent on external aid.
Grameen receives a regular, substantial supply of cheap funds from the U.N.-affiliated International Fund for Agricultural Development (IFAD) and the state-run Bangladesh Bank. At the end of 1986, 65 percent of Grameen's assets consisted of borrowings from IFAD and another 14 percent of borrowings from the Bangladesh Bank, the Dutch government, and the Ford Foundation. The average cost of these borrowed funds was a mere 3.3 percent in 1986.
Grameen redeposits the cheap funds in commercial banks and earns 14.5 percent on fixed-term deposits or 8.5 percent on short-term deposits. This maneuver allows Grameen to lend at 16 percent per annum, a rate at which no small loan program could cover costs unless its own funds were heavily subsidized. According to one reputable study initiated by Yunus himself, Grameen's implicit rate of subsidy to borrowers is 39 percent at the actual cost of funds, and 51 percent at the opportunity cost. The external support has allowed Grameen to narrowly break even since 1984 while losing money on its loan operations.
Supporters of government-financed microenterprise lending have emphasized that the world's rural poor would otherwise have to pay exorbitant interest rates for credit. In lobbying for the Gilman bill, for instance, Bread for the World, a grassroots Christian citizens' group that lobbies on foreign aid, declared that microenterprisers depend on loans from moneylenders which "can involve interest rates as high as 200 percent a year, or even 20 percent a day."
But such claims appear to be exaggerated. A highly acclaimed 1989 World Bank report on financial systems notes that informal entrepreneurs most often get their credit from family and friends (generally, free of charge), and secondarily from professional moneylenders, pawnbrokers, tradespeople, and associations or acquaintances., The report cites separate studies of five Asian countries, which indicate that professional moneylenders account for less than 20 percent of informal rural credit and on average only 6 percent.
While acknowledging the Grameen Bank's "impressive record," the World Bank study discounts the value of such lending schemes because of the drawbacks associated with reliance on external funds. "Few collect deposits, partly because the supply of cheap external funds reduces the intermediary's incentive to provide this service, but also because deposit taking is viewed as too complex a task for unpaid group leaders." (The Grameen Bank lends to individuals only as members of five-person groups.)
Similarly, the World Bank study relates how one African ministry wished to use its nation's cooperative credit system to channel low-interest funds from foreign donors to targeted programs. The cooperative director declined because he thought the funds his institution would loan could never be recouped. He was forced to reconsider or resign. The plan went into effect, repayment rates were extremely low, and the defaults affected repayments of the institution's other loans.
Hernando de Soto's pioneering book explains why only legal and regulatory reforms will permanently enfranchise Peru's microenterprisers—property rights, small claims courts, limited liability, easy licensing of businesses without bribes or onerous fees. (See "What's Wrong with Latin American Economies," October 1989.) The World Bank study's recommendations read like a page from de Soto: "Legal reforms would make it easier for small enterprises with relatively large financial needs to use formal services. Such reforms include better definition and enforcement of property rights. Squatters and small farmers with clear land titles would then have an acceptable form of collateral.…Licensing and registration formalities and taxation of businesses need to be kept in check.…Formal institutions could extend more of their services to the noncorporate sector if it was profitable to do so."
For Muhammad Yunus, on the other hand, "Credit is a human right. If the existing financial institutions fail to ensure that right it is the obligation of the state and the world community to help find alternative financial institutions which will guarantee this fundamental human right." This vision suggests endless foreign aid transfusions to lossmaking credit schemes in every poor rural village and town. De Soto's work, by contrast, implies that mercantilist states would sooner wither if Western donors cut the dole.
We can marvel at the Grameen Bank's loans to hundreds of thousands of small entrepreneurs, but the model is far from self-supporting. After examining the root causes of Peru's thriving unregistered economy, de Soto established a union of formal and informal business owners and managers to jointly press the government for legal and regulatory reform. He will sooner replicate the American Dream by creating the institutions that underpin it than Yunus will by trying to finance it one entrepreneur at a time.
Melanie S. Tammen is a policy analyst with the Competitive Enterprise Institute in Washington, D.C.
This article originally appeared in print under the headline "Foreign Aid: Treating the Symptoms".