Columbia University economist Jeffrey Sachs said, “The key to ending extreme poverty is to enable the poorest of the poor to get their foot on the ladder of development.” He was speaking of one of the newest and most controversial financial innovations of the modern era: microcredit lending. Microcredit was conceived by nongovernmental organizations (NGOs) seeking to do just that — enable the poorest of the poor to achieve credit. This revolutionary model of using community-based initiatives to provide small-scale loans has been celebrated by the global community. Muhammad Yunus, founder of the first major microcredit lender, Grameen Bank, stated, “This is not charity. This is business: business with a social objective, which is to help people get out of poverty.” Microcredit models often target women in poverty-stricken communities and are designed to stimulate small-scale economic growth, such as family-owned stores or eateries.
Unfortunately, today, private investors provide many of the funds controlled by microcredit lenders. In turn, microcredit institutions are compelled to impose high interest rates on low-income borrowers in order to generate a return on investment. The significance of this transformation of the microcredit industry — from a nonprofit tool for development to a for-profit industry — cannot be overstated.
Mexico has recently become a flashpoint in the debate over the benefits of microcredit lending, and it may well be that the future of this rapidly evolving “business” will be decided in the sprawling metropolis of Mexico City. With more than 2.5 million clients, Mexico City-based Compartamos Banco is the largest microfinance bank in Latin America and stands out as the most prominent microcredit lender in Mexico. In 2007, the company sold off 30 percent of its stock for $458 million in its initial public offering. Compartamos has risen to fill a niche in Mexico’s economic sector: Roughly 30 percent of Mexicans live on less than $2 a day and lack access to traditional financial services. In examining Mexico’s microcredit industry, the question of whether or not these loans truly help the poor and marginalized “get their foot on the ladder” is especially salient.
Compartamos believes that providing a return on investment helps to secure more capital and thus reach more potential borrowers. Higher interest rates on loans can create these profits, and are also necessitated by the higher risks and administrative costs associated with microcredit lending. However, the question of what is a morally justified profit margin, and who really benefits from these loans, is complex.
The New York Times reports that the average interest rate on a loan from Compartamos is 82 percent, while the global average hovers around 37 percent for microcredit lenders. This interest rate has its origins in Mexico’s hyperinflation in 1995; Compartamos raised its interest rates above 100 percent in order to combat an inflation rate of roughly 35 percent. However, even after Mexico’s inflation rate returned to normal, Compartamos kept its interest rates at hyperinflated levels. A large percentage of this interest turns into profit for Compartamos, which has averaged a 53 percent return on shareholder investment since 2000. Of the $450 million obtained in the IPO, $150 million went into private investors’ pockets.
Furthermore, the regulation of Compartamos’ practices is questionable. Acción, the NGO that created a set of rules for the regulation of microfinance institutions, was one of the first major stakeholders in Compartamos and has received at least $135 million in returns on investment. This personal interest in the financial success of Compartamos would seem to give them a bias regarding the fair regulation of this quickly growing company.
This graph shows Compartamos’ profits relative to other microfinance institutions:
But beyond the question of fair regulation, does Compartamos-style microcredit lending yield results? One of the largest studies to observe the effects of microcredit lending was conducted by IPA (Innovations for Poverty Actions) in Compartamos-dominated regions of Sonora, a state in northern Mexico. Even this study, funded by Compartamos, found that microcredit did not increase business profits or prompt people to start new businesses. David Roodman, a development economist and senior fellow at the Center for Global Development, stated, “On current evidence, the best estimate of the average impact of microcredit on the poverty of clients is zero.”
Although microfinance is typically viewed as a praiseworthy innovation in development, there are still dangers involved. In 2010, there was a crisis in the southern Indian state of Andhra Pradesh when microcredit lenders requested large-scale loan repayment. Many borrowers were grossly overleveraged and had taken out loans to pay off earlier commitments. Trapped in this debt spiral, the inability of borrowers to repay led to the partial collapse of India’s microfinance sector, and over 80 suicides within a few months.
Mexico is also vulnerable to untenable debt spirals. Alex Silva, president of Canadian microcredit lender Calmeadow, has stated, “What has happened in India could take place in Mexico … [one of] the main features of Mexican microfinance [is] overleverage.” The danger of overleveraged borrowers is very real for the Mexican microcredit sector; in fact, 28 percent of Mexican borrowers have taken out four or more loans from microcredit institutions.
Microcredit lending in Mexico is a nuanced issue, pitting the ideas of small loans and financial inclusion against the dangers of poor regulation, overleveraged community borrowing and extravagant profit margins in what is meant to be a “social business.” Contemporary Mexican microcredit, dominated by Compartamos Banco’s high interest rates and profit margins, poses a real danger to the future of microfinance in Mexico. The practices that have defined Banco Compartamos’ business models may yield profits for the organization and their investors, but the poverty-stricken borrowers will probably be, at best, as well off as they were before — and possibly worse off.
Alex Haer is an undergraduate at Rice University and an intern for the Baker Institute Mexico Center.