A $9 Trillion Question: Did the World Get Muhammad Yunus Wrong?

In the development world, Muhammad Yunus and Hernando de Soto are considered saints.

In 2006, Yunus and the Bangladeshi microbank he founded, Grameen, won the Nobel Peace Prize for their pioneering work in microfinance -- a means of providing small loans to the very poor. Last week, U.S. President Barack Obama awarded him the Presidential Medal of Freedom, the country's highest civilian honor, commending him for "[unleashing] new avenues of creativity and [inspiring] millions worldwide to imagine their own potential."

In the 1990s, de Soto played a key role in the World Bank's remaking of Peru's economy; today, he serves as the head of Lima's Institute for Liberty and Democracy. He is an intellectual of global importance, perennially on the Nobel shortlist for his advocacy of property rights for the impoverished.

But the brilliant ideas advanced by Yunus and de Soto have had limited real-world impact, and in practical terms, neither of their economic notions has the capacity to remake the world, as is often claimed. Sadly, the honors they have received often hide this hard truth, limiting vital criticism of their work. But, by looking critically at de Soto and Yunus, a way to combine the best of their ideas and solve a multitrillion-dollar poverty problem suggests itself.

De Soto's widely heralded 1986 book The Other Path describes the poor as small entrepreneurs, stuck in a poverty trap because their wealth is informal. In The Mystery of Capital, published in 2000, he estimated that the world's poor held roughly $9 trillion in frozen savings, locked up in unregistered assets, such as homes and businesses.

De Soto's proposed solution was to formalize these untitled homes and other assets. But this policy prescription requires a strong central government, substantial public funding, an efficient apolitical bureaucracy, and major legal changes. In virtually all poor countries -- perhaps except China, with its command economy and centralized government -- this would create opposition from business and government elites that would derail the program, even if such changes were in their long-term interest.

For his part, Yunus has shown that the poor benefit from and can learn how to use credit. Most importantly, he and Grameen Bank demonstrated that the poor do repay their loans. But his ideas have not proven easy to implement -- at least with the massive scale that would be required for them to make more than a symbolic difference for the world's poor.

As of 2004, loans provided by microfinance organizations amounted to just $17 billion worldwide. This is a pittance compared with the potential credit requirements of de Soto's 4 billion poor, most of whom are small-scale entrepreneurs. All capitalists need capital -- but the current system will never provide an adequate amount.

Moreover, most of the existing microfinance credit is subsidized. Very little comes from private, profit-seeking capital markets (as of 2004, just $2.7 billion, or about 60 cents per poor person per year). This is because development banks do not really require collateral for their microloans. They often use subsidized credit, as they generally aren't profit-seeking. But banks backed by private capital markets require collateral. This means that their loans are too expensive for most of the long-term needs of the poor.

For instance, the private Mexican microbank Compartamos charges 100 percent annualized interest -- which, to be fair, reflects the real risk of providing an unsecured loan. But such long-term interest rates cannot encourage capital investment in projects that need time to gestate. And though shorter-term loans with 25 or 50 percent annualized rates beat the street rate, such debt cannot be carried for any length of time. As a result, the pool of global capital is largely inaccessible to poor people. And the solutions proposed by Yunus and de Soto for formalizing the economy of the poor and thus lifting them from poverty prove only marginal.

But there is viable market-based approach that would create a deep pool of capital the poor could tap: the provision of micromortgages, or secured, long-term, low-interest rate microloans. Such loans would not require governments to change their civil codes. They would only have to make narrowly focused legal and regulatory changes; then, they would have to establish registries, licensing private firms to prepare applications for the registration of informal property. In this way, the micromortgage process could become self-funding, helping grow the pool of credit.

How would it work? Let's consider a poor individual living in a house without a title or even an address in Mexico. He hopes to formalize his house. So, he visits a local bank to apply to register his property. To the bank, he represents potential demand for credit -- the bank has incentive to research his claim, help him map his land, assess any improvements, and submit his information to the registry. The bank would do this in return for his loan business and a fee to cover costs.

The bank would then submit the individual's information to the government, ready for entry into an official national digital registry. Were the application accepted for processing, he could take out a form of title insurance from the bank, which could then safely extend credit to the applicant. The modest application fee would be added to his loan principal, allowing him to immediately use the balance for, say, a long-term micromortgage to finance a business.

De Soto estimates that the poor in Mexico already hold well over $300 billion in frozen savings. Modern registries would facilitate micromortgages and so prove to be an enormous economic boon to both businesses and the poor -- all at no great risk or cost for poor governments.

Yunus and de Soto offer us real insights into how the poor can, finally, work themselves out of poverty: Yunus shows they need credit and de Soto shows they need to join the formal economy. But we must build on their ideas and combine them in order to develop a more viable way to realize their inherent promise. If the world's poor can gain access to private capital via their formal titles, then we will have a real solution to a $9 trillion problem.

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YENJH

10:01 AM ET

August 20, 2009

Microcredit still works.

As a result of this financial downturn largely caused by the developed world, the World Bank estimates that an additional 53 million people will fall into extreme poverty in the developing world. While we all would like quick and easy answers to the world's problems, we must not forget the difficult lessons of the past. I am specifically referring to financial innovation that brought us a system that aggressively marketed and bundled mortgage products that put us in this current financial crisis. It was easy to sell the catchy idea that everyone deserves to own their own home no matter how much they make, whether they have a job and whether they can make payments. Now let's juxtapose these facts with what is being proposed - micromortgages. I fear that big private capital markets will bully the poorest of the poor into bad terms that will only put these people in a worse condition likened only to slavery. With amounts too big to pay off, they will not only be poor, but beholden to the developed world.

The author suggests that microcredit is not as successful as advertised because it has limited reach. I beg to differ - just ask the 100 million families that microcredit has helped through the Microcredit Summit Campaign. They have seen their condition improve using simple microloans without relying on any financial innovation such as micromortgages. I must admit that micromortgages are attractive on face value, but I fear the unintended consequences need to be addressed so we do not face a situation where we hurt those we are trying to help.

ANDREABOHNSTEDT

12:09 PM ET

The article (like much of the

The article (like much of the microfinance and surrounding consultant industry) is based on the assumption that all those poor people are also naturally entrepreneurs and capitalists - and I think that's a flaw in the argument. Just look around the readers here: how many - with undoubtedly easier background conditions than the amorphous 'poor' - are happily employed rather than running their own business? But we're looking to poor, sometimes illiterate people with limited education to all become successful entrepreneurs. What many of these 'microentrepreneurs' do are survival activities rather than running an actual business - selling onions today, and if that fails, second-hand clothes tomorrow. Much microcredit goes into such trading activities where many small entrepreneurs venture into exactly the same products.

And a great many microfinance NGOs aren't that capitalist either with the donor support, traveling consultants, and subsidised funds they get.

DINUNARAYAN

8:47 AM ET

August 21, 2009

microfinance

The idea that markets can provide a viable funding alternative for the credit needs of the poor sounds good in theory but may not be as practical as the author argues, especially in developing countries. It has been tried extensively in India. Indian micro-lenders have already received more than $1billion from PE and VC funds. However, the pressure to generate returns for the capital is now weighing heavily on the micro-lenders. Many such lenders are now said to be more focused on generating returns on equity than creating livelihoods. Moreover, securing micro loans is a foolhardy proposition when micro-lenders such as Grameen have demonstrated that repayment rates could be near 100 percent if peer pressure is used creatively. Group dynamics and teamwork form the bedrock of micro-lending. People who borrow small loans repay not because they fear losing what they have but it is considered dishonest not to do so.
Making poor people mortgage their meager holdings will undoubtedly rob them off whatever savings they have in case of defaults due to natural disasters such as drought and floods. Such calamities are common in developing countries and the governments are least equipped to handle them. The author's suggestion may work in countries that have efficient government delivery systems robust processes. The author has also failed to understand the cultural dynamics of countries such as Bangladesh or India. Poverty alleviation measures have to be tailor made for each country, perhaps region even. No doubt progress will be slow. But it will be sustainable. Cookie-cutter solutions hardly work for such problems.

JOHNLOCKE

1:54 PM ET

September 11, 2009

3 Comments

All three commentators have made good points. I don't see a mechanism that the writers will be notified but since it is a part of a permanent record let me, as the author, make a few quick comments on them.

Yenjh makes two important points; abuse by lenders and the success of microcredit. The west was damaged by bad loans. When I bought my house 20 years ago I had to put money down, but until the crash borrowers got money back. No lender would be foolish enough to do that in a poor country, so don't worry. Keep in mind that informal houses are not pledged as collateral (they don't exist in a legal sense) so they represent pure equity which becomes available to homeowners who register their property. My guess is that most credit will not exceed 50% of market value.

I am pretty sure that 100 million families have not gotten significant microloans. But even if they did, most microloans are too small and, often, too expensive to make any substantial difference. And where, by the way do the other 900 million families go for a loan?

Andrea B says it is wrong to assume poor people are natural entrepreneurs. What on earth does she think most of them are? Buying a bag of onions at a farm and selling them one at a time in the city is entrepreneurship. And, by the way, if they show up the next day to do it again, they are successful entrepreneurs. What is the main missing piece to allow them to better serve this market niche have found? Capital.

They are not employees but, by and large, canny, efficient entrepreneurs. Even someone who has a job in the informal economy knows that the business must make a profit for him to be paid so he is a minor partner, not an employee). You want proof? Those billion families are still alive, have built a billion homes and are growing in numbers. What does she think they do all day?

I agree with her critique of the microfinance industry; you don't need western consultants and do-gooders flying in from DC, you need local lenders who make a deal good for both sides.

Dinunarayan talks about his fear that micro lenders are more focused on rates of return than on livelihoood programs. My point exactly. Lending is a commercial activity not charity. If it is a subsidized social program, it is not financial business and there will never be enough real money to make it change lives. 100 bucks for a family may be useful but with one billion families, how will a social program raise $100 billion in charity? And by the way thats a drop in the bucket; if the $9 trillion number is correct, their capital needs are in the trillions, not billions. So if its not charity, and you want to tap capital markets, then rates of return matter. If its charity, say so.

High repayment rates rates through peer pressure? I have seen the statistics and some have questioned them but I have no way of knowing the true rate. But no matter what, keep in mind that there is a cost to these borrowers clubs that generate such high repayment rates. Everyone must attend, someone from the lender must run the meetings, eveyone is on the hook for the failure of others all of which is time consuming and so creates a cost and risk. Who pays those operating costs as well as the cost of money? Either the borrower or some charity. The for-profit Mexican microbank Compartamos charges 100% pa which reflects the real risk and cost of unsecured lending. We could do secured lending in Mexico for around 20% pa.

Mr Yunus was celebrated in a Sixty Minutes piece a few years back and it showed a woman who had borrowed money for a cell phone and so had, in effect, been granted the communications monopoly for her village by Grameen. But leaving that quibble aside, I called someone who knew Bangladesh to ask what he thought her house was worth. CBS explained she was in the cell footprint because she was on a major thoroughfare and with that in mind he said $1500 - $3000 (it was a pretty big house). What could she have done with a long-term loan for $750 to $1500? The point is that investment capital is rarely meaningful in small dribbles for short periods. You can't build a house using your credit card.

It is hard to even begin answering Dinunarayan's second half. Will floods sweep away land too? Land has value and so might be secured to get the money to rebuild rather than waiting for USAID tents and charity. Moreover we work with insurance companies for boty title and casualty.

As to cultural dynamics, I don't need to understand them, I just need to provide capital and training (where needed) to local banks and local borrowers, both of whom understand the environment quite well thank you. The reason that there is so much protest about foreigners not knowing the local environment is that foreigners try to do way too much. Aid officials design the programs and then aid consultants implement them. If you are going to occupy a country, you need to know the local enviornment. If you are going to fund economic programs, you need to know how to write a check to hire locals to design and implement them, not consultants in Washington.

And finally you admit "progress will be slow"? How do you define slow? $2.5 trillion and 60 years (Prof. Wm. Easterly) with no aid graduates? That isn't just slow it is stalled. When do we try something new?

A $9 Trillion Question: Did the World Get Muhammad Yunus Wrong?

As Yunus receives the Medal of Freedom and Nobel rumors swirl around Hernando de Soto, it is time to give these two poverty-fighting visionaries another look.

BY PETER SCHAEFER | AUGUST 18, 2009

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