Microfinance and rural industries in developing countries

Microfinance and Rural Entrepreneurship

The objective of this study is to conduct an analysis of the field of entrepreneurial finance and to describe important issues or current dilemmas in the field. Toward this end, this study will conduct an extensive review of literature in this area of inquiry.

The difference between rural and urban entrepreneurship is reported in the work of Ahirrao and Chaugule (2010) to be "only a matter of degree rather than the content." (p.1) Ahirrao and Chaugule state that "It is essential to have a balanced regional development of the country and to avoid the concentration of industry in one place. Rural areas must try for better utilization of human resources to improve the rural economy." (2010, p.1) The industrial unit in rural areas or rural industries include such as "handlooms, handicrafts, sericulture, agro-based units, service industries, rural workshops, metal-based industries, dairy and related activities" as well as others. (Ahirrao and Chaugule, 2010, p.1) Whether the venture falls within the definition of rural industries is dependent upon "the scale of operation, the level of technology, the types of raw materials to be used and the size of investment." (Ahirrao and Chaugule, 2010, p.1) Rural industries, services, and enterprises "constitute the non-farm sector." (Ahirrao and Chaugule, 2010, p.1) The stated strategy that is appropriate for building rural industries in developing countries is one of expansion of products and services in order to diversity the rural economy and assist in the further development of agriculture resulting in "inputs to agriculture as well as process large varieties of agricultural produce." (Ahirrao and Chaugule, 2010, p.1) Rural industries in addition, provides "new opportunities for gainful employment, particularly to the under-employed during lean periods, when there are no agricultural operations." (Ahirrao and Chaugule, 2010, p.1)

I. Plight of the Rural Poor

Microfinance is reported to be "changing the lives of the rural people, re-energizing the poor community, particularly the most oppressed, suppressed and neglected community of the rural society." (Ahirrao and Chaugule, 2010, p.1) It is stated that expansion of credit access in addition to the extension of other financial products and services to rural individuals of the low-income group below the poverty line is inclusive of "women, small marginal farmers, artisans, tenant's agricultural laborers, and share croppers." (Ahirrao and Chaugule, 2010, p.1) Ahirrao and Chaugule state that the rural poor are "the most disadvantaged of access to credit through formal sources. Lack of access to the credit has always been a major hindrance in promoting micro-enterprises." (Ahirrao and Chaugule, 2010, p.1) The primary concern of rural development is "addressing the needs of the rural poor in the matter of sustainable economic activities. Alleviation of rural poverty can be achieved by identifying income-generating activities with focus on micro finance as the basic input for socio-economic development." (Ahirrao and Chaugule, 2010, p.1)

III. Sustainability and Micro-Finance

The work of Noruwa and Emeka (2012) entitled "The Role and Sustainability of Microfinance Banks in Reducing Poverty and Development of Entrepreneurship in Urban and Rural Areas in Nigeria" reports that "The achievement of good economic growth is anchored around an environment of well focused policies aimed at poverty eradication through the empowerment of the people by availing them of access to factors of production, particularly credit." (p.33) Credit has been acknowledged widely as "an essential tool for entrepreneurship development." (p.33) The ability for Nigerian entrepreneurs to engage in new business is stated to be limited by a lack to access to financial institutions. (Noruwa and Emeka, 2012, paraphrased) Noruwa and Emeka (2012) report that microfinance banks serve as a means to empower the poor and provide valuable tool to assist the economic development process. About 70% of the population are engaged in the informal sector or in agricultural production. The Federal and state governments have recognized that for sustainable growth and development, the financial empowerment of the rural areas is vital, being the repository of the predominantly poor in society and in particular the SMEs. If this growth strategy is adopted and the latent entrepreneurial capabilities of this large segment of the people is sufficiently stimulated and sustained, then positive multipliers will be felt throughout the economy. To give effect to these aspirations various policies have been instituted over time by the Federal Government to improve rural enterprise production capabilities." (Noruwa and Emeka, 2012, p.34) A community's productivity is reported to be "correlated with its accumulated human capital and the capital stock to leverage that human capital." (Noruwa and Emeka, 2012, p.35) Noruwa and Emeka additionally report the fact that early studies in microfinance "…sought to understand why they worked or didn't. The typical structure of a microloan, typically a few dollars to less than two hundred dollars, involves the creation of a loan committee composed of trusted members (usually elders) of a village or community. The loan committee then makes loans to groups of four or five borrowers who are known to each other (some program prohibit relatives from belonging to the same borrowing group) who then decide among themselves who will get the first tranche of loans." (Noruwa and Emeka, 2012, p.35)

IV. Theory of Micro-Finance

The theory of micro-finance is such that focuses on enabling the "acquisition of the technological capital to kick-start the entrepreneurial process. The idea that the free market can serve to assisting in breaking cycles of debt and in fostering income-generating market activities in poor communities was not acknowledged until the publicity of the Grameen Bank. Government social policy could not reconcile the high interest rates associated with micro debt markets and indeed often sort to shut down those markets by enforcing usury laws." (Phan, 2010) It is reported that from the standpoint of business "other obstacles have denied poor people access to credit, such as the lack of collateral. No standard existed to affirm how financial institutions could benefit from bearing the administrative costs and the risks of loaning to the poor." (Phan, 2010) Reported as well is that the servicing of microloans or monitoring of the "provision of grants is economically infeasible for traditional financial institutions and government because of the costs of identifying, delivering, and monitoring micro-credit to communities who are not already part of the market economy." (Phan, 2010) Microfinance institutions such as Grameen Bank have demonstrated that the idea that credit can only be extended in large suns in order to realize profit is an idea that is false.

The work of Mahieux, Zafar and Kherallah (2011) entitled "Financing Smallholder Farmers and Rural Entrepreneurs in the East and North Africa" states that providing "…sustainable and adequate financial services to resource-poor rural households faces many challenges, including limited capacity of financial service providers and low level of client education. Most commercial banks are not interested in moving into the rural areas due to the low-income levels, lack of scale economies, and poor infrastructure in the rural areas. In addition, few banks actually understand the most common economic activity in rural areas, i.e. agriculture, and those who do may be reluctant to serve the agricultural sector, given its seasonality and the inherent risks of farming. They also may be hesitant to finance rural micro- and small enterprises, given their difficulties to access markets, and the lack of experience and capacity of their promoters." (Mahieux, Zafar and Kherallah, 2011, p. 5)

The lack of financial institutions in rural areas has often compelled governments to intervene "with state-dominated banks focused on agriculture. Many of these initiatives are reported to have filed since they were "too bureaucratic, too policy-oriented, too concentrated on risk to only one segment of the population, too weak in customer focus or suffering from too many political interferences either in their management or monitoring of their loan portfolio." (Mahieux, Zafar and Kherallah, 2011, p.5) Furthermore, clients also believed the government-sponsored institutions were instruments that make provision of grants and that the banks would be plagued with poor loan recovery rates. (Mahieux, Zafar and Kherallah, 2011, paraphrased)

Stated as one of the primary gaps in the development of banking services for rural areas is poor infrastructure - including such as roads that are bad, electricity supply that is erratic and communication systems that are lacking. In addition, it is noted that the legal environment in rural areas is such that "is also suspect" in the areas of insecure property rights (specifically land titles in rural areas) that serve to place limitations on the collateral options of the bank and this is reported to be combined "with poor contract enforcement opportunities removing the incentive of the bank to make provision of credit, particularly for long-term loans. Also presenting a barrier are market inefficiencies and agricultural value chains are often poorly organized and lack in the area of transparent pricing and are fragmented in primary production making the transaction costs even higher. The combination of all of these challenges serve to "increase the costs and risks of serving rural areas and require continuous attention and innovation." (Mahieux, Zafar and Kherallah, 2011, p.6) In addition, access to financial services for women in some countries due to cultural and social factors is likely to be more burdensome and to make a requirement of alternative methods in addition to awareness building on a long-term basis." (Mahieux, Zafar and Kherallah, 2011, p.6) It is reported that IFAD in Africa intervenes at different levels of the financial sector including those stated as follows:

(1) At the micro level: IFAD aims at enhancing the sustainability of financial service providers while facilitating transparent information sharing on their financial and social performance management, including terms and conditions, particularly the effective interest rates/margins charged. With respect to its clients, IFAD aims to make them bankable by providing them with the necessary capacity building enabling them to implement, develop and manage their activity through provision of skill and management training, assistance to form sustainable producers' associations, and assistance to access accurate market information.

(2) At the level of financial institutions: IFAD supports a wide range of financial institutions through training and capacity building enabling them to provide better services to IFAD target groups and also second-tier organizations such as associations and apex institutions through advisory services, training and capacity building so that they can provide professional and cost-efficient financial and technical services to retail financial institutions and improve market transparency; and (3) At the policy and regulatory level: IFAD aims at improving enabling framework conditions for a range of financial service providers to reach clients with low incomes with appropriate products and services, and to protect rural poor people's savings and deposits Mahieux, Zafar and Kherallah, 2011, p.7)

IFAD African states six guiding principles in rural finance interventions including those listed as follows:

(1) Support access to a variety of financial services, including savings, credit, leasing, equity financing, venture capital financing, remittances and insurance, recognizing that rural resource poor people and local entrepreneurs require a wide range of financial services;

(2) Promote a wide range of financial institutions, models and delivery channels, tailoring each intervention to the given location and target group;

(3) Support demand-driven and innovative approaches with the potential to expand the frontiers of rural finance;

(4) Encourage -- in collaboration with private-sector partners -- market based approaches that strengthen rural financial markets, avoid distortions in the financial sector and leverage IFAD's resources;

(5) Develop and support long-term strategies focusing on sustainability and poverty outreach, given that rural finance institutions need to be competitive and cost-effective to reach scale and responsibly serve their clients; and (6) Participate in policy dialogues that promote an enabling environment for rural finance, recognizing the role of governments in promoting a conducive environment for pro-poor rural finance. (Mahieux, Zafar and Kherallah, 2011, p.8)

Mahieux, Zafar and Kherallah (2011) report a rural microfinance innovation in Syria and report that households in Syria are poor and have "limited access to sources of finance, because of high interest rates that moneylenders charge or lack of adequate physical collateral that traditional financial institutions require for any given loan." (p.8) The managerial and financial capacities of traditional 'sanaduq' (Credit and Savings Union Associations) have been strengthened and they have been linked with the formal financial sector instead of assisting or financing financial institutions to extend the rural network absent a long-term growth perspective, profit and sustainability. (Mahieux, Zafar and Kherallah, 2011, paraphrased) The 'sanduq' is reported to be "an improved version of the savings and credit association while differing in the following aspects:

(1) The sanduq requires mandatory membership and members cannot borrow until their shares are fully paid;

(2) Once membership shares are paid, members can borrow from the sanduq even if they don't place their savings in the sanduq;

(3) All members regardless of whether they are active borrowers are entitled to receive annual dividends based on their contributions to sanduq resources; and (4) Seed capital is necessary during the first two/three years of sanduq operations as to avoid placing a too heavy financial burden on the sanduq with operating expenses. Seed capital is provided as a loan to be paid back after 3 years. (Mahieux, Zafar and Kherallah, 2011, p.8)

Four principles that are stated to be fundamental to sanduq are those of:

(1) self-reliance;

(2) autonomy;

(3) sustainability; and (4) outreach to the resource-poor. (Mahieux, Zafar and Kherallah, 2011, p.8)

It is reported that self-reliance "refers to cultural self-reliance, based on the concept of the sanduq as an ancient community-based institution, organized self-reliance based on the self-financing of the sanduq through share capital paid up by members and retained earnings derived from adequate, nonsubsidized financial margins and insistence on timely full repayment of loans." (Mahieux, Zafar and Kherallah, 2011, p.9) Autonomy is based on the self-selection of members-owners, in the choice of financial products and services offered by the sanduq to its members, in the determination of its lending decisions, and in the determination of its financial policy, especially margins charged by the sanduq." (Mahieux, Zafar and Kherallah, 2011, p.9) Sustainability is reported to be based "on the establishment of operationally and financially self-sufficient local financial institu8ions, together with a regional association. Future linkage with the financial sector will also enable sanduq to reach sustainability." (Mahieux, Zafar and Kherallah, 2011, p.9) It is additionally reported that outreach to the resource-poor "is achieved through growth in the number of members, expansion in the sanaduq, growth of resources either internally (membership shares) or externally (financial links with commercial banks or microfinance institutions).' (Mahieux, Zafar and Kherallah, 2011, p.9) IFAD reports specific public-private partnerships including those stated as follows:

(1) Partnership with the private sector for better access of small producers to markets and enhancement of quality of production at grassroots level;

(2) Partnership with the public sector to enforce the necessary legal framework and to develop the indispensable infrastructure;

(3) Partnership with financial institutions inclusive of commercial banks, microfinance institutions and leasing companies to finance the needs of different stakeholders within value chains and service providers to the value chains;

(4) Partnership with insurance companies to develop specific products aiming at mitigating risks for stakeholders and financiers;

(5) Partnership with communities to strengthen their capacities to gradually own and operate productive assets and/or specifically created companies;

(6) Partnership with local SMEs and entrepreneurs to develop services to value chain stakeholders like processing, storage facilities, transport, maintenance and repair, inputs supply. (Mahieux, Zafar and Kherallah, 2011, p.9)

Value chain upgrading and financing is reported in the work of Mahieux, Zafar and Kherallah (2011) to involve "all stakeholders, producers, processors, exporters, intermediaries, service providers to value chain stakeholders." (p.10) The upgrade of value chains is comprised by the provision of financial and non-financial services to all stakeholders as shown in the following illustration labeled Figure 2.

Figure 2 -- Value Chain Upgrading and Financing

Source: Mahieux, Zafar and Kherallah (2011)

The supply chain approach makes it easier to finance small cash-crop farmers and smallholders are reported to be "financed indirectly via contract farming with better rated processors. This involves the farmer making a commitment to provide 100% of a specific crop to the processor and the processor makes a commitment to purchase 100% of the production of the farmer at a price that is pre-determined with limits placed by quality of the product. The price is paid to the farmer in part and in part to the bank for the purpose of repaying the working capital .loan amount that the financial institution extended to the farmer. (Mahieux, Zafar and Kherallah, 2011, p.9) It is reported that emergent farmers, or those with "the potential to grow into commercial farming that lack the financing and farm-management expertise, justify an individual approach since they have the potential to develop into commercial or professional farmers with corresponding growth of financial services." (Mahieux, Zafar and Kherallah, 2011, p.9) Criteria reported to be established are those relating to "minimum size, sufficient entrepreneurial spirit, basic understanding of business planning, and farm-management skills. With a combination of financial services and technical support, these farmers stand a fair chance of success. Emergent farmers can be financed under the existing retail structure of a particular bank, but the local branches involved would need to hire and train agri-finance specialists who understand farming and have the ability to appreciate the particular risks associated with it. It is essential to form alliances with other stakeholders in the value chain who have also an interest in developing and investing in the farming sector." (Mahieux, Zafar and Kherallah, 2011, p.9)

Summary and Conclusion

Micro-Finance holds great promise for rural communities that are characterized by low-income and low-resource households. Micro-Finance provisions will enable rural poor to become entrepreneurs that flourish and growth as funding for business ventures are very hard for rural poor to obtain. There are various models of micro-finance and there is little research in this area of inquiry on the effectiveness of micro-finance although the studies that do exist report success in this area of entrepreneurship. It is important that future studies examine micro-finance in rural areas to determine the effectiveness of micro-finance for the rural poor entrepreneur and in order to gain an understanding of what aspects of micro-finance provision are the most successful and result in the largest growth of entrepreneurship in rural areas.