Analysis of microfinance and rural entrepreneurship in developing contexts

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)

II. Micro-Finance and Micro-Credit

Micro-credit places an emphasis on "…building capacity of a micro entrepreneur, employment generation, trust building and help to the 'micro entrepreneur' at initiation and during difficult times." (Ahirrao and Chaugule, 2010, p.1) Micro-credits are such that are "enough for innovative and hard working micro entrepreneurs to start small business such as making handicraft items. From the income of these small businesses the borrowers of micro credit can enjoy better life, food, shelter, health care and education for their families and above all these small earnings will provide a hope for better future." (Ahirrao and Chaugule, 2010, p.1) Ahirrao and Chaugele (2010) report that in rural areas "…the micro entrepreneurs continue to produce the traditional designs for local markets produce a large variety of essential products such as milk, food products, village crafts and homemade snack foods. Many are engaged in retail trading of groceries and textiles. These enterprises represent a substantial supply resource for semiurban and urban markets. Micro credit is emerging as a powerful instrument for poverty alleviation in the new economy. It is a powerful instrument and has improved access of rural poor." (Ahirrao and Chaugule, 2010, p.1)

Ahirrao and Chaugule additionally report that enhancement of the rural artisan's access to credit "for consumption and production, the establishment of new and strengthening of existing micro-credit mechanisms and micro-finance institution will be undertaken so that the outreach of credit is enhanced." (Ahirrao and Chaugule, 2010, p.1) The work of Phan (2010) entitled "Entrepreneurship and Microfinance: A Review and Research Agenda" reports that it has been stated that encouragement of entrepreneurship on a small scale among the poor is a method that can be used in breaking the "poverty trap" as well as to "foster production surpluses." (p.2) Phan states that micro-credit "as the means to increased capital, is the primary input to kick-start the entrepreneurial production process." (nd, p.2) Micro-credit is reported to be a concept that is centuries old. The poverty trap persists due to a "combination of social stigma from failed attempts at entrepreneurship, institutional constraints on lending practices, and the inability to recover quickly from setbacks such as natural disasters and personal loss such as the death of a household earner." (Phan, nd, p.3) Kiiru (nd) states in the work entitled "Microfinance, Entrepreneurship and Rural Development: Empirical evidence from Makueni District, Kenya" that Although microfinance has elicited different reactions from different stakeholders, there seem to be a general agreement that it is useful in reducing poverty. However the context in which microfinance is of help to rural poor households is not well researched." (p.3) It is reported that poor households are "held up in a vicious cycle of poverty, where labor, their best resource is 'locked up as unproductive' due to different constraints including a liquidity restrain. For example, a poor household may have family members who are willing to work in the family garden to grow crops. However if they cannot afford improved crop varieties and farm inputs then the returns to their labor are not enough to ensure a good standard of living. Many governments and donor communities believe that the liquidity constraint is the most important constraint impeding poor households and that if it is addressed it will be possible for households to escape poverty. Economists argue that to break the vicious cycle of poverty, there needs to be an outside force that will intervene at some point of the cycle to improve demand for goods and services. This could be done by for example injecting some liquidity, thereby unlocking the productivity of household labor. Microfinance promises not only to break the vicious chain of poverty but also it promises to initiate a whole new cycle of virtuous spirals of self enforcing economic empowerment that lead to increased household well-being." (Kiiru, nd, p.3) The promise of microfinance is shown in the following illustration labeled Figure 1.

Figure 1 - The Promise of Microfinance

Source: Kiiru (nd)

There are reported to be at least two assumptions that go with this model and those are stated as follows:

(1) It is assumed that all poor people can become micro-entrepreneurs if only they were given a chance through credit;

(2) It is assumed that there is a vibrant market for goods and services and that it is possible for micro-entrepreneurs to get linked up to markets for their products; otherwise how else is micro financing supposed to improve incomes if there was no demand for goods and services. (Kiriiu, nd, p.4)

Phan (2010) states that according to theory the objective of micro-finance is "to enable the acquisition of technological capital to kick-start the entrepreneurial process. 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. From a business standpoint, 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. Servicing microloans or monitoring 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. Financial institutions are able to, through charging market interest rates or higher than usual interest rates, to "cover their administrative costs while enjoying repayment rates significantly higher than that of the traditional commercial banks." (Phan, 2010)

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: