Why Government Microfinance Doesn't Work

"I've got this thing and it's fucking golden!"

One of the reasons a lot of people find microfinance attractive is that it is a fundamentally capitalist approach to economic development.  Done right, it can be sustainable and even profitable.  By focusing on a social mission, successful microfinance institutions (MFIs) can reach more clients by leveraging capital, similar to commercial bank.  And just like the Ice Queen warns in Atlas Shrugged, government intervention in capitalist programs spells disaster.  Whether or not this is true for other industries (it’s not), it is most definitely the case in microfinance.  Successful government-run microfinance institutions are the exception, not the rule.  And not only are governments generally bad at administering loans, they can be destructive to the market as a whole.  On the CGAP website question 13 of the FAQ is “Do governments do a good job of delivering microfinance?”  The answer is thorough:

There are several highly successful government MFIs, such as Bank Rakyat Indonesia’s microfinance department. However, the vast majority government microfinance programs do a poor job of delivering retail credit. Such programs are usually subject to political influence, high default, continuing drain on national treasuries, and sometimes lending based more on the borrowers’ influence than their actual qualifications. Among government programs reporting to international databases, only 1/8 of clients are being served sustainably.

To begin thinking about why government microfinance doesn’t work, it is important to think about the types of governments serving microfinance communities and the nature of government in general. On average, the governments of developing countries tend to be more corrupt and have less accountability than those of the first world.  This is particularly true at the lower levels, where politicians can usually buy the votes of entire communities with cash handouts.  In the same CGAP article, the political nature of government microfinance in discussed:

There are structural dynamics that make it hard for governments to deliver good retail credit.  Sound credit administration requires screening out borrowers who are not likely to repay, charging interest rates high enough to cover costs, and responding vigorously to late payments.  These requirements usually run counter to the practical incentives and imperatives of even the sincerest working politician. The government-run MFIs that deliver good microcredit tend to be insulated from politics, managed by technocrats, and strongly and explicitly focus on sustainability.

Aggressively pursuing microfinance loan defaulters isn’t going to win a politician any friends in a community, and funding for a government microfinance program is basically found money anyways.  Using a microfinance program – already a means of distributing money to voters – as a way to win the favour of poor communities is an appealing proposition for an incumbent politician, particularly if he is not responsible for the program going belly-up.  In other words, politicians can use a microfinance program as a voter outreach tool without dipping into campaign funds.  Also, government programs will be less likely to use the group lending methodology since sustainability is not a priority (the federal funding spigot only turns off when there is a new team at the controls).  Instead, many of these programs favour individual lending without the same protections afforded by the social collateral of the group lending model.


These dynamics cause repayment problems among the first troublesome clients, ultimately leading to epidemic of default.  This is because ensuring repayment is as much about maintaining an appearance of solvency as it is “responding vigorously to late payments.”  Perception is important, and if clients think you might not be around tomorrow to give them another loan, most will avoid going down with the ship and just stop paying altogether.  For a NGO (non-government) MFI, this is a death blow.  Once the number of clients in arrears reaches what Malcolm Gladwell calls the tipping point, the whole fragile institution can unravel.  But at least successful NGOs with strong repayment records have leverage over their clients in the sense that defaulters will be sacrificing the ability to take out another loan if they choose not to pay.  With government microfinance, the perception is that the money tree (the program) will continue to grow leaves (money) whether you pay or not, so not paying is less of an issue.  No one feels individually responsible for contributing to the program’s demise, since it will also be buoyed by federal largesse.

Typical U.S. politician, chained to a few $1 bills

A lot of government microfinance programs subsidize interest rates, which undermine the sustainability of the program and make it reliant on federal funding.  This has a two-fold effect.  The first issue the program will lose money and never reach sustainability, the goal of every microfinance institution.  The second and more problematic issue is that subsidized interest rates undermine the market by creating artificially low conditions for competition.  How can NGOs compete with a program that isn’t even charging enough to break even?  In theory, the NGOs would not be able to compete with a robust government program, driving them out of business as they fail to attract enough clients to turn a profit.

Government-run microfinance institutions tend to be bloated, inefficient sinkholes that can be used as the tool of politicians.  By undermining a market-based, competitive microfinance industry, government programs can be detrimental to the same communities they serve.  In question 14 of the same FAQ, CGAP asks: What is the government’s role in supporting microfinance? The answer that government should perform its stated function, which is to craft sound macroeconomic policy, avoid trying to over-regulate the microfinance sector, and support non-government microfinance institution with funding.  What they shouldn’t do is get involved in microfinance operations.  In the long run, only the politicians will benefit.  Sheeeyit.


4 thoughts on “Why Government Microfinance Doesn't Work

  1. Christopher Carr

    “And just like the Ice Queen warns in Atlas Shrugged, government intervention in capitalist programs spells disaster. Whether or not this is true for other industries (it’s not), it is most definitely the case in microfinance.”

    I couldn’t disagree more about this only being true for microfinance. Whenever unentitled parties gain control of any industry there is going to be disaster, especially if those unentitled parties have goals that are inconsistent with the goals of those entrepreneurs and financiers that built the industry in question in the first place.

    “On average, the governments of developing countries tend to be more corrupt and have less accountability than those of the first world. This is particularly true at the lower levels, where politicians can usually buy the votes of entire communities with cash handouts.”

    Aren’t identity politics, special interest groups, lobbying, industry privilege, regulation, deregulation, etc. all just sterile, euphemistic, roundabout ways of buying votes? You could say that at least corrupt politicians in the developing world are corrupt out of necessity.

  2. John Galt

    I am glad that you are finally getting to quoting Ayn Rand. I agree with the above comment poster that not only does government mess up micro-finance, they also mess up most other enterprises. They should stick to regulations and oversight of corrupt investment banks and leave micro-finance and other businesses to the private sector. As was shown in “The Big Short” they probably shouldn’t have even bailed out AIG thus allowing Goldman to fail as it deserved to under the rule of “moral hazard”-another term that could have been used in Atlas Shrugged.

  3. Dominique

    I went looking for this in some of the other micro-finance based info on the site and blog, but didn’t find it – maybe you can help:One of my corcenns about MF is the interest rate charged to the borrowers. If this rate is very high (say, 15%+), then it seems likely that many borrowers would be unable to earn that from business investment. If, in fact, many/most borrowers are using the loans for more consumption-type purposes, then the issue is compounded – they are agreeing to pay, say, $230 next year for $200 today, but if their income doesn’t change, then all MF does is makes them $30 poorer over the course of a couple years. i.e. Could MF institutions be the third world equivalent (roughly) of payday loan places, pawn shops, and high interest credit cards in the first world? While I think these things have their place here, I think that many of those who use them end up worse off than if such options weren’t available, and certainly, the idea that I, as a donor, would want to make a charitable gift to enable Al’s Pawn Shope or Quick Cash Payday Loans to expand their reach is not very appealing. Yeah, these corcenns may be beyond the scope of what you’re trying to address in this blog post, but it’s just odd to me that we as a society generally condemn high interest loans to the poor in the U.S., but apparently seek to expand the practice in the third world (if indeed the typical loan is fairly high interest).

  4. Marjon

    Roy, most health prgmoars aim to become self-sustaining in some sense, and so do most MFIs. And in both cases, some succeed; many do not; and it’s difficult to find reliable information about how common success is.Health prgmoars, however, have demonstrated more tangible and verifiable impact on people’s lives. Regardless of the sustainability of a program, curing a case of tuberculosis (for example) can make a permanent difference to an individual, who in turn can make a permanent difference to his/her family and community. The odds that a program can become self-sustaining – when there is any information about them – should be taken into account. But so should the benefits of helping and empowering individuals.In addition, we still have major questions in general about the extent to which MFIs are helping the people they serve. There are questions about whether they’re reaching the right people, and about whether those people are benefiting or overpaying (). We haven’t yet identified a microfinance charity that can address these concerns well; we have identified health charities that appear to be at a much higher level of transparency, accountability, and knowledge about the impact of their work.

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