Third Step in the Microfinance Theory of Change: Manage the Business for Major ROI?

The classic microfinance theory of change involves three steps the poor person must take to make this theory true:

1. Take a loan from (or save with) a microfinance institution (or similar entity)

2. Invest the money in a viable business

3. Manage the business to yield major return on the investment.

I closed the last post of Theme Three (# 22) with David Roodman’s observation that microenterprise (= IGA for this Theme) may be just “one more resourceful survival strategy” (Due Diligence, p. 27) among the many the poor pursue. From the exploration of what we know about Step 1, it seems fair to grossly estimate that about 50 percent of the poor who have access to microfinance providers actually take Step 1. And of those, about 50 percent take Step 2—or very roughly, one quarter of the poor with access to microfinance are in a position to take Step 3. Now I turn to questions about how they do when they try to …

Manage the business to yield major return on the investment

Why demand a major return on investment of the “usefully large sum” of money in an income-generating activity (IGA)?

Think about it! This is not an investment to maintain the value of one’s money against inflation or for long-term growth of capital. The expectation is much higher—enough income, net of IGA expenses and principal and interest payments to the lender (or to self in the case of savings), to allow the family to have food or other necessities for survival. The poor can make a little go a long way, but a “little” may fall critically short of “enough.”

Referring to the potential of loans to the poor to meaningfully augment household income from microenterprise, Banerjee and Duflos in their book Poor Economics (p. 213) write:

So many have managed to be entrepreneurs in the face of so much adversity, and have made so much out of so little. There are, however, two troubling shadows in this otherwise sunny picture. First, while many of the poor operate businesses, they mainly operate tiny businesses. And second, these tiny businesses are, for the most part, making very little money.”

In their Chapter 9 (“Reluctant Entrepreneurs”), Banerjee and Duflos go on to show that while marginal return on a dollar investment can be very high for a tiny business, the overall return is very low – the business is not making much money. Moreover, the average poor “entrepreneur” gets stuck on micro. Their graphical analysis predicts that marginal return will drop rapidly as the micro-business grows and then reaches a point beyond which it cannot profitably grow without infusion of far more capital and management skill than is typically available, even when served by microfinance providers. This explains why most microfinance clients do not grow their businesses and often prefer to have two or more tiny ones. Except in relatively unusual circumstances, it is financially irrational to try to grow to the level of small-to-medium enterprise.

This question more than any other comes from the beating heart of public support for microfinance. If the poor do not make enough additional income from investment of their loans or savings to enhance their survival prospects, much less prosper, then why bother with microfinance?

So I will do several posts about evidence relevant to this question. Here is an overall summary of what we seem to have learned from the recent round of randomized controlled trials that touch on this question.

Microcredit seems to have little early impact on poverty or welfare (health, education, empowerment) indicators (within 18 months of joining a program), except for those who already have business activities in which they can invest their loans. These borrowers experience business growth and, sometimes, increased household expenditure. Microsavings seem to have more measurable impact but again more on those who have businesses at the outset. Whether from credit or savings, the impacts on business development are found predominantly among those already engaged or predisposed to engage in business. Makes perfect sense.  But what about their household income?

This summary doesn’t tell us much about the return on investment by those roughly 25 percent who do have businesses and invest their loans or savings in them.

In coming posts, I’ll go deeper to explore what other forms of evidence seem to tell us and try to compose a nuanced picture of what we know about the success of the poor in taking Step 3 in the classic microfinance theory of change.