Macroeconomics Meets Microfinance

1 October 2010 at 04:00 15 comments

Vegetable sellers in Abura

In my time as a fellow, I expected to interview borrowers and hear lots of touching personal stories. I never expected to finally understand economics in a way textbooks never described it for me. Economics was not a course I chose to take. It was a mandatory credit I had to take. While I managed to memorize how supply and demand curves moved, for the life of me, I could not see the practical applications of economic theory. This was the case until a very special aha moment last week thanks to my field experiences and a fantastic discussion with CRAN’s Director of Microfinance. I finally understood the interplay of demand and supply at a very practical level. Upon reflection, I am starting to believe that a vital assumption for microfinance to be a success story is that there is continued excess demand in the marketplace. But what happens if supply exceeds demand?

In the two months that I have been at CRAN, I’ve interviewed over 130 borrowers and have started noticing themes in the type of businesses that these borrowers have. There are vegetable sellers, food sellers, second-hand clothing sellers, and provision (convenience store) stall owners. It seems that a lot of the borrowers are selling a product of sorts. And when asked about how they used their loan, the most common response is that they increased their stock. By increasing their stock, the borrowers were able to increase their sales and profits. Thus, their businesses grew. While this sounds like a success story, I find myself asking, how long can this growth be sustained? How many vegetable sellers does one small village need? And if one of the premises of microfinance is to graduate clients to higher loan amounts, how long can you keep graduating vegetable sellers in a village before the supply of vegetables exceeds what the village can consume?

This becomes a demand and supply issue. I’ll walk you through a simple example. Let’s say that in a hypothetical village, the demand for tomatoes is $2,000. There are 5 tomato sellers in the market and none have taken out micro-loans before. Here’s the scenario:

–          Prior to taking any loans: Each of these 5 tomato sellers has $200 worth of stock. So in total, $1,000 worth of tomatoes are sold. There are opportunities to grow in this market, because not all the demand for tomatoes is being met.

–          1st cycle of loans: The MFI sees an opportunity in this village and gives loans to each of the 5 tomato sellers. They can now increase their stock to $300. So the total supply of tomatoes is $1,500 and there are still opportunities for growth.

–          2nd cycle of loans: All the clients grow their sales, repay their loans, and improve their businesses. The MFI decides to graduate these 5 tomato sellers to higher loan amounts where now, they each have $400 worth of stock. The total supply of tomatoes is now $2,000. Supply matches demand and the market is at equilibrium.

–          3rd cycle of loans: After another cycle of successful repayments, the MFI decides to graduate these clients yet again. Now, each of the 5 tomato sellers has $500 worth of stock. The total supply of tomatoes is now $2,500, which exceeds demand.

In this case, what do you do at cycle 3? When there’s excess supply in the market and these clients have to repay their loans regardless of their ability to sell, you’re bound to see some clients become delinquent or default altogether. In a situation where demand is held constant, at one point, you will hit a ceiling where you can’t graduate clients any longer. When facing this situation, you have to either stop graduating clients, or graduate some clients at the expense of losing other clients, or go to a different geography to continue expanding your services.

This also brings up the question of the purpose of microfinance. If microfinance is access to capital for populations not served by the commercial banking system, then not graduating clients is not necessarily an issue. In this case, you are still providing clients with a service that they need. However, it is a different story if you view microfinance as a development tool where clients are more empowered after each loan cycle and eventually reach a position where they can access loans from the commercial banks. If this second definition is how an MFI defines its mission, then situations where supply outpaces demand can really challenge the pursuit of this mission.

I’m starting to believe that a key assumption in microfinance as a development tool is that there’s excess and growing demand for goods in a given marketplace. This excess demand facilitates graduating clients to higher loan amounts and maybe eventually to accessing loans from commercial banks. Macroeconomic factors that increase job creation, purchasing power or demand for goods and services become critical to an MFI’s success. Without a productive labour force that has the purchasing power, a micro-entrepreneur will inevitably face a demand cap for the goods and services that he or she provides.

At an operational level, MFIs have to be very observant on the demand and supply factors faced by its clients in the different markets that it operates. It is important that loan officers are trained on observing, inquiring about, and analyzing these factors. The health of an MFI’s portfolio very much depends on it. CRAN’s Director of Microfinance told me that this hypothetical example is actually not too different than the day-to-day realities that MFIs face. I can’t help but marvel at the economic forces at play. What a pleasure it is to better understand a topic that was inaccessible to me before.

Vegetable Market in Abura

By Zerrin Cetin, KF12 Ghana

Entry filed under: blogsherpa, Christian Rural Aid Network (CRAN), Ghana, KF12 (Kiva Fellows 12th Class). Tags: , , , , , , .

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  • […] the Kiva Blog for a detailed account of the complexities of over-supply of microcredit, and about various challenges microfinance institutions face. […]

  • 2. Eivind  |  4 October 2010 at 06:36

    My 5 cents of thoughts:

    This example illustrates nicely the fact that capital, being micro or not, is only a tool. To make a better living, microcredit must be properly used, and other factors must change as well.

    In your example: If the tomato vendors are happy after the 2nd loan cycle, there is no reason for giving them a third…..This village is not big enough for five successful tomato vendors.

    I hope: Two or three tomato vendors, or the MFI, realise this. And these vendors start an other business. The credit given has hopefully helped these vendors, and the people to which the vendors have spend their profit. The tomato growers are hopefully happy; they have found new customers to their crop.

    The big question is however: Are the tomato-growers able to start exporting their tomatoes to other markets.

    • 3. zerrincetin  |  5 October 2010 at 02:04

      Great question, Eivind. From what I’ve seen, especially in the rural areas, the entrepreneurs tend to stick to trading in their villages. Some travel to nearby villages to sell their products, but in general, most tend to stay in one geographic area.

  • 4. Read my new Kiva blog « Zerrin Cetin's Blog  |  4 October 2010 at 03:17

    […] my new Kiva blog October 3, 2010 Filed under: Uncategorized — zerrincetin @ 3:18 pm Possibly related posts: (automatically generated)New post on the Kiva Fellows Blog!Officially an […]

  • 5. LG  |  3 October 2010 at 20:25

    I agree that there is a growth ceiling for most of these businesses. For many borrowers this would be fine–they take out one or two loans and after that their businesses could self-sustaining.

    But because they goal is to keep these clients in the loan cycle with even bigger loans, the clients end up purchasing stock for their businesses with high-interest loans, even after the point where they should be able to provide the capital themselves.

  • 6. Dan  |  3 October 2010 at 17:10

    I think your story illustrates micro-economic principals, but when it gets into the macro-economic aspects there is more fluidity than your example suggests. First, if each of these “tomato sellers” increases their profits, that money flows back into the village to the vendors of wares and services that they need more of. This growth in the economy will affect the demand for tomatoes in some positive way. So the demand will not stay static at $2000.
    Second, these “tomato sellers” are not restricted in plowing back their profits into more tomatoes. As has already been mentioned, the local entrepreneur will be watching for opportunities, whether it is with other vegetable crops or using tomatoes to create finished food or whatever. Merchants on the ground can sense the edges of market saturation much better than any overseer from the top will.

  • 7. Rike  |  3 October 2010 at 14:45

    Your article pinpoints the constraints to the outcome of Microfinance very nicely, dear Miss Cetin!
    It was a pleasure to read this.

    “Macroeconomic factors that increase job creation, purchasing power or demand for goods and services become critical to an MFI’s success. Without a productive labour force that has the purchasing power, a micro-entrepreneur will inevitably face a demand cap for the goods and services that he or she provides.”

    That’s exactly the problem. Development countries need more than microfinance institutions. In my opinion Microfinance institutions can help to close gaps between the most unprivileged people and the rest of the society. But over all there is a basic need for “real” development in those countries, there need to be jobs and productivity apart from “trading”.

    “What a pleasure it is to better understand a topic that was inaccessible to me before.”

    I couldn’t manage to see this disillusionment as a pleasure, but maybe it helps to focus on the right private political activities (rather than ‘donating’ money to MFIs, which are not interested to think about demand ceilings):
    When will the necessary political/economical decisions in “our” countries be made, that will really change the macroeconomic situation in development countries (e.g. subsidies (cotton etc.), exploitation of raw materials, issuing patents, sending our rubbish (old clothes, chicken’waste’))?

    • 8. zerrincetin  |  4 October 2010 at 04:07

      Thanks for the encouragement, Rike. The pleasure for me is finally seeing a practical application of economics. It’s always been a topic where I struggled to see the practical implications of academic theory. While what I’ve learned is perhaps a bit discouraging, but the learning itself is still pretty exciting for me 🙂

  • 9. Eivind  |  3 October 2010 at 06:22

    Great Blog.

    It is blogs like this that make my want to contribute to the work done by Kiva.

  • 10. Fehmeen | Microfinance Hub  |  3 October 2010 at 01:28

    Over-supply of micro-enterprises is an issue many people are beginning to comprehend; however, good entrepreneurs are sharp enough to read market trends and for those who have trouble, MFIs can use a number of tools (recently added to the SMART Campaign) to determine if the borrower’s business model is viable. As mentioned by Gabe Francis, the collective demand of society grows as they prosper economically, but in theory, there are only so many tomatoes a family can consume.

    I agree, growth in demand is a major assumption in all business models, simply because we’re used to that kind of capitalism. There are talks about a zero-growth economy that will make our lifestyles sustainable, but I don’t think the poor will accept that idea very well.

  • 11. fred  |  1 October 2010 at 13:57

    Switching out of slacker mode for a while: these people are right there, they don’t rely upon market forecasts, so I trust them to adjust to conditions and switch out of the tomato market before it turns south. Some won’t, and if they have extra tasty tomatoes to sell, why would they? People still want to eat tomatoes, don’t they?
    I think that if microfinance is to live up to at least part of its promise, it will be because it will lift communities out of poverty, not just individuals, though they will do the lifting, not us.
    Bottom line is I trust the people I loan to to be smarter than I would be with that money. The stakes are way higher for them, what am I going to tell them? If anything, these people should be acknowledged for what they’re teaching me.

  • 12. Gabe Francis  |  1 October 2010 at 11:25

    Expanding on Fred´s point- A key thing to note here is that as the borrower’s income grows they purchasing power does as well, which in turn increases demand. So by the third cycle, in theory, the demand for tomatoes is actually larger than $2000. This self-enforcing economic cycle is central to macro-theory.

    One rapid way to increase this supply demand cycle is in the creation of new markets. For example, my MFI director at FUDECOSUR in Costa Rica often gives a speech to his village banks encouraging them to start butterfly farms. Imagine, he says, how beautiful it would be if we could create butterfly farms so that at every celebration- birthdays, weddings, graduations- people released butterflies into the air. By creating a market for something that didn’t exist before new economic inversion and growth is stimulated. Cool idea huh?

    Perhaps one measurement of MFI success should be how many new business markets have been created.

  • 13. vaughanbrv  |  1 October 2010 at 08:42

    wooo great post! don´t also forget the potential for clients to move into new businesses/expand into new products as their loan cycles advance to find some new sources of demand

  • 14. fred  |  1 October 2010 at 07:49

    Nice post. Of course, if all works well the borrower is also a customer to other local businesses, which in turn can make the demand grow, so that maybe it could absorb some of the increase. My faint memories of economics classes feature something about the speed at which money goes around as a worthwhile factor.

    Then again, I too am surprised that macroeconomics have a practical application beyond a surefire cure for insomnia — I can vouch for the latter’s amazing potency.

  • 15. brittanygoesglobal  |  1 October 2010 at 04:16

    Zerrin, wow. This post is absolutely amazing, it is one of the best I’ve read on the fellows blog. Thanks for breaking down this reality in a really easy and accessible way!

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