Microfinance was once celebrated as Asia’s tool to lift people out of poverty. From Bangladesh to India, Cambodia and the Philippines, the promise was simple: provide small loans to low-income households, help them start businesses, increase income and escape poverty.

Pioneered in the 1970s, microfinance was designed to provide financial services to low income people typically excluded from traditional banking.

Small loans, usually between US$200 and US$500 were particularly targeted at empowering women to start businesses and support their families. According to the World Bank, more than 1.7 billion people do not have access to banking.

Yet decades of experience suggest that credit alone has not delivered the transformation to economic independence promised.

We need to ask a difficult question: what if we solved the wrong problem?

Based on flawed assumptions

One fundamental problem is the assumption that poor households in developing nations lack capital but have profitable investment opportunities.

In reality, many poor families operate very small businesses such as food stalls, small shops, farming, tailoring or petty trading. These activities are often labour intensive and face intense local competition.

Giving more people loans can therefore create more businesses without creating more customers. When many borrowers enter the same market, additional credit may simply divide existing demand among more businesses. That boosts competition and makes it harder for individual businesses to generate a profit.

This problem is closely related to another assumption: that poor families are entrepreneurial. Some borrowers do have business experience, skills, networks and opportunities that allow them to generate a high return on their investment.

But others would benefit much more from stable employment, education, vocational training and infrastructure such as reliable roads and transport, electricity, internet access, and market facilities.

Treating all poor households as potential entrepreneurs can therefore lead to the wrong policy intervention. Evidence from India shows access to microloans increased borrowing and investment by existing businesses, rather than helping people to start new businesses.

This suggests microloans can help particular types of households, but they are not a universal mechanism for escaping poverty.

What some microloans are actually used for

A second problem is that loans are not always used for productive investment. Poor households face medical expenses, school fees, food costs, housing needs and unexpected economic shocks.

Sometimes, a business loan is used for these immediate needs or to repay another debt. That borrowing may help manage a financial emergency, but it does not necessarily generate the additional income required to repay the loan and increase household wealth.

The cost of borrowing can further increase this pressure. Microfinance loans can carry substantial interest charges. In Bangladesh, for example, the Microcredit Regulatory Authority sets a maximum charge of 24% on microfinance loans.

With such high interest rates, a small business has to earn enough just to pay back the loan. The real problem is that the enterprise the loan pays for might not make enough profit to cover the cost and risk of borrowing. A micro business that only makes a small return may not earn enough to repay the debt, especially if the loan is just financing survival rather than financial independence.

Multiple loans can create further problems

When borrowers obtain loans from several financial institutions, new borrowing can be used to repay existing debt rather than to finance productive investment.

Research on rural households in Cambodia shows how microfinance borrowers increasingly rely on other debt to meet microfinance repayments. This debt juggling means lenders such as banks or development agencies appear to maintain a strong repayment record, but households remain financially vulnerable.

The experience of Pakistan highlights another important change in microfinance: the increasing use of land as collateral. In rural Sindh province, land is one of the most valuable assets held by farmers and is widely used as security for bank loans. But farmers with small land holdings have less access to credit than large landowners, because they lack enough collateral to pledge against loans.

This creates an important paradox. The original promise of microfinance was to help people who had no collateral. The modernisation of the sector can instead make the poor’s most valuable productive asset – their land – the security behind their debt. And that can put their main asset at risk if they have trouble repaying the loan.

Broader support is essential

The stark lesson is that access to capital is only one constraint on economic development.

In reality, entrepreneurs also need skills, technology, infrastructure, digital connectivity, market access, and stable employment opportunities. For the poorest households, taking on debt may be particularly inappropriate when they lack the capacity to generate a reliable and sustainable return.

This article is republished from The Conversation under a Creative Commons license. Read the original article.