Context: Microcredit has gained much traction as a tool for ensuring the welfare of the most impoverished in the society but there are certain flaws in the model.

What is microcredit?

Microcredit refers to the granting of very small loans to impoverished borrowers, with the aim of enabling the borrowers to use that capital to become self-employed and strengthen their businesses. Loans given as microcredit are often given to people who may lack collateral, credit history, or a steady source of income.

Need for and significance of microcredit:

1. The core idea of microcredit is that a small loan will provide access to the larger economy to people who typically live outside the scope of the institutions on which the mainstream economy rests.
2. Such a loan is meant to enable them to commence with productive activities, and will give them the initial boost required to gain entry into an industry, after which production will be able to sustain itself, and the loan will gradually be repaid.
3. Microfinance activities usually target low-income individuals, with the goal of helping them to become self-sufficient. In this way, microfinance activities have an aim of poverty alleviation as well.

Why are microcredit institutions failing to deliver long-term benefits?

1. Lack of evidence of transformative effects of microfinance on the average borrower.
2. The primary reason for the lackadaisical effects of microcredit is the stringent repayment schedule offered by most microcredit institutions.
3. Since most borrowers to whom microcredit is given have little to no credit history as a result of their exclusion from traditional systems of credit, institutions offering microcredit are unable to judge the risk associated with lending to certain borrowers, and cannot be sure what the risk of them defaulting will be.
4. To lower the risk of defaulting, microcredit lenders therefore resort to repayment schedules that demand an initial repayment that is almost immediate, after which borrowers must adhere to an inflexible weekly schedule for repayments.
5. The effect of this is that borrowers are unable to use the loans on investments that will take some time to be fully realised, and instead are forced to use the loans they receive on short term investments that only boost production to an extent, and the overall growth of their incomes remains meager.

How can the microcredit system be reformed to have greater benefits for borrowers?

1. Revise repayment schedule with some grace period to begin repayment.
2. Switch from weekly repayment schedule to a monthly one.
3. As for the barriers to assessing credit risk, these can be mitigated by using community information.

What are the other applications of microcredit?

1. For entrepreneurs to begin production and attain self-sufficiency.
2. Small microcredit loans can allow rural labourers to migrate to urban areas to find work during the lean season, when there is no work to be found on farms.
3. Microcredit can be used in situations where seasonal factors cause drops in income to overcome these “seasonal credit crunches” and avoid taking decisions which cause people long-term negative impacts.
4. Microcredit can also be used to dampen the effects of shocks like floods by providing people with a form of insurance that both increases production before the shock and provides a safety net after.

Way ahead:

Microcredit has a vast range of applications for poverty alleviation and general development, but existing systems require reform in multiple areas to allow for unfettered benefits that last. Furthermore, in areas were the application of microcredit is relatively new, microcredit systems must be carefully evaluated before they are put into place, so as to enable the greatest benefit from such institutions.