An Economic Framework for Understanding Microcredit in Developing Countries

This paper investigates the economics of microcredit to reduce vulnerability and food insecurity. It presents a model that shows how a microcredit market based on trust can co-exist with a commercial collateral-based market. The model provides an economic structure to microcredit that is different from collateral-based models of lending. The model illustrates how:

• Grameen Bank operates microloans in Bangladesh;
• Non-endorsement of the notion of trust as a form of capital in China, has led to the very poor being excluded from the microcredit market;
• In India, MFIs and commercial banks have progressed into microcredit and other forms of finance and are being promoted by rural development NGOs;
• Microcredit lenders in India lend fundamentally on trust and are focused largely on the poor in rural areas;
• MFIs can co-exist with subsidized credit from government banks;
• Microcredit emergence has affected informal lending and usury rates from money lenders.

The theoretical model indicates that trust-based lending, coupled with certain incentives, can go far in supporting growth opportunities in developing countries. Development policy should be flexible enough to permit trust-based micro-lending to the poor.