Review

Reviewed Work(s): The Economics of Microfinance by Beatriz Armendariz de Aghion and

Jonathan Morduch
Review by: Shahidur R. Khandker
Source: Economic Development and Cultural Change, Vol. 56, No. 2 (January 2008), pp. 484-
490
Published by: The University of Chicago Press
Stable URL: http://www.jstor.org/stable/10.1086/523604
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484 economic development and cultur al change

are captured in the base social accounting matrix. In conclusion, this is an

excellent volume well worth reading by scholars interested in the impact of
globalization on poverty and by the general equilibrium modeler.

Beatriz Armendariz de Aghion and Jonathan Morduch. The Economics of

Microfinance. Cambridge, MA: MIT Press, 2005. Pp. 346. $45.00 (cloth).

shahidur r. khandker
World Bank

Armendariz de Aghion and Jonathan Morduch’s book is an excellent reading

on the economics of microfinance. With increasing recognition of microfinance
in policy making, this book is a timely contribution toward understanding
the pros and cons of microfinance as a tool for development. Given that
economics of microfinance is a new branch of development economics, there
is hardly any microfinance book that covers both theory and practice in a
volume that is easy to read.
The book reviews how the microfinance movement has grown out of in-
digenous efforts to reduce the inefficiencies in production and consumption
created by imperfections of credit markets. It cross-examines the lessons learned
and their implications on poverty reduction, discusses how the poor save and
build assets that in turn justify microfinance rather than microcredit inter-
ventions, and reviews how microfinance institutions overcome market and
institutional failures. The book is an attempt to bridge the gap between research
and practice from a rich but fragmented literature in microfinance. The book
also discusses how microfinance is challenged to deliver financial services at
costs affordable to both clients and providers. The authors sketch a passionate
view of microfinance in this book.
The themes that stimulate discussions throughout the book are threefold:
(1) microfinance is an innovation in the credit market, (2) microfinance is a
development agenda, and (3) microfinance has its challenges. In what follows,
I will discuss the book’s achievements and then offer my observations about
its shortcomings.
The book considers the innovation aspect as a major theme of the economics
of microfinance. The premise is that, because of credit market imperfections,
many of the poor do not have access to the financial services of commercial

The views expressed in this review are mine and do not reflect the views of the World Bank.

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 Book Reviews 485

and state-run banks. The microfinance movement has grown to overcome this
barrier by developing alternative organizations that offer financial services to
the poor. The book reviews the basis for and nature of microfinance innovation,
describing, for example, how group lending works in microfinance and how
microfinance continues to innovate toward reducing both lending and loan
default costs. The book discusses innovations in microsavings and microin-
surance and emphasizes the fact that having access to savings and insurance
matters even more to the poor than having access to microcredit.
The book considers the second theme of microfinance, that is, its devel-
opment agenda, as being more significant than its role as a branch of finance.
Microfinance emerges as a tool to reach the poor, especially women, who are
not reached by formal institutions. Microfinance is expected to alleviate credit
constraints, increase efficiency in production and consumption, and reduce
poverty. It is seen as a tool that mobilizes untapped savings and offers insurance
against income and consumption risks. Attaining higher efficiency, managing
risk, and reducing vulnerability are important goals of its development agenda.
The book then cross-examines the impact literature to determine whether
microfinance meets the development role in reaching and empowering the poor
and women, enhancing income and productivity, and reducing poverty in the
process. There are identification problems in estimating the impact of micro-
finance on household and intrahousehold outcomes. The authors conclude that
the available studies do not support the view that microfinance has accrued
substantial gains for its beneficiaries. That is, however, different from the findings
of the studies of Grameen Bank and other programs from Bangladesh sponsored
by the World Bank. These studies clearly demonstrate that microfinance is a
powerful tool in reducing poverty, empowering women, and promoting other
facets of development. Yet, the authors opine that existing studies have not
achieved a wide consensus on microfinance’s reliability, and they conclude that
more robust methods must be used to demonstrate whether microfinance really
helps the poor. Note, however, that no method of imperfect evaluation is perfect
and robust and that findings are sensitive to the method used to evaluate any
program. Given this, it is not clear what the authors are advocating here.
Microfinance has another hurdle besides proving its effectiveness in development.
Subsidy independence is a challenge for microfinance, indicating its limitations
and lack of sustainability. Although there are good reasons for using public
funds to develop microfinance, there is evidence suggesting that subsidized funds
are neither necessary nor sufficient for microfinance development. Fragmented
credit markets require innovation and diversification. The innovative design is
complicated and costly. Microfinance seems a pseudo public good that should
not be priced at the full cost of its development and charged back to the ultimate

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486 economic development and cultur al change

beneficiaries because of its greater motivation for poverty reduction. Consider-

ations such as the poverty reduction goal of microfinance may justify donor
funding. The counterview is that soft funds make microfinance vulnerable to
subsidy dependency.
The dilemma is how to attain cost efficiency in order to make microfinance
subsidy independent. The book draws on the experiences of some well-known
programs that were developed with subsidized funds and then later became
almost subsidy free when they reached a critical level of operation. It also
draws on experiences from other settings where microfinance started without
any subsidy and managed to optimize outreach and profitability.
Yet, for many programs, attaining cost efficiency is daunting given the high
transaction costs of banking for the poor. The task is even more challenging
when microfinance assumes the development challenge of poverty reduction. For
example, charging high rates of interest is one way to attain cost efficiency and
thus self-sustainability. But this option is counterproductive when microfinance
is expected to reduce poverty. The interest rate is seen as a screening device to
differentiate good borrowers from bad borrowers. So high interest rates may only
end up with high loan default rates. In addition, using high lending rates to
cover the cost of sustainability ignores the fact that projects supported by mi-
crofinance may not generate enough returns to meet the costs of loans as well
as the goal of poverty reduction. The project returns depend on the ability of
borrowers as well as on the growth potential of activities financed under mi-
crofinance. Poverty reduction may require borrowers to engage in higher-return
activities than those that microfinance usually supports. Indeed, poverty reduc-
tion requires, in addition to finance, investments in infrastructure, market op-
portunities, skills of entrepreneurs, and promotion of growth-oriented activities.
Microfinance organizations can hardly afford big investments, and consequently
they may not be able to meet both goals without complementary public invest-
ments.
The experience of microfinance innovations matters, but there is no hard
and fast rule that what works in one environment will work in other envi-
ronments. Each organization is unique in approach and product design. There
are important lessons to be learned from each experience. Microfinance in-
novation is for development, but all innovations are not cost effective. The
proponents may be too simplistic in their overly optimistic views of micro-
finance. The critics may also be too naive in their overly pessimistic views of
microfinance. That is, the donor-driven microfinance movement may not be
a waste. Indications of microfinance schisms are apparent in the book.
The reality is perhaps somewhere in the middle. We should give credit to
microfinance where it is due. Microfinance has managed to carve out a market

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 Book Reviews 487

niche, through innovation, where no other institutions have been successful in

reaching its clients. It has managed to deliver credit and other financial services
to the poor, especially women. These are credible achievements of microfinance.
Indeed, the lack of conclusive and substantive impacts does not mean that
programs do not matter. Moreover, the presence of subsidy dependence in some
microfinance organizations does not mean that microfinance is not worth sup-
porting. Programs may be cost efficient and yet subsidy dependent at the same
time, because reaching a target group like microfinance’s requires costly inno-
vation and adaptation. More important, accrued benefits of microfinance may
never be properly evaluated. Despite complications in estimating true program
effects, a few studies show that programs are cost effective. The microfinance
programs deserve public support, perhaps especially for its early development.
The Economics of Microfinance has not given enough coverage to the demand
aspect of microfinance. The institutional design determines, to a large extent,
the supply side, including price and cost. Without due emphasis on the demand
side, it is difficult to ascertain what microfinance can accomplish through the
stated mission objectives of an institution. For example, without a proper
identification of the demand, it is difficult to differentiate the poverty reduction
objective from the objective of sustainable microfinance development. In many
places, microfinance development starts with the premise of how to serve a
market niche at a price that is acceptable to both clients and providers. This
is a banking concept based on cost efficiency. Some programs that are designed
based on this concept rarely combine efficiency with equity. Bank of Agriculture
and Agricultural Cooperative of Thailand and Bank Rakayat Indonesia are
examples of this paradigm.
Other programs, including the Grameen Bank, combine equity with effi-
ciency by relying on subsidized resources at the outset to keep interest rates
low in an effort to reach and help the poor, especially women. The Bolivian
experience on the other hand shows how programs can be designed at market
prices. The price of credit is relatively higher in an individual-based lending
system than a group-based system. Therefore, a delivery mechanism does not
determine whether borrowers would benefit or who among the borrowers would
benefit from microfinance. These are demand-side issues separate from the cost
efficiency of microfinance.
The microfinance paradigm shifts when microfinance combines social ob-
jectives with financial objectives. Whether it can meet such social objectives
as poverty reduction depends on innovations on the demand side. The demand
side does not receive much attention in this book. Practitioners need to know
not only with what services and at what costs they can provide microfinance
but also, more importantly, whose demand they are addressing and who are

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488 economic development and cultur al change

the real winners of their movement. Meeting outreach objectives such as reach-
ing the poor does not mean having achieved poverty reduction. Furthermore,
achieving institutional cost efficiency does not mean having developed an
institution that addresses concerns of both equity and efficiency. In other words,
a careful examination of the structure of demand for microfinance is critical
for evaluating whether microfinance can help reduce poverty. In many cases,
poverty reduction is an added objective that may or may not be satisfied with
microfinance. If poverty reduction were a concern to begin with, then the
development pattern of an institution such as microfinance would have been
different. The Bangladesh Rural Advancement Committee program is a case
in point.
In general, microfinance is intended to reach the poor and the disadvantaged.
Even with good intentions, many microfinance programs exclude the “very”
poor. Whether this exclusion is by design or choice is an open question. A
proper analysis of demand dynamics should be a central focus of the economics
of microfinance. It is necessary to determine the barriers of entry to microfinance
by the very poor and to find out the limitations of microfinance as a means
for reducing poverty. Product development must be seen in terms of the needs
of borrowers. That is to say, clients are not homogeneous and programs cannot
have only a single product. Microfinance must have a well-structured design
that accords with the heterogeneity of clients. The question of which product
is more appropriate for which customers and when must be answered using
a proper dynamic analysis of demand. A key message is that poverty reduction
and microfinance development may not always be combined: microfinance
development may proceed without the objective of poverty reduction. Micro-
finance has a market niche to provide opportunities to the millions who are
not reached by formal institutions. If microfinance can alleviate poverty in the
process, even in small ways, then this will be a win-win initiative.
The book’s remarks about the role of groups in microfinance are not well
placed. Group-based lending is an innovation created to handle the infor-
mational conundrum of imperfect credit markets. Theory predicts that, under
certain circumstances, group lending is better than individual lending. Group
lending also provides a role for social capital. At the same time, it may create
a group collusion that hampers repayment. The benefits of group lending may
not outweigh its cost. It is not known a priori when benefits outweigh the
costs of group practices. The evidence regarding group lending so far is mixed,
and empirical studies lag behind the theory of group lending. The fact that
extant research shows either no positive effects or counterintuitive effects of
group lending does not mean that group lending does not work. Perhaps the
problem lies more with the limitations of the methods that are used to verify

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 Book Reviews 489

the validity of the hypothesis. Using cross-sectional data on group lending or

a comparison between group and individual lending across programs or even
a comparison of programs that provide both types of lending without a ran-
domized treatment is likely to yield biased estimates. The limitation of many
studies is that they have failed to control for why certain individuals select a
certain system. The book’s assertion that an alternative institutional framework
may do better in providing microfinance than group lending is speculative at
best.
The book has not focused on the dynamics of microfinance institution. First,
the institutional development of microfinance must be responsive to the needs
of its clients. However, many innovations of microfinance may not be as
responsive to the demand of clients as to the need for attaining cost efficiency.
The book provides a good account of innovations undertaken by some fine
institutions around the world. Yet it has failed to articulate how much of
microfinance innovation (e.g., the introduction of a more flexible Grameen II
model) has been due to the needs for attaining cost efficiency and how much
has been in response to the changing market demand of clients. This differ-
entiation is necessary for determining the potential role of microfinance as a
tool for development.
Second, the book lacks discussion of market dynamics in the process of
microfinance evolution. For example, new entrants are creating competition
in the limited but fragmented credit markets where microfinance has already
been running for some years. That is to say, there are market saturation issues
regarding microfinance. More important, financial services, such as remittance
transfers, are gaining currency in microfinance innovation in some countries.
Finally, the Economics of Microfinance also lacks a coherent approach regarding
the institutional framework that governs the parameters of a successful mi-
crofinance institution. Although the book covers some issues of microfinance
beyond group lending, it misses some notable ones, for example, leadership,
management hierarchy, accountability, and transparencies, all of which are
critical ingredients of a successful microfinance organization. Many argue that
Grameen’s success lies not in its group system but in its leadership, which is
committed to its success. Such topics are not discussed in this book. Another
aspect that is missing from the book is the supervision and regulation of the
microfinance organization. In many emerging markets, a major policy concern
is how to regulate microfinance organizations and help them mobilize resources
from markets without resorting to donor funds.
Aside from the book’s limitations, the authors have done a great job in
covering the theory, practice, development, and sustainability of microfinance

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490 economic development and cultur al change

programs. I have enjoyed reading the book, and I recommend it to policy

makers, practitioners, researchers, and students of development economics.

Kym Anderson and Will Martin, eds. Agricultural Trade Reform and the Doha
Development Agenda. New York: Palgrave Macmillan for the World Bank, 2006.
Pp. xvii⫹420. $90.00 (cloth); $35.00 (paper).

bruce gardner
University of Maryland

In the multilateral trade negotiations of recent decades, agriculture has played

a role out of proportion to its economic importance. It has been a frustrating
role in that the reluctance of agricultural interests to give up protections against
import competition has been a serious obstacle to agreement. This book reports
a thorough and multifaceted effort to estimate the consequences of trade lib-
eralization as contemplated in the “Doha Round” of World Trade Organization
(WTO) negotiations.
The book differentiates itself from the existing literature on the subject by
employing a large-scale multi-country general equilibrium model to estimate
effects, both in agriculture and other sectors, of a reform framework agreed
upon in July 2004 in the Doha Round. This involves reductions in members’
legally bound tariffs, export subsidies, and domestic support to farmers.
Ten chapters on specific aspects of liberalization by 21 individuals, singly
and in teams of experts on their topics, are followed by a detailed presentation
of findings and implications. The chapters include analyses of alternative for-
mulas for tariff cuts, loss of developing countries’ tariff preferences that cur-
rently exist, special and differential treatment of developing countries under
new arrangements, eliminating agricultural export subsidies, reducing do-
mestic commodity support, and several subtopics within these. Particular at-
tention is given to domestic support, with four chapters covering (1) issues
in what is achievable within the system of “boxes” that classify policies by
the extent to which they distort markets, (2) country-by-country estimates of
effects of support reduction, (3) the particularly contentious case of U.S. cotton
subsidies, and (4) possibilities for compensating currently protected industries
for losses under liberalization.
Two key methodological features of the book are its quantitative approach
and its prospective or ex ante method of analysis. A quantitative approach is
standard in economic analysis of trade policy today, but it is worth recalling

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