The Missing Parts of Microfinance: Services for Consumption and Insurance

In many developing countries the informal economy is the most dynamic sector. In Latin America, eighty-four out of every 100 new jobs in the 1990s and 54 percent of all employment opportunities were derived from the informal sector. In Africa and Asia, the informal economy has become equally important because formal economy opportunities have shrunk.

In an effort to support this sector, development actors have engaged in microfinance initiatives, whereby small and micro-entrepreneurs have been provided with productive credit to create or expand their businesses. These programs have grown in popularity as a result of their reported success in increasing entrepreneurial income and expanding the number of informal sector businesses.

This paper examines the microfinance revolution and its impact. It looks at the characteristics of informal sector businesses and the way in which microfinance was designed to meet business needs. After examining the reported successes of microfinance, the paper shows that, because informal household and business activities are intermixed, microfinance's emphasis on productive credit for businesses only partially meets entrepreneurs' needs for financial services. As a result, the impact of microfinance initiatives is reduced. Finally, the paper suggests ways in which microfinance can improve its services to better support the informal sector and to meet the economic and poverty-alleviation goals forwarded by its proponents.

Characteristics of the Informal Sector

The informal sector in most developing countries includes a vibrant array of business types and products that defy easy classification or generalization. Low barriers to entry allow businesses to range between the service, production, and commerce sectors. These businesses include such diverse activities as animal husbandry, hair styling, and furniture making. Some entrepreneurs engage in informal activities to supplement their income from a formal sector job, whereas others derive the majority of their income from their informal businesses. In terms of regulation, informal activities work in a continuum between legal and illegal. Some activities conform to most parts of the law, while others avoid almost all legal requirements. This informality extends to informal businesses' labor composition, which includes such diverse arrangements as unpaid family labor, occasional employees working under unwritten agreements, and full-time workers employed under some type of formal contract. Finally, while a large minority of informal sector actors is from poor or vulnerable families, many can be classified as non-poor.

However, substantial similarities lie underneath these surface differences. Most important, informal businesses operate in an economic environment with high levels of insecurity and risk. Since they are informal, entrepreneurs cannot take advantage of protections offered to formal businesses, including contract enforcement, bankruptcy laws, or unemployment insurance. Informal entrepreneurs are also vulnerable to economic shocks as a result of the limited size of their market or of household-specific factors such as illness (which can breing an informal enerprise to a standstill since the microentrepreneur is often the sole laborer). These factors influence entrepreneurs' decision-making and business needs.

Informal businesses also share two common failings: small size and low productivity. The insecurity of their operating environment, combined with low education and/or managerial skills, discourages many activities that allow businesses to grow and become more efficient. For example, the insecure future of any one business activity encourages diversification rather than specialization so that families can be assured of an income. Also, the semi-legal status of most informal businesses discourages the types of investment and growth that would otherwise elicit government supervision. Finally, low education levels hinder entrepreneurs from taking advantage of new technologies. The result of these factors is a preponderance of informal sector entrepreneurs that utilize cheap and unsophisticated technologies, rarely employ modern inputs, and rely on labor rather than capital-intensive production. These characteristics in turn lead to small businesses with low productivity levels and reduced returns to entrepreneurs' activities, thus inhibiting the growth of the sector and placing caps on entrepreneurs' income levels.

Finally, appropriate financial services, which could be used to...