Thursday, May 08, 2008

Microfinance and the Food Crisis

Microfinance institutions around the world – the tiny banks that make micro-loans to the developing world’s working poor – face a significant challenge in even the best current global economic scenario. A political tide threatens them that could reverse much of the progress against poverty they have made over the past decade.

The reason is that the twin crises of world food price inflation and the US sub-prime mortgage meltdown may be linked at the hip. And as a result, the developing world’s working poor could well channel their anger toward some of the new links with global capital markets that seemed so beneficial to them until now.

Not only would microfinance institutions be the primary victims of an angry reaction against a financial system that is now delivering unaffordable grain bills alongside credit. In many cases, they are also the only institutions positioned to help productive people avoid calamity as food prices wreck their budgets.

Before looking at the immediate steps these institutions should take, consider why the two crises may be related and why this poses such a threat to microfinance in even the best imaginable scenario.

Twin crises

What joins the two crises at the hip is the possibility – already under discussion in some of the earliest post-mortem analyses – that a general inclination in the US to tolerate inflationary policies after the dot-com bubble burst just shifted that bubble to the housing sector. And the further pursuit of inflationary policies in the US to stave off a countrywide recession in an election year following the bursting of the housing bubble may have broken the few remaining bonds restraining commodity prices in the world’s reserve currency – the US dollar.

In other words, the prices of local bread around the world – whether of a tortilla in Mexico, injera in Ethiopia, or naan in India – may all partially reflect policies pursued by the US government mainly to deal with its own domestic economic and political problems. If people around the world determine this is true, they will attack the financial links that subject them to the vagaries of the US political economy.

Given these risks, a recognition by the US and many developing countries just how intertwined their fates have become would not be a bad thing. Such a realization could drive governments to harmonize their policies – and avoid the worst effects of the twin crises. And yet even this, the best-case, scenario poses risks to microfinance.

Best-case scenario

A best-case scenario for the global economy looks something like this. The US would dismantle the subsidies that have diverted grain from food to ethanol production. It would also balance its national budget to reverse the inflationary thrust of recent deficits.

Many developing countries would respond by letting their currencies rise – at least temporarily – against the dollar. Doing so would break the link that transmits US inflation to their markets. As their currencies rise, they would be able to dismantle barriers they have erected to agricultural trade that are starving people.

Such a rosy scenario, if it came to pass, would be a significant step toward solving deep problems for developing countries. A tide of US grain would reduce food prices – despite Australian drought and the rise in the cost of petroleum-based fertilizers. And it would be even more cost-effective in currencies rising against the dollar. As a result, many developing countries would be able to provide restored levels of staples without export barriers that have infuriated and alienated their farmers at a time when they most need them.

This scenario also starts to solve deep problems for the US The resulting export earnings could start to reverse foreign indebtedness that has shaken global confidence in the US economy. And that would lay a basis for an eventual restoration of dollar exchange rates before inflation becomes endemic and baby boomers retire.

Yet despite all of these positive effects, the scenario poses risks for microfinance. What microfinance institutions must do to manage this best-case scenario may therefore represent the minimum contribution they have to make to deal with global threats.

The microfinance contribution

Even the best-case scenario fails to address one challenge to microfinance – and gives rise to another. First, it cannot address the pain of individual microfinance borrowers hit hardest by the food crisis.

People who work 12 hours a day have seen 40% price rises in food that used to consume 35% of their budget. So instead of having two thirds of their income for everything else, they are down to half.

Second, it involves increased foreign exchange volatility with an initial further drop in the value of the US dollar before a longer-term rise. This matters strongly in a sector where stability in the exchange rate of the dollar has let growing institutions focus on credit risk and liquidity more than currency risk. They must prepare for a foreign exchange environment more like 1998 than the quieter years since then.

The immediate imperative for microfinance institutions is to find creative ways to balance the health of food producers in their portfolios against the distress of food consumers. Institutions that can vary the rates on their loans to these sectors should do so.

And all microfinance institutions – even those in dollarized economies – need to improve their management of foreign exchange risks. They must not take dollar stability for granted when even the best-case scenario implies greater volatility.

The fortunate thing is that many microfinance institutions have the dexterity to adjust the rates on their loans to different borrowing segments and the skill to manage volatile exchange rates.

We must not delude ourselves into thinking they can mitigate the effects of the gathering inflation on their own, however. They will need help from policymakers in developing countries and the US to avoid having to manage a scenario less benign than the best case sketched here.

David Apgar is the author of Relevance: Hitting Your Goals by Knowing What Matters (Jossey-Bass, 2008)

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