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From Informal Economy to Micro-Enterprise: The Role of Microcredit

Address to Results/Résultats Canada Convention
by Hon. David Kilgour, Secretary of State (Latin America & Africa)
Cartier Place & Tower Suite Hotel, Ottawa
October 24, 1998

The informal economy has always existed around the world, but its importance as a safety net for the poorest has grown dramatically in the past decade or so. How can nations harness their marginalized informal sector and tap into the enterprising spirit of the individuals behind it? How can the day-to-day existence of millions of very poor entrepreneurs develop into sustainable micro-enterprises? One major difference between the informal economy and successful micro-enterprise obviously is access to credit.

Walk through the congested downtown of any major city in the so-called developing world – Mexico City, Maputo, Lima or Accra – and you will see thousands of people of all ages selling everything from tropical birds to tacos, and from used clothing to scrap metal. Fire eaters, musicians, and prostitutes eke out a living through activities that may be unregulated, semi-legal, or completely criminal. Traffic jams in Canadian cities today attract "squeegee kids," an entrepreneurial innovation that began in informal economies of the developing world.

The growth of informal economies can be attributed to the heavy migration of rural people to cities. At the same time, economic restructuring in much of the world has resulted in dislocations. The ability of the formal economy to absorb new workers is limited: the informal economy has acted as a giant safety valve, preventing even greater hardship and social explosion.

Mixed Blessing

The informal economy is testament to the entrepreneurial abilities of the world’s poorest citizens. It is a mixed blessing though. While it absorbs millions who have no way of participating in the formal economy, it is by nature precarious. Critics point to urban congestion from unregulated downtown street stalls and to health hazards from food prepared in unsanitary conditions. The line between the informal economy and urban crime is often blurred – street vendors often sell stolen goods, unlicensed taxi drivers sometimes sell drugs, act as pimps on the side, or even rob their passengers.

One of the challenges of poverty alleviation is how to encourage the entrepreneurial spirit in the informal economy, but at the same time to formalize it enough that some of its more negative elements are reduced. The missing ingredient in many of these precarious enterprises is access to reliable and affordable sources of credit. One solution, recognized by many of us here today, is microcredit.

Access to Credit

Access to credit is often what entrepreneurs need to transform their tiny enterprises into viable occupations. Other factors include skills, access to markets, and the overcoming of obstacles associated with the lifestyle of poverty. Not all informal activities lend themselves to legitimate entrepreneurial success, but the challenge of bringing credit to the poorest of the poor as a means of alleviating poverty is the reason we are here today.

International poverty alleviation is an essential goal of a proactive foreign policy. When people are making a decent living, they are less likely to make crime or war. Poverty and dependence are prime sources of social instability; self-reliant neighbours are more likely to become friendly trading partners. It is in Canada’s own major interest to support innovative international development approaches that work.

Before looking at microcredit as a key part of the solution, I would like to reflect a bit further on the nature of the informal economy. Several tendencies occur:

• A large proportion of those involved in the informal economy are women and children, reflecting their impoverishment and frequent exclusion from the formal economy.

• By nature, the informal economy is mostly unregulated and untaxed. This accounts for its dynamism, but also limits its ability to contribute to the formal economy.

• Most significantly, it is growing.

Measuring the Informal Economy

How big is the informal economy? By definition, it escapes official statistics and is impossible to measure accurately. In Africa, it has been estimated that the informal economy involves 60 to 70 per cent of the labour force, and produces almost a quarter of output. The International Labour Organization estimated during the 1980s that the informal sector absorbed fully three quarters of new entrants into the African labour force. Since then, this has evidently increased.

At the beginning of the 1990s, the informal sector was estimated to contribute between 25 and 40 per cent of Mexico’s GDP, and it provided work for about a quarter of the economically active population. Since the peso crisis of 1994-95, the informal sector swelled dramatically, up by 13 per cent during the one-year period of the crisis alone, based even on conservative estimates.

In Lima, "informals" represent 60 per cent of the economy according to Hernando de Soto. His 1989 ground-breaking book, The Other Path, argues that the black market developed in response to excessive government regulation. In a rave review of that book in The Economist, the then president of the Inter-American Development Bank was quoted as saying he wanted to establish his institution "as the bank for Latin America’s informal sector."

Conventional credit arrangements do not lend themselves to micro-entrepreneurship. Lenders are reluctant to lend to the poorest of the poor because such borrowers lack collateral. Also administrative costs of such loans, which usually involve small sums, are seen as making them less profitable than larger loans to fewer secured borrowers.

Microcredit

As an alternative to conventional lending practices, microcredit has been around long enough and provided enough success stories to dispel such misconceptions. Given an opportunity, many of the world’s poorest people have the drive and street smarts to break out of the vicious cycle of poverty. The dynamism of the informal sector is testimony to this. Repayment rates are often much higher among microcredit borrowers than conventional small business loans. This reality has enormous implications for a wider solution to the global war against poverty.

This is not to suggest that every poor person is a potential entrepreneur or that microcredit is a panacea able to alleviate poverty everywhere and in all circumstances. A large informal sector will always exist, and indeed is an important factor even in our so-called developed countries. The diversity of cultures, circumstances and of individuals makes the situation complex. It also presents our biggest challenge: how to replicate and adapt successful experiences with microcredit to vastly different cultural and social circumstances.

The success of the Grameen Bank of Bangladesh is well known. It has loaned money to some of the most needy of the world’s poor and experienced repayment rates as high as 98 per cent. Many of us have also followed with interest the BancoSol in Bolivia, which began as an NGO, but was so successful it became a commercial bank. Not only have such experiments provided seed money for numerous small enterprises, but they have also provided a savings vehicle, enabling these banks to move towards self sufficiency.

Personal Observations

I’ve visited a number of successful microcredit projects in Africa, Latin America and the Caribbean. They come in many different forms – some are rural and others urban. They are large and small, and some are more formal than others. Education levels among participants vary greatly, as do levels of poverty. A common element is that the most successful micro-entrepreneurs tend to be women, but men are also successful.

The most successful projects are ones where participants feel a sense of ownership in what they have accomplished, both in the individual micro-enterprises they create and the microcredit lending system itself. In the world of microcredit, top-down structures simply don’t work. To throw money at a problem from outside risks repeating the same mistakes that have perpetuated aid dependency for many years.

Donors’ Role

This raises a dilemma for international donors, both public and private, who are often required to provide funding in initial stages. These organizations need to be accountable and show that funds have been wisely invested. Too much micro-management by outsiders, however, usually means that the beneficiaries lose the sense of ownership that is so essential for the success of these programs. That is why many Canada-assisted programs, the Peru-Canada Fund for example, attempt to operate at arms’ length and use local people as much as possible.

How do we measure success? There are concrete criteria – repayment rates, growth rates of individual enterprises, etc. – but they don’t tell the whole story. More subjective, but equally important, is the extent to which microcredit empowers participants. As families learn business and money-management skills from their experience, they take these skills with them in life. The poor, especially women, often suffer from a sense of helplessness and lack of self esteem. Through peer support and by experiencing small successes, they gain the confidence to achieve even greater goals. Financial success in micro-enterprises not only provides the means to repay loans, but can, in time, provide working capital to continue and expand a business.

Hon. Diane Marleau

Many of you earlier today heard my colleague Diane Marleau, Minister for International Cooperation, La Francophonie, and the minister responsible for CIDA. She has pointed out on other occasions that CIDA is committed to promoting micro-finance and micro-enterprise in more than 42 developing countries and countries in transition. By next year, CIDA will be involved in another eight countries – six of them in the African and Caribbean regions. This involvement, totalling more than $100 million, represents a strong Canadian commitment to micro-finance and micro-enterprise.

Conclusion

International poverty alleviation is in Canada’s interest, and through CIDA and other institutions, including many non-governmental organizations, Canadians are active in solutions that work. The dramatic growth of the informal sector in many developing countries in recent decades suggests there is no shortage of entrepreneurial ability. Our challenge is to find ways to use innovative tools such as microcredit to channel the entrepreneurial impulse of the informal economy into sustainable micro-enterprises, contributing to long-term development solutions.

Thank you.