THE ROLE OF CREDIT IN ENHANCING POVERTY LEVELS AMONG LOW INCOME EARNERS IN UGANDA:

Background of credit in Uganda:

As early as the pre-colonial times, the colonial masters undertook investment with a few selected Asian families that had settled in Uganda to conduct trade. Besides Asians born in Uganda, there was hardly any participation of indigenous entrepreneurs in investment related activities unless if they were chiefs or kings. The arrival of independence and all its promises of a better economy did little to reverse the situation. Rather than allow and promote more indigenous entrepreneurs to engage in investment related activities, the government of the time maintained the status quo. The only difference was that it took up a share of the investment opportunities that were created with the departure of the British colonialist. Subsequently all major investments remained owned by the British through their holding company CDC and the government (Obwona and Egesa 2004). Indigenous entrepreneurs were left to run small businesses engaged in mostly retail trade.

Agitation for more engagement of indigenous entrepreneurs in investment picked up momentum following the fall of the first government of Uganda, which was overthrown by the then head of the military, Idi Amin through a military coup. The situation was worsened by the declining relationship between Government and some of Uganda’s neighbors where previous political leaders had turned to for exile. The poorly managed economy was further constrained by the expulsion of all Asians from Uganda.

Micro finance is a key policy strategy for poverty alleviation. Inadequate access to credit by the poor has been identified as one of the contributing factors to poverty. To redress the issue, the policy of increasing access to both production and consumption credit by the poor has been articulated. For sustainable poverty alleviation, the policy also emphasizes the sustainability of the micro finance institutions (MFIs) that deliver services to the poor. It is for this reason that the government credit programmes are to be wound up and all recovered funds from such schemes will be channeled to sustainable MFIs.

A number of stakeholders such as (UNDP, USAID, EU) have been working to develop the micro finance sector either through provision of technical support and capacity building, or through provision of funds for on-lending to the clients. Credit is considered to be an essential input to increase agricultural productivity, mainly land and labour. It is believed that credit boosts income levels, increases employment at the household level and thereby alleviates poverty. Credit enables poor people to overcome their liquidity constraints and undertake some investment, especially in improved farm technology and inputs, thereby leading to increased agricultural production (Adunga and Hiedues, 2000).

Furthermore, credit helps the poor to smooth out their consumption patterns during the lean periods of the year (Binswanger and Khandker, 1995). By so doing, credit maintains the productive capacity of poor rural households (Heildues, 1995). World Bank (1989) also observed that improved consumption is an investment in the productivity of the labor force.

Navajas et al (2000) argue that the professed goal of micro credit is to improve the welfare of the poor as a result of better access to small loans. Diagne and Zeller 2001) argue that lack of adequate access to credit for the poor may have negative consequences for various household level outcomes including technology adoption, agricultural productivity, food security, nutrition health and overall welfare.

The effect of credit on firm survival can be positive or negative depending on its use and cost. Access to credit may prolong survival if it is used to increase start-up size at entry as established in Geroski et al. (2007) and Audretsch and Mahmood (1995). Access to credit may also be important for firms facing temporary cash flow problems, which could precipitate failure. McPherson (1995) found such a positive effect of credit on firm survival for firms in Malawi. However, credit use may increase the failure risk of firms if it is too costly. Nkurunziza (2005) found that Kenyan manufacturing firms that used loans had a higher hazard rate compared to firms that did not use loans in the 1990’s.

Credit programmes in Uganda can be traced as far back as the early 1960s when two credit schemes namely the cooperatives credit scheme (CCS) in 1961 and the progressive farmers loan scheme (PFLS) in 1964 respectively with a focus of transforming farmers from subsistence to commercial practitioners and as a strategy to reduce poverty. Another state directed credit programme, the rural farmer’s scheme (RFS) was launched under the support of the Uganda commercial bank (UCB) in April 1988 also with similar objectives as the two credit programmes already mentioned above. All the above three credit programmes failed and were suspended due to high default rates and their failure was attributed to reasons ranging from incorrect mechanisms used to choose credit beneficiaries, cumbersome appraisal procedures which resulted in delayed disbursement, lack of sufficient staff to monitor the credit, the absence of readily available market for farmers’ produce. Other reasons for the failure of these credit programmes were top-down deficiencies such as bureaucracies, questionable integrity of loan officers, poor disbursement policy (in-kind), high transaction costs, lack of security for the loans and political interference (Muhumuza ,2007).

Client-Bank relationship and Interest rate

It has been well documented that the relationship between the bank and its client is an important aspect of obtaining favorable credit terms. The finding of more favorable rates provided by firms with stronger relationships reinforces the significant attention that banking institutions have accorded to relationship banking of recent. Moreover, relationship banking has never been important than during this error of economic slowdown partly blamed on weak client-bank relationships. According to Arano and Emily (2008), the greater the duration and scope of the relationship between the borrower and the lending institution, the more ‘soft’ information becomes available, and the more efficient the pricing of the loan due to a reduction in the asymmetric information problem which aggregates to lower credit risk and hence lower bank

spreads. Degryse and Cayseele (2000) using ordinary least squares regression on a sample small business loans in Belgium found spreads decrease with the scope of the relationship. Further, this argument is reinforced by the findings from studies carried out by Diamond (1984), Ramakrishnan and Thakor (1984), Fama (1985), Sharpe (1990), Diamond (1991) and Boot (2000) who postulate that the greater the duration and scope of the relationship between the client and the financial institution, with this relationship providing both public and the more important private information, the more information becomes available, and the more efficient the pricing of the loans and deposits due to a reduction in the asymmetric information problem and hence lower spreads

The Credit Reference BureauUganda currently ranks at 48 out of 183 Economies for this indicator. The following reforms have been undertaken to improve the access to credit in Uganda. The phenomenon of credit rationing and its consequences for the investment decision is undoubtedly one of the topical issues in Uganda .Premised on demand and supply surveys on credit allocation and using investment equation , credit investment ratio ,evidence shows that small firms are rationed in their access to credit .Small firms and firms in agricultural sector find it most difficult to get loans from financial institutions because agency ,information, enforcement and transactions costs are higher.

Ugandan owned firms appear less likely to obtain credit than firms owned by foreign owned .This is partly due to the fact that most banks are foreign and there is an element of trust and social interaction that supplement physical collateral and therefore play a central role in the credit market. However, credit rationing weak financial sector weaken this transmission mechanism.

Faced with increasing economic difficulties and also influenced by the world wide trend towards financial liberalization and deregulation, the government since 1987 embarked on a wide ranging structural reform programs that included a liberalization of financial systems .Financial liberalization policy prescriptions draws extensively on the financial repression theory of McKinnon (1973) and Shaw (1973) for its intellectual support .This is expected to increase savings from which the private sector is expected to benefit through increased access to credit .However, banking institutions still give priority rates and low charges to their established prime hence denying new borrowers access to credit.

It is worth noting that with the restructuring of the economy and the drive towards greater private –sector –led growth, the demand on the financial sector to meet the needs of small-scale enterprises, which are increasingly recognized as the key to development has become great. If the formal financial sector limits access to credit by small and micro-enterprises, then their demands have to be met through alternative means, particulary internal funds ( Chen and Reinikka,1998)

Much as there has been very much scanty formal studies on the demand for credit in Uganda ( e.g ,Matovu and Okumu, 1996) there is wide belief that resources are not adequate to meet formal and incipient demand for credit.

The Micro Deposit taking Institutions Act, 2003 and the Financial Institutions Act, 2004 mandate the Bank of Uganda to establish a Credit Reference Bureau (CRB). CRB Regulations were gazetted in 2005 and the first private CRB commenced operation in Uganda in 2008. This system initially required Ugandan financial institutions to issue smart cards to their borrowers as part of a borrower identification program. To date, there are 23 Commercial Banks, three credit institutions and four Micro deposit Taking institutions (MDI) on the Bureau. Since it is now mandatory to have a CRB inquiry done by the financial institution from which a loan application is made, credit reports are retrieved using an online Bureau interference and application information is available in real time. Acceptance of data on the Bureau increased from 0.2% in December 2008 to 91% in August 2011.

There are over 1,340 Microfinance institutions (MFIs) in Uganda three of which have so far been licensed under the Micro Finance Deposit Taking Institutions Act (MDI), 2003. There are a number of programmes/projects providing support from Government and other Development Partners such as GoU/ IFAD/EU-funded Microfinance Outreach Plan (MOP), and Microfinance Support Centre Ltd (MSCL) funded by African Development Bank (ADB). These programmes provide loans and matching grants to MFIs for expansion of financial services.

Poverty is still a problem in Uganda and according to the Millennium Development Goals facts, 31 percent of Ugandans are still living below the poverty line. In the past the Government of Uganda has brought some programmes to address this poverty like the Entandikwa Credit Scheme but which did not address the problem as many people still remained poor (Micro support centre, 2007). Recently in 2006 under prosperity for all program, the government started an idea of having a Savings and Credit Cooperative Organization (SACCO) at every Sub County so as to promote rural Micro credit enterprises which encourages savings, investment and development. However much the government has tried these initiatives, it is reported that 70 percent of rural people have no access to financial services because of some problems like, lack of collateral security, inadequate information about financial services and fear to lose their property after failing to pay back the loans among others (AMFIU, 2010). Therefore, there was a need for the researcher to find out the extent to which savings and Credit Schemes are contributing to rural financial accessibility and development.

In general savings and credit schemes have contributed much towards rural development and rural financial accessibility. This study presents what other researchers and writers have written about how small savings and Credit schemes have contributed to rural, financial accessibility, development and the relationship between credit schemes, financial accessibility and investment.

A Savings scheme is a programme designed to encourage savings through small but regular deposits or automatic deduction from salaries or wages. Savings and credit scheme aims at poverty alleviation to poor and law income families

Savings and credit schemes are becoming a beacon of hope to the developing countries. These institutions grant loans to members at reasonable rates of interest in times of need. The lent money helps entrepreneurs in impoverished societies to start essential businesses in their

communities (Guilford, 2007). According to Guilford (2007) credit facilities enable impoverished persons to start businesses, rebuild after natural disasters like floods and hurricanes, and to receive both short- and long-term loans to meet their financial needs and improve their overall quality of life. The impact of micro lending is changing the economic landscape of the areas where it is most prevalent

According to Stiglitz and Weiss (1981) interest rates charged by a credit institution are seen as having a dual role of sorting potential borrowers (leading to adverse selection), and affecting the actions of borrowers (leading to the incentive effect). Interest rates thus affect the nature of the transaction and do not necessarily clear the market. Both effects are seen as a result of the imperfect information inherent in credit markets. Adverse selection occurs because lenders would like to identify the borrowers most likely to repay their loans since the banks’ expected returns depend on the probability of repayment. In an attempt to identify borrowers with high probability of repayment, banks are likely to use the interest rates that an individual is willing to pay as a screening device.

Again in the last 20 years, government of Uganda has initiated, implemented and supported various micro credit schemes aimed at fighting poverty in the country with a focus of creating revolving funds for micro credit to households at the grass roots. Such interventions include the South-western smallholder’s rehabilitation project, ECS and poverty alleviation action Plan (PAP). However some of these efforts have had little success and limited impact on addressing the needs of the targeted population due to design flaws, and management inadequacies (Microfinance support centre limited report, 2007 However, borrowers willing to pay high interest rates may on average be worse risks; thus as the interest rate increases, the riskiness of those who borrow also increases, reducing the bank’s profitability. The incentive effect occurs because as the interest rate and other terms of the contract change, the behavior of borrowers is likely to change since it affects the returns on their projects. Stiglitz and Weiss further show that higher interest rates induce firms to undertake projects with lower probability of success but higher payoffs when they succeed (leading to the problem of moral hazard).

Commercial banks and other formal institutions fail to cater for the credit needs of smallholders, however, mainly due to their lending terms and conditions. It is generally the rules and regulations of the formal financial institutions that have created the myth that the poor are not bankable, and since they can’t afford the required collateral, they are considered uncredit worthy (Adera, 1995). Hence despite effort in developing countries, and the expansion of credit in the rural areas of these countries, the majority still have only limited access to bank services to support their private initiatives.

Challenges of micro finance as a tool for poverty alleviation

Despite the role played by micro credit institutions in Uganda towards eradicating poverty, poverty is still at large simply because the problems are both internal and external as discussed below:-

. Targeting of the Poor

With the enactment of the MDI ACT 2003, MFIs have been compelled to re- think their strategies from quasi social economic development and humanitarian focus towards stricter commercial orientation and profit making. The MFIs have embarked on strategies to improve and stabilize their respective capital asset bases to enable them attain full financial institutional self-sustainability; towards attaining competitiveness and market share within the industry. The developments also demand that micro finance players develop standards and professional ethics to guide service delivery. To be competitive and gain market share, micro finance institutions are now more focused on the principles of profit making. The new profit orientation of the MFIs has motivated them to clearly define their market niche. While the PEAP policy document assumes that the poor who do not have access to formal financial services will be targeted by the MFIs (MFPED, 2001) 1 2 , the MFIs are targeting only a small proportion of the poor whom they have code named —the economically active poor“. The MFIs definition of the economically active poor are those that have businesses and the capacity to repay back the loans. From the poverty spectrum, the economically active poor are the richest of the poor just close to the poverty line. This has serious policy implications for the poor of the poor (the core poor).

The new focus on sustainability as demanded by the MDI Act (2003) might have the effect of motivating MFIs moving more towards the non-poor clientile who will have more capacity to repay the loans. Key informant interviews with some of the Executives of MFIs revealed a number of interesting issues. First their argument is that they are now running microfinance as a business and in business the determining factor is profits. In the microfinance business one of the key factors that influences profitability is the portfolio quality, basically because the higher the loan default the higher will be the write-off of bad loans which lowers the profits. So one of the ways of minimizing the loan default is through careful analysis of the repayment capacity of the potential clients.

From their experience of repayment capacity analysis, the MFIs have come up with a categorization of the poor into economically active poor and the core poor. The economically active poor have the repayment capacity and therefore can qualify to get credit from the MFIs, but the core poor do not have the repayment capacity and so are not eligible to get MFIs credit. To them the poorest of the poor need grants which should be taken care of by the state. One MFIs Executive said —I f you are doing bussiness and you lend to people whom you can see can not be able to pay back, are you a good or a bad business man? Who will take care of your operational losses now that grant funding is increasingly becoming a story of the past?

The other issue that came to the forefront was the return to investment to attract investors in the MFIs. The MFIs argued that they are required to be sufficiently capitalized under the new shareholding arrangement by MDI Act (2003), thus the need to attract private sector investors to the industry. Their argument is that private sector investors will mainly be motivated by the expected return on their investment, hence the importance of screening

out the core poor who will spoil the portfolio quality and profitability. It therefore follows that targeting all the poor, including the core poor who have no repayment capacity, would be a bad investment decision.

The third issue that arose was in connection with their operational policies to identify the poor. While mention of the poor is mentioned in most of MFIs mission statements as the target group, they do not have any operational parameters to identify the poor. Since the driving factor is the repayment capacity and profitability, it may not be surprising that some of the clients of the MFIs are the non-poor. What was also evident in the MFIs lending operations was the increasing level of collateralization even among the group lending methodology. Apart from the group guarantee, most MFIs require the members to pledge some form of collateral either in the form of household chattels, land. Of course the collaterals pledged by MFIs clients are not of the same quality as those required by formal banks but is still of significance to the poor. The increased collateralization is argued to give more e incentive to the borrowers to repay. The challenge therefore is that if the microfinance services are not accessible to the core poor, how will their welfare be improved? Additionally given the persuasive economic arguments of having private sector led provision of microfinance services and the distortions that are generated by grants and or subsidized government credit schemes, the core poor stand the risk of being the forgotten lot in the development process.

Access to Savings Services by the Poor The MDI Act 2003 classifies players in the micro finance industry into those to be regulated under the MDI Act (2003) and those not to be regulated under a tiered arrangement. The Act recognizes four different tiers: Tier 1 are the formal commercial banks and Tier 2 are the Financial Institutions registered under the Financial Institutions Statute of 1993. Tier 3 will constitute of Deposit-taking MFIs that will be incensed and supervised by the Central Bank. The Tier 3 MFIs will be allowed to take deposits and intermediate them. The Tier 4 MFIs will not be regulated by the Central Bank and will not be allowed to take and intermediate deposits. These will be the credit only MFIs such that even if they take compulsory savings as part of their methodology, they are not allowed to intermediate those savings. The opportunities raised by tiered classification is that all institutions in tier s 1 œ 3 are legally allowed to engage in microfinance business.

This explains why some commercial banks like Centenary Rural Development Bank (CERUDEB) is actively engaged in the microfinance sector. The other opportunity is that it allows the Tier 3 institutions to take on deposits for intermediation which is a cheaper source of capital, hence having the potential effect of raising their profitability and sustainability. However the greatest challenge raised by the MDI (2003) Act relates to the Tier 4 institutions that are non-regulated which by law may collect compulsory savings from clients but cannot intermediate them. The challenge r elates to the number of MFIs that are likely to meet the licensing requirements and qualify to be in Tier 3. Ledgerwood et al (2002) estimated that very few MFIs (less than 5) are likely to meet the licensing requirements in the short run and most of them will remain in Tier 4. This raises specific challenges relating to access of savings services and sustainability of Tier 4

institutions, all of which have policy implications for poverty alleviation. As a result of financial sector reforms (which included the divestiture of Uganda Commercial Bank), most of the non-profitable rural branches were closed thereby creating a vacuum of financial service delivery to the poor. However due to the legitimate concerns of the safety of public savings, the Tier 4 institutions will not be allowed to take deposits. But if in the short-term only very few MFIs will qualify to be in Tier 3, then the poor will not have access to savings products. It is argued in the development literature that the poor can save but all they lack is access to flexible savings products. Savings are key products of micro finance activity and both MFIs and clients value savings as important complements to the financial management, institution /client relationships and to the livelihoods of the low income population. Interest Rates The other challenge relates to the terms of credit to the poor especially interest rates. Profitability and sustainability is a key indicator of success that is used to judge whether the MFIs will qualify to move to Tier 3 or not. From the MFIs institutional side, the sustainability equation relates the revenue side and the expenditure side. The revenue side can improve by either increasing interest rates and commissions or portfolio volumes. It is probable that inefficient MFIs especially in Tier 4 which are the majority may try to improve their sustainability levels by raising the interest rates and commissions. Though it is argued in the literature that demand for credit by the poor is interest inelastic, it can be counter argued that high interest rates that are due to inefficiencies are counter productive to the poor. Currently the interest rates charged by the microfinance institutions range between 2.5% - 4% per month, before factoring in the other commission and fees which vary across MFIs. It is also true that under the liberalized environment, interest rates can not be controlled. However it can be argued that competition in the microfinance sector can be enhanced if there is perfect information flow about interest rates charged by the different players, a role that the government can do without necessarily fixing interest rates. MFIs Being Urban-based On the expenditure side, the MFIs can improve their financial sustainability by minimizing their operational costs which is consistent with the microfinance best practices. However this has implications on the location of the MFIs office and definition of the operational area which in turn has implications for access to microfinance services by the rural poor. As observed by Wamatsembe ( 2001), MFIs that follow the microfinance best practices prefer to operate only in urban and peri-urban areas (usually within a radius of 5 k kilometers for town centers). Clearly the motivation for this is to minimize the heavy transaction costs that are associated with rural credit operations, thereby denying the rural poor with access. The policy implication is that big MFIs will definitely need some incentives to increase their rural outreach.

The policy incentive structure as outlined by the Microfinance Outreach Plan (MOP) in their document entitled —Matching Grant Facility for Capacity Building (MCAP) Design“ is

a step in the right direction. Basically the MCAP is a fund initiated by Government and supported by key donors an other stakeholders in the microfinance sector with the overall aim of providing a coordinated donor-funding mechanism for microfinance capacity building, based on agreed Best Practice principles and cost sharing basis, in ways that would enhance impact, market responsiveness and sustainability. The proposed incentive structure is such that good performing MFIs (thus those abiding by Microfinance Best Practices) that will be willing to expand their outreach into remote rural areas will have their operational losses for first year for the specific rural branch opened under this arrangement (and possibly at most second year losses) refunded.

However existing rural branch losses incurred before the signing of the memorandum of Understanding (MOU) between the MFIs and MCAP/MOP are not covered by this policy. The additional incentive is that part of the new rural branch set up costs will also be refunded from this fund, which amount depends on the extent of remoteness of the branch. This proposed incentive mechanism is expected to lure the urban based MFIs to the rural areas, thus making the services more accessible to the rural poor. Design of Appropriate Financial Products for the Poor The poor are not a homogeneous lot of people, hence the challenge of designing appropriate financial products that meet their diverse needs. Currently the MFIs are mainly providing generic products with standardized features. The current product features of most MFIs are characterized by short loan periods (on average 4 œ 12 months), no grace periods, weekly repayments and small loan amounts. These product features may not be suitable especially for agriculture related investments, from which the rural poor mainly derive their livelihoods. While MFPED (2000) under the Plan for modernization of agriculture (PMA) clearly identified the poor farmers priority as access to credit and financial ser vices so as to improve agricultural production, the MFIs financial products are not tailored to agricultural production. . If the poor farmers took the MFIs loans to purchase production inputs say like high yielding seeds, the first weekly installment repayment will be due even before they plant the seeds or before the seeds even germinate which raises the issues of sources of funds for loan repayment. Such restrictive MFIs credit products will constraint the uptake of new, more productive and high-yielding technologies by poor farmers which would have a profound impact on household income and poverty alleviation. Ahmed (1999) also argued that payment of small period installments may not be a good method of collecting loans from poor people experiencing persistent negative shocks, despite being accepted as a best practice. Ahmed (op cit) further argues that for MFIs to meet the needs of the poor, they need to understand the vulnerabilities that the poor operate in and design flexible products that cater for the income vulnerabilities of the poor.

Anecdotal evidence also suggests that these generic features of MFIs products have made the clients to develop the culture of multiple borrowing from MFIs so as to get commensurate loan amounts and subsequently raised their vulnerability to the debt burden. However an empirical investigation is required to assess the extent to which this could be affecting poverty levels at the household levels so as to appropriately inform policy. In addition credit from the informal sector was also utilized for heath and consumption purposes. The other consumption purposes included purchase of durable assets, ceremonies etc. Interestingly 15.7% and 29.1% of all the loans from money lenders/commercial firms is utilized for heath care and consumption respectively. This underscores the productivity of consumption credit in enhancing household welfare irrespective of the interest rates. What all this points to is that there is a demand for consumption credit which the MFIs need to take on board in the design of products.

Gender Bias of Microfinance Interventions

The major challenge is that MFIs perceive gender responsiveness to be focus on women. One MFIs Executive when asked about how gender responsive their policies were said —The Microfinance industry is the most gender responsive in the whole world because it targets mainly the women clients and employs many women as loan officers“. This clearly demonstrates a high degree of misunderstanding of gender issues which have implications for microfinance as an instrument for poverty alleviation. Gender however refers to cultural and social ascriptions given to women and men by society (MFPED, 2000:8) 16 . These include the different attributes, status, roles and responsibilities, opportunities and privileges accorded to women and men as well as their access to and control over resources and the benefits. All these distinctions can be time and location specific. The MFIs need to know and understand the gender relations and issues, appreciate how it impacts on men and women so that their policies can be gender responsive thus enhancing the participation of both men and women in micro finance activities. The critical gender issues relate to the gender roles, the ownership and control of resources, decision making. Despite the famous rhetoric that —If you empower the woman, you empower the whole household“, it is critical that MFIs review their policies, procedures and products to make them more gender responsive to enhance the participation of both sexes in the microfinance programmes for effective poverty alleviation. The MFIs also need to understand the practical and strategic gender needs of their clients. Practical gender needs relates to survival like food, clothing, shelter or health and Strategic needs aim at changing the status quo of the community for example the means through which poverty eradication can be achieved through training, giving skills supporting business. The MFIs need to design products that meet both practical and strategic needs.

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