Monday, June 19, 2006

The Mystery of Capital

Hernando De Soto's landmark book, The Mystery of Capital, identified a key reason for economic problems in the developing world: that much economic activity had moved to extralegal sectors due to high government regulation. Thus, while the poor had assets, they did not have capital, in that their assets could not be used for collateral, or sold in legally enforceable transactions. DeSoto's prescription was for governments to adopt private property systems, where the poor's assets could be titled.

But a relatively new financial system is emerging that may help with this issue; microfinance or microcredit. Under this system, the poor are extended credit based on trust, or "social capital" rather than collateral, or "financial capital". Leaders in the area are Grammen Bank, Accion, Opportunity International and SKS. If you are interested, a great place to start reading is a recent series of articles in the Economist. Or read one of the books about the founder of Grameen, Muhammad Yunus. It is encouraging to see unsubsidized microfinance lenders emerging in several markets, as early entrepreneurs are improving the business model.

My view is that microfinance is already providing access to early stage credit that is needed for entrepreneurs to build and expand their businesses. An added benefit is that this form of lending tends to favor women, helping them break a downward cycle of economic dependence. However, the reforms proposed by DeSoto are also needed, or else entrepreneurs will hit a "ceiling" in these societies for two reasons- capital needs for expansion and rewards for big ideas. It is one thing to borrow $100 to start a food stall, but the successful entrepreneur will want to expand with more stalls, or a restaurant. While an entrepreneur can grow a business with internally generated cash, in many cases growth will be quicker with access to larger loans or equity investors.

Also, if you can't sell a successful business (because it is extralegal and unlicensed), this will restrict the "big ideas" that are driven by an exit strategy or liquidity event. In particular, these "rewards" motivate entrepreneurs and attract equity investors. What would Silicon Valley look like if you could get small loans, but not venture capital? Would as many aspire to build the next Google? When entrepreneurs in the developing world are able to derive an enterprise value for their business, this will further drive economic activity.

Fundamentally, poverty alleviation and entrepreneurship are both driven by hope of a better life. Societies and economic systems need to allign incentives to allow these hopes to be realized. Microfinance is a good start, but more will be needed. And those that criticize microfinance lenders for moving to larger average loan sizes don't understand that these lenders are providing services for their successful customers... just as your local bank does.

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