UNITED NATIONS CAPITAL DEVELOPMENT FUND    Microfinance

Issue 16 / September 2005

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By Tamara Cook, Microfinance Specialist, and Alexia Latortue, Senior Microfinance Specialist, CGAP

Some acronyms never make it into the mainstream, and forever remain part of the secret language of a closed group of people that share the same profession, hobby or interest. But everyone is talking about the MDGs, or Millennium Development Goals.

Outside the development field, media campaigns on either side of the Atlantic are rallying support by popularizing slogans like "Make Poverty History" or "Plus d'Excuses." Development insiders are brimming with excitement in anticipation of the upcoming World Summit in September that will review the status of achieving the MDGs. Practitioners on the ground, including those involved in microfinance, hope to capture this momentum to further their causes.

But one idea around which everyone seems to be rallying - the need for more money - may not be as clear-cut as many would like to think. Although there is no doubt that more resources are needed, no amount of money will help achieve the MDGs if aid is not spent more effectively.

Underlying Conditions for the MDGs

The MDGs are framed as concrete outcomes in the areas of nutrition, education, health, gender equity and the environment. Increased work in these specific areas will be a large part of the development strategy driven by the MDGs. But decades of experience have shown that progress in these areas is affected by other factors in the broader context, such as a functioning government, physical security, economic growth, and basic infrastructure. More recently, evidence has shown that the availability of financial services for poor households is also critical to achieving the MDGs. (See CGAP Focus Note 23: Is Microfinance an Effective Strategy to Reach the Millennium Development Goals? http://www.cgap.org/docs/FocusNote_24.pdf)

Microfinance, or financial services for the poor, enables poor people to increase incomes and reduce their vulnerability to risks, to send more children to school for longer, to improve health and empower women. It does all this by enabling the poor to make their own choices in charting their path out of poverty sustainably and with self-determination, self-reliance and self-respect. Microfinance is an enabler, part of the fertile soil in which the MDGs will take root.

Tackling Aid Effectiveness: Microfinance as a Test Case

At the Consultative Group to Assist the Poor (CGAP) we believe that working to ensure that all people have access to financial services is one important way to contribute to the MDGs. So continued investments in microfinance, along with spending on other more traditional development sectors such as education and health, makes good sense.

But in spite of significant funding and a fairly broad consensus on good practices in microfinance, donor programs on the ground continue to waste money, undermine markets, and fail to reach their objectives. To address this disconnect, CGAP paired up with former U.K. Secretary of State for Development Claire Short and other development ministers in 2002 to launch a unique aid effectiveness initiative using microfinance as a test case for other development sectors.

CGAP member donors agreed to hold a mirror up to each other to explore how effective, or not, they are. Seventeen agencies including the United Nations Development Programme (UNDP), the U.S. Agency for International Development (USAID), and the African Development Bank underwent intense scrutiny by their peers and CGAP through short and highly action-oriented peer reviews. The Microfinance Donor Peer Reviews focused on what donor agencies can most directly influence-their own internal systems, policies, processes, and incentives. Agencies received letters with recommendations, which they all disclosed publicly. Leaders like Mark Malloch Brown, then of UNDP, described the review as the most "hard hitting, gloves-off, actionable advice" they ever received.

Ministers and Heads of the participating agencies met in Paris in February 2004 to discuss next steps for implementing the recommendations. They agreed that unless internal systems are effective, donors may end up doing more harm than good. There was broad consensus that improving and, in some cases, completely reengineering the internal systems of international development agencies is crucial for achieving the objectives of microfinance, and more than that, the MDGs.

The findings yielded five core elements of donor effectiveness, depicted as the Donor Aid Effectiveness Star. Agency heads have found the Star useful for the all their work, not just in microfinance. (See Elements of Donor Effectiveness in Microfinance: Policy Implications: http://www.cgap.org/docs/PeerReview_policy_070604.pdf)

• Strategic Clarity: The coherence of an agency's vision of microfinance and whether this vision and agency policies are in line with accepted good practice. A good microfinance policy is important, but by itself is not enough: it must be internalized by staff and translated into results on the ground.
• Strong Staff Capacity: This element measures whether there is sufficient technical expertise to manage operations. The trend toward the generalist staff means that few people who design and implement microfinance programs have a minimum baseline of knowledge.
• Accountability for Results: Transparency about microfinance programming and performance. Decisions on whether to continue, terminate, or replicate a program should be guided by performance against measurable objectives, such as key financial indicators. In many agencies, especially the multilaterals, pressure to approve and disburse projects often takes precedence over setting up systems to ensure accountability.
• Relevant Knowledge Management: How well the agency learns from its own and others' experiences, and whether learning is applied to new operations. Ideas and experience are often not communicated well within and among agencies, so mistakes may be repeated and successful approaches not incorporated into new program designs. Capturing information about what works is only the first step. Deliberate communication strategies are needed to ensure that this information is actually applied to operations.
• Appropriate Instruments: Whether an agency has instruments that allow it to work directly with the private sector. It is harder to practice good microfinance if donors must channel support through governments. Yet, even when agencies can work directly with the private sector, they do not always use funding instruments in a flexible and performance-based manner. Effective agencies choose those instruments-grants, loans, guarantees, and equity participation-that best respond to market needs and seek to complement, not displace, private capital. They also link disbursements to the attainment of clear performance goals.

Top management of the participating agencies agreed that unless internal systems are effective, donors may end up doing more harm than good. Interestingly, those donors that faced the toughest challenges are among the ones that have taken the most concrete action to improve their effectiveness. For example:

• United Nations Development Programme conducted an in-depth portfolio review that highlighted the importance of technical inputs at an early stage of the project.
• African Development Bank is using the peer review recommendations to reshape the mandate, staffing, business plan, and strategy for its new microfinance group. The Board of Directors has stopped approving ill-designed credit components in larger projects.
• Agence Française de Développement agreed to reduce average project sizes for microfinance projects, since microfinance cannot effectively absorb as large amounts of money as some other types of projects like health or infrastructure.
• European Commission has reoriented its microfinance strategy to focus on providing grants for capacity building of financial sector players. Recognizing it lacked a comparative advantage in providing credit lines, it decided to discontinue them.
• International Fund for Agricultural Development has stepped up efforts to improve the transparency of its operations by partnering with the Microfinance Information eXchange (MIX), an international web-based information platform following industry standards.

(For more examples, see: CGAP Aid Effectiveness Initiative: Update on Actions Taken (February 2004) http://www.cgap.org/docs/HLM_UpdatePaper.pdf)

A large number of CGAP member donors-well beyond the original 17 that participated in the peer reviews-have since engaged in our aid effectiveness work through several joint efforts, including:

• new donor operational guidelines on microfinance that incorporate lessons learned from the past 30 years (http://www.cgap.org/donorguidelines/)
• Country-level effectiveness and accountability reviews that address how donors can respond to gaps in local financial systems and partner more effectively with governments and the private sector (http://www.cgap.org/clear/)
• upgrading staff skills through multi-donor training courses and sharing information tailored specifically for staff that fund microfinance (http://www.cgap.org/direct/)

More Effective Aid, Not Just More Aid

Unfortunately, the key headlines around the MDGs cannot be so easily boiled down to urging rich countries to provide more aid. Shouldn't it be a greater priority to better spend the billions that are already committed? Jeffrey Sachs, in his recent book, The End of Poverty, talks about the need to fix the "plumbing" of international development assistance to be effective. And shouldn't this "plumbing" be fixed before doubling or tripling the amount of money pumped through it?

CGAP is a global resource center for microfinance standards, operational tools, training, and advisory services. Its 30 members - including bilateral, multilateral, and private donors - are committed to building more inclusive financial systems for the poor. For more information, please visit: www.cgap.org.