Why the dream of microfinance is turning sour

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I remember the day three years ago when I decided I no longer wanted to be a part of the microfinance industry. I was standing in a one-room house in a small town in southern India, meeting a family that had taken out a microfinance loan. The mother and father were tired and nervous – both had the gaunt, prematurely aged look that is the hallmark of rural poverty in India. With them was their daughter Laxmi, a tiny eight-year-old girl, hiding in the folds of her mother's sari.

"For the three days that they took her away, I couldn't touch food," Laxmi's mother told me through a translator, pointing at her daughter. "We are just glad to have her back." A few weeks before, Laxmi had been kidnapped and held hostage by a local moneylender called Mrs Lalitha. Laxmi's parents had failed to keep up with payments on a debt. The debt was not to a loan shark or a mafia boss, however. It was to a registered Indian microfinance company which still claims in its brochures to be dedicated to fighting poverty, with a particular emphasis on women's rights and "empowering the girl child". Loan repayments had been informally outsourced to the moneylender.

What happened to Laxmi would no doubt have horrified the founder of the microfinance movement, the Nobel Prize-winning economist Muhammad Yunus. For most of the past year, however, a backlash against abusive and exploitative microfinance practices has been growing across Asia. In southern India, microfinance banks have been blamed for an epidemic of suicides among indebted farmers. The backlash has also spread to Bangladesh and Dr Yunus himself. In March, the Bangladeshi government forced him to step down as head of Grameen, the pioneering microfinance bank he created. Officially, he has been asked to leave because he is over the retirement age. Unofficially, he has become a political threat to the ruling party in Bangladesh, which sees Grameen and microfinance as "bleeding the poor". Last week, he lost his final court appeal to avoid being sacked as head of the bank he created.

Some of the accusations made against microfinance are unfair, exaggerated and bear little relation to how small loans actually affect the poor in Bangladesh and India. On the other hand, supporters of microfinance, including Dr Yunus, have been content to let equally misleading myths about their work go unchallenged for years. It is an industry that has got used to making promises it cannot keep.

In the past few years, most people have heard of Dr Yunus's microfinance concept, and the system it offers for reducing poverty in the developing world. By offering small loans to women in villages and slums, microfinance companies encourage the poor to start small businesses of their own and use the money generated to improve their standard of living. Interest is usually charged at a rate of anything from 20 to 35 per cent.

It is a system where, in theory, everyone wins: the women achieve financial independence while retaining their dignity, and microfinance companies are able to use the interest payments to fund their own expansion. The most commonly used proof of microfinance success is repayment rates. When a microfinance bank is functioning normally, more than 98 per cent of loans are repaid in full and on time.

I was one of many people to be inspired by these ideas. In 2007, I joined one of India's new microfinance consultancies, advising microfinance banks on business planning, staff training and grant applications. I was not the only one to be impressed by Dr Yunus's vision of a world without poverty: through the Department for International Development, British taxpayers have supported microfinance loans to millions of people in India alone. What is distinctive – and attractive – about microfinance is the boldness of its aims. Microfinance visionaries are not interested in merely reducing poverty – they promise to end it, abolish it, banish it.

The Indian company I worked for was extremely professional, and filled with dedicated and well-intentioned people. But as I began to work with microfinance organisations across India, it became clear that there was a huge difference between the rhetoric of ending poverty and the actual services being offered in the slums and villages I visited. The fact is that microloans do help some people – but they also carry severe risks.

Perhaps the most misleading myth is that high rates of loan repayments imply a rapid escape from poverty. India's largest microfinance company, SKS, says that it exists to "eradicate poverty". SKS's founder, Vikram Akula, recently published his memoir. The title reads like a manifesto: A Fistful of Rice: My Unexpected Quest to End Poverty through Profitability.

Dr Yunus has made similar claims, and in doing so set the tone for the rest of the industry. At his Nobel Prize lecture, he boasted that microfinance and similar schemes had the power to destroy world poverty entirely, so that one day all that would be preserved would be relics of poverty, kept in a "poverty museum".

I began to understand the flaw in this idea while working on a project with a bank near Varanasi in northern India. I was there to monitor the bank's performance. Sitting behind the counter with the bank teller on payment day, I could see women queuing up to make their weekly loan repayment, each clutching bundles of banknotes to push across the counter in exchange for a receipt. More than 95 per cent of the loans owed were being repaid, on time and in full.

In theory, this was the system working as it should. Each pile of rupees landing on the teller's desk represented another loan instalment paid, another successful village business and another family escaping from poverty. And with it, another step towards Dr Yunus's great poverty museum.

I had visited the villages where these women came from, and I knew that there simply were not enough tea stalls and sari workshops for this to be remotely possible. Even if every one of these women had started her own sewing workshop or vegetable stall, there could never be enough customers to sustain them all. There is a limit to how many tea stalls you can have in a single village.

In fact, although many microloans did go towards starting businesses, a huge proportion was spent on simply getting by and surviving in poverty. The villagers used the loans to pay off other debts, meet medical fees or fund their children's weddings. There is nothing necessarily wrong with this kind of spending, but clearly it is not a means of ending poverty.

I came to see microloans as playing a very similar role to credit cards in the West. Cards and microloans provide a useful source of money when people are in need of ready cash, but they are not interest free, and for most people they are not a route to wealth and affluence. Those who are financially illiterate or unfortunate are at considerable risk of sinking into a spiral of debt when this kind of lending goes wrong. This is what happened to Laxmi's parents – and many others in southern India where microfinance is now in crisis.

The second myth is that microloans are the most useful service we can offer the poor. Dr Yunus has argued that access to loans should be considered a "human right", as without credit it is impossible to earn one's way out of poverty. It would be more realistic to admit that debt is not a passport to wealth in Bangladesh, India or inner London.

It would have been helpful if the microfinance movement had placed more emphasis on other banking services, such savings or insurance, than om loans. A right to savings, rather than credit, would be genuinely useful. Insurance for health also has the potential to improve people's lives dramatically. Both these ideas have been explored by microfinance companies – and savings are a compulsory component for Grameen bank customers. But the main focus is still on loans.

A few months after I left the microfinance consultancy, I again visited the town where Laxmi's family lived. I was told the moneylender was still working with the local microfinance bank, even though a kidnapping court case was pending against her. Weekly loan meetings were even being held in her house. The bank still listed women's rights and "empowering the girl child" as its key priorities. If microfinance ever does build a museum to poverty, Laxmi's one-room home would be a good place to lay the foundations.

Some names have been changed