China’s economy may lead the region in many ways, but in one surprising area it is lagging behind: microfinance. The concept of distributing small loans to the poor has flourished across Asia since its introduction in Bangladesh three decades ago. Yet it has a notably minimal footprint in China.

A casual observer might say China doesn’t need microfinance. After all, it is now the world’s third-largest economy. But beyond the prosperous cities, millions of people still languish in poverty. China has the second-largest number of poor after India. About 254 million people in China lived on less than $1.25 a day in 2005 (as measured in purchasing power parity dollars), according to the World Bank. The income gap is widening between rural and urban areas and has today reached a historical high.

Microfinance is one tool that can reduce this entrenched poverty by providing entrepreneurs with credit, just as it has in other developing countries. Loan sizes would be larger than in India because GDP at purchasing power parity per capita in China is higher at $5,962 versus $2,972 in India, according to 2008 World Bank figures. But loans would still be used for income-generating activities such as raising livestock, buying materials for micro-businesses and farming, and setting up small trade and services. This is especially pertinent as the government seeks to create a “harmonious society” in part through poverty reduction and human development.

At the moment it is very difficult for China’s poorest citizens to get loans. The absence of civil society in China until recently means there are few established poverty-reduction programs and the role that they can play is relatively new. There is no coherent government policy to foster and oversee microfinance and there are no clear laws governing the industry. In addition, Chinese microfinance institutions are allowed to operate only in the county where they are registered, and obtaining licenses is a highly bureaucratic process.

Despite China’s extensive banking system, which includes government rural credit co-operatives that are meant to serve poor people in the countryside, the neediest are left out. Co-op loans tend to be too big, cumbersome and bureaucratic for the poorest citizens to access, and bank branches are not conveniently located.

Some Chinese microfinance institutions are starting to address this by partnering with foreign groups to learn their methods and put operations into place. That is a crucial first step, but their efforts will be limited unless Beijing creates a regulatory environment favorable for microfinance institutions. The government could start by boosting microfinance through private village banks. This would require dropping investment restrictions on foreigners and loosening local license requirements.

China is understandably cautious after the failure of rural cooperative funds, which were depository institutions established in the 1980s to funnel lending to rural areas. Lack of effective supervision and meddling from local governments led to their closure in 1991. Many peasants never received their deposits back. Microfinance institutions, however, could be restricted from taking deposits, so wouldn’t present the same risk.

It will take hard work and reform to grow microfinance in China. But millions of poor people in China could benefit from the opportunities provided by a small but powerful loan.

Mr. Akula is founder and chairperson of SKS Microfinance. Mr. Khanna, the author of “Billions of Entrepreneurs” (Harvard Business School, 2008), is Jorge Paulo Lemann Professor at Harvard Business School and serves on SKS Microfinance’s board of directors.

Featured in Wall Street Journal Online, October 7, 2009

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