Monday, November 07, 2005

Where the real hidden wealth of the poor lies

The Economist has a recent article on microfinance. Unfortunately it's rather slipshod writing, quite below the usual editorial standards. There's even an egregious error in computing the annual interest rate from the "5/6" practice. (Can you get the correct figure yourself? Use monthly compounding.)

There is list of factors that prevent the poor from gaining access to financial services:

Inflation tends to be high and volatile; government is often incompetent; and the necessary legal framework for financial services is often missing. Property laws can make it impossible for poor borrowers to use assets such as their home as collateral for loans.

In the past, many countries have outlawed “usury”, and today many Islamic countries prohibit the charging of interest. Governments in developing countries often impose caps on the interest rates charged on loans for the poor. Despite their popular appeal, such caps undermine the profitability of lending and thus reduce the supply of loans.

Incomplete and erratic regulation of financial institutions has also undermined the confidence of the poor in the financial services that are available. When they can find an institution that will accept their tiny deposits, it often lacks the sort of government deposit insurance that is routine in rich countries, so when a bank goes under, savers suffer. For example, Indonesia's PT Bank Dagang Bali, once known for its work with poor clients, was closed by regulators last year after it was discovered to be insolvent and riddled with fraud. Many savers did not get their money back.

Corruption is also commonplace in many developing countries. A recent study by the World Bank found that in two poor states in India where the financial system is largely controlled by the government, borrowers paid bribes to officials amounting to between 8% and 42% of the value of their loans. Corruption raises the cost of every financial transaction, allows undesirable transactions to take place and undermines consumer confidence in the financial system. This, and the related curse of cronyism, explains why access to financial services in countries where the state has control over the financial sector is poorer than where it does not.

Inadequate basic public services add to the burden on financial firms. SKS, a fast-growing microfinance institution in India, has had to build back-office systems that can work on two hours of power a day; it closely monitors voltage when its computers are running and keeps a diesel generator on hand. Many others simply give up on the idea of modern technology and continue to use paper instead. This makes them vulnerable.

I would argue though that the biggest obstacle (not mentioned above) is the very poverty of the poor. They have no collateral worth putting up. Hence, the hidden wealth of the poor is nowhere in the here and now; instead, it lies in the future, after productive opportunities (unlocked by credit) are realized. But formal lenders want some surety now about this future wealth, creating the quandary.

Removing the collateral requirement requires substitute methods of enforcing repayment. Informal moneylenders zip back and forth on motorbikes and do daily monitoring (and often, daily collection); they charge higher interest rates to recover their added monitoring costs and risk. Grameen-type microcredit relies on group liability lending; in this case it's the borrowing group which assumes much of the risk-taking and transaction costs in screening and monitoring its members. Such financial innovations are opening the way for the enterprising poor to improve their own living standards.

Nobody advocates microfinance as the solution to poverty. But it's certainly part of the solution. The poor are not more apathetic, lazy, or dishonest, than you or I. They just have less money.


Amadeo said...

Indeed, the poor will usually not have sufficient hard "collaterals" with which to guarantee credits granted.

But a novel form of collateral has been the projected cash flows that are expected to be generated by the business activity that is being financed. This is supposed to "guarantee" repayment of the loan.

And this is the rock upon which microfinance is anchored on.

Econblogger said...


Of course, all business credit is premised on repaying the loan out of the future cash flows. The essence of the credit problem is that the lender's share in the projected cash flow is not guaranteed. First, the lender is not sure the cash flow will materialize; second, the lender does not know how trustworthy the borrower is in returning the lender's share. That is why the collateral system was instituted, to the unfortunate exclusion of the poor.

Amadeo said...

But since we were discussing microfinance, then we should point to the collective experiences of successful microfinance institutions in the area of credit repayments. They have been abnormally high, leaving little for bad debts or uncollected credits.

Even the local credit union here in our city of which I have been an active member since the 70's can put to shame the commercial banks which rely heavily on hard collaterals. The former essentially lends based on microfinance's heavy reliance on projected cash flows.

Of course, there is the added burder of trust and reliability which has to be built from the ground up. This is where educational programs come in, programs initiated as part of pre-membership or post-membership. And we should include continued and close monitoring of credits. This we learned from the intrepid 5/6 entrepreneurs.

Ordinary Citizen said...

Anyone really interested in the "wealth of the poor" should check out the new executive summary of the most recent World Resources Report:

The 24-page document is available free online.