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Even a small delay in when microfinance loan repayments start can create large economic gains for micro-entrepreneurs in developing countries. That is one takeaway from a new research paper co-authored by Rohini Pande, Mohammed Kamal Professor of Public Policy. In "Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor?" Pande and her co-authors conducted a field experiment with poor urban borrowers in Kolkata, India to determine whether a grace-period, which delays when repayment starts, influences entrepreneurship. The paper is published in the October 2013 edition of American Economic Review.
Researchers test the hypothesis that conventional microfinance contracts that require repayments to begin immediately following loan disbursement might discourage the poor from investing in high-return but risky business propositions. "In other words, the rigid contract terms could be causing clients to invest in relatively more liquid and safe but relatively low return investments," Pande writes. "While this may reduce default, it could reduce the ability of an entrepreneur to make upfront business investments that could lead to successful long run entrepreneurship."
Researchers assigned a random sample of microfinance client groups to a grace period treatment, where they were assigned to a loan contract which included a two-month grace period before repayment began. Outcomes for these client groups were compared to those for clients who remained on the regular microfinance contract where repayment started within two weeks of loan disbursement. The field experiment yielded several key results:
"Ultimately, these results offer an explanation for why previous research on microfinance impact has found little effect on poverty," writes co-author Erica Field, associate professor at Duke University. "If microfinance clients are discouraged from making profitable business investments, they will have little hope of escaping poverty through microlending."
From a policy perspective, Pande says that the timing of the research is opportune.
"The results suggest that evaluating design features of the debt contract can provide valuable insights on the best ways of meeting the credit needs of micro-entrepreneurs and help identify alternative methods of reducing liquidity constraints,” she writes. And it appears the importance of design features may soon translate into policy. On the heels of India’s microfinance crisis, parliament is debating a bill that could drastically change the regulatory framework of microfinance. One of the issues on the table: repayment periodicity and grace periods for loan contracts.
This research paper was funded by: the ICICI Foundation, the Exxon-Mobil Foundation, the International Growth Centre, and the South Asia Initiative at Harvard.
Rohini Pande is the Mohammed Kamal Professor of Public Policy, and co-director of Evidence for Policy Design (EPoD) at Harvard Kennedy School. Her research examines how the design of democratic institutions and government regulation affects policy outcomes and citizen well-being, especially in South Asia.
Rohini Pande, Mohammed Kamal Professor of Public Policy
"The results suggest that evaluating design features of the debt contract can provide valuable insights on the best ways of meeting the credit needs of micro-entrepreneurs and help identify alternative methods of reducing liquidity constraints,” Pande writes.