Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor?Coauthors
Erica Field, Duke University; John Papp, Highbridge Capital Management; Natalia Rigol, MIT
How much of a difference does six weeks make in the life of a poor entrepreneur? According to a long-term study of microfinance repayments by fledgling businesswomen in developing countries, it can be the difference between failure and success.
In recent years, the success of microfinance as a development tool has come under scrutiny, with studies showing that it has had relatively little impact on poverty or the growth of microenterprises.
One of microfinance’s undisputed successes has been to limit the risk of lending to the poor. But Rohini Pande, Kamal Professor of Public Policy, and her three coauthors (Erica Field of Duke University; John Papp of Highbridge Capital Management; and Natalia Rigol of MIT) wanted to know if the repayment obligations in typical microfinance contracts, while helping limit the danger of default, also “blunt the potential impact of microfinance.”
Working with Village Financial Services, a microfinance institution in Kolkata, India, they randomly assigned a typical contract to some loan recipients, requiring a first repayment after two weeks, while other recipients received a two-month grace period. Borrowers were surveyed both at the beginning of the loan and after three years. The field experiment, the first major study to focus on repayment flexibility, yielded striking results. Entrepreneurs who received the grace period had a 19.5 percent higher monthly household income, on average, than those who did not. Their weekly business profits were 41 percent higher. They reported roughly 80 percent more business capital. And they invested 6 percent more in their businesses and were twice as likely to start new ones.
Interviews with a random sample of grace-period clients helped illustrate what had happened. A sari seller told the researchers that the grace period had allowed her to invest the entire loan amount in her business, rather than setting some money aside for the first repayment. The funds enabled her to get larger wholesale discounts. She took on more entrepreneurial risk by increasing her stock and expanding the variety of saris she offered. For most interviewees, the higher return on investment, combined with the grace period, reduced the risk of default, especially if their business fortunes took a temporary hit.
A tailor was able to buy a sewing machine, rather than using a borrowed machine or sewing by hand, and to buy enough fabric to expand into the ready-made market, which allowed him to make business connections as far away as Assam, a neighboring state.
But the study also found that grace-period clients’ heightened risk-taking was accompanied by a higher default rate: They were six to nine percentage points more likely than regular clients to miss repayments in the short run. Twenty-four weeks after the date when the final installment was due, 2 percent of regular clients and 9 percent of grace period clients had failed to repay. After a year, the difference was roughly the same. The research also found that those borrowers who benefited the most from a grace period were risk-averse clients and those without short-term liquidity (such as a savings account).
Given the remarkable performance by most grace-period borrowers and their expressed willingness to pay for a grace-period, why have lenders not included a grace-period option? The answer may be that microfinance institutions are wary of attracting the wrong type of borrower. Nevertheless, a calculation by the researchers suggests that a relatively small subsidy of 150 rupees (less than $4) per client would make it possible for lenders to offer the grace period without suffering losses.
Pande says that from a policy perspective, the research is coming out at the right time. “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. Indeed, a recognition of the importance of design features is filtering into policy. The Indian parliament is considering a bill that could drastically change the regulatory framework of microfinance. Among the issues on the table: repayment periodicity and grace periods for loan contracts.
- by Robert O'Neill