Lessons from Micro-finance II

This is in continuation from an earlier post and also in response to the issue of microfinance "crowding out" local savings, as raised by Niranjan Rajadhyaksha.

Niranjan quotes Milford Bateman (in response to Tim Harford) and refers to the iron law of microfinance - "...to the extent that local savings are intermediated through microfinance institutions, the more that country or region or locality will be left behind in a state of poverty and underdevelopment". In other words, the microloans "crowds out" credit to the small and medium enterprises and "crowds in" credit to micro-businesses, mostly single employee businesses run by the owner.

However, the crowding out arguement may need to be qualified. Here is an intutive clarification. Most of the customers of micro-loans are the poorest of the poor. In any case, the amounts involved in such loans are very small and to that extent the savings "crowded in" are also likely to be small. More importantly, I am inclined to believe (no studies I could find out, only intutive arguement) that the savings of these people, especially in the context of the poorest in these developing societies, are in any case not (and cannot be) the source of funds for small and medium businesses.

I suppose there must be a form of informal "savings pyramid", which outlines the flow of savings of the different categories of people based on their incomes. The savings of the poorest is invariably too small, the transaction costs too high, and the marginal utility benefits for these poor savers too meagre, for these savings to find their way into the pool of formal lending institutions. It therefore stands to reason that the bottom most rung of the "savings pyramid" that feeds the formal sector are the lower middle class, and not the poor or the poorest.

This strand of analysis may be slightly corroborated by the World Bank study on the sources of credit mobilization across 45 countries. The study finds that the "share of household credit in total credit increases as countries grow richer and financial systems develop". It finds that it is socio-economic trends that determine credit composition. All this sits nicely with the aforementioned "savings pyramid" hypotheis.

By logical extension of the Bateman arguement - the former (small and medium businesses) being in the organized sector and the latter (micro-businesses) part of the informal economy, microfinance ends up promoting the unorganized parallel economy. It may therefore be more relevant to link up the expenditures on these micro-loans to the formal sector. But such arrangmeents, with its attendant bureaucracy and transaction costs, has its own pitfalls.