The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.