Credit

Directions: Type your name below and then post your analysis paragraph. Use my example as a model.

Mr. Hopkins

The poor don't have access to credit because....

Kevin Clydesdale - Commercial banks and other formal financial intermediaries refuse to lend to poor households in developing countries due to the high costs of such small transactions, households having lack of traditional collateral, lack of the basic requirements for financing and on top of that, geographic isolation. These potential micro-enterprises may have huge potential in talents and entrepreneurship; however, the bigger formal financial intermediaries do not recognize the potential as something that they will profit in. As a result, most of the poor households are stuck in the poverty trap which is defined as, “a spiraling mechanism which forces people to remain poor. It is so binding in itself that it doesn't allow the poor people to escape it. Poverty trap generally

happens in developing and under-developing countries, and is caused by a lack of capital and credit to people,” (Duflo). By providing access to financial services, in return, it will help stimulate the independence and self development of those poor households and micro-enterprises thus helping the entrepreneurs. Furthermore, by providing financial services, the workers may become more efficient workers with the investment in materials that they didn’t have before. For example, a farmer may be able to buy a tractor and double the amount of crops that he is able to produce, thus making him more efficient. If financial intermediaries were to allow these poor households access to finance, this would cause an outward shift in the PPF, shifting P to P1 on the graph to the right. Not only will this improve the living conditions of those poor households, but it will also act as a way to improve their risks in lives (such as sickness and other uncertainty factors). On top of that, with the access to financial services, the poor may gain connection to a more diverse economics life, thus increasing their confidence leading to them playing a larger role in a larger community.

Michael Chu

Formal credit is a luxury that is hard to come by in developing countries, depriving many people in need of loans. Credit, or the contractual trust in which a borrower receives something of value now and agrees to repay the lender at some date in the future, generally with interest, is the backbone of many developed countries’ economies. Credit allows money to be continuously poured into the economy, and if lended responsibly, the economy should grow stronger. Many large companies borrow extremely large sums of money, on credit, to start new ventures and investments. These new investments usually lead to outward shifts of AD and AS (due to increased capital stock, leading to long-run economic growth. This can be seen on the graph to the right from the shift from LRAS to LRAS1, AS to AS(sr1), and AD to AD1. The equilibrium price in this scenario also increases, which also signifies a stronger economy. Because many developing countries don’t have access to formal credit, its people aren’t able to invest in new businesses or in infrastructure that would shift the PPF curve outwards, thus restricting economic growth. Why don’t developing countries have access to formal credit? Credit is built on the trust and reliability of the borrower to pay the loan back. Many of these large banks don’t trust poorer people’s ability to payback their loans. Their “credit rating,” as it’s referred to, is weak.

Karan Mehra -

The more likely someone is to default on their loans, the interest rate increases. When a lender needs more information about the borrower he incurs more costs and therefore the interests rates go up. This is only part of the explanation for why traditional banks do not tend to lend to the poor and loan sharks are so prominent. Kabuliwalas are such types of loaners. They don’t have to worry about vetting a person before loaning to them because their reputation as “fierce and implacable” men ensured that there was a minuscule chance a borrower would dare default. (Banerjee) A bank like Citi couldn’t use these intimidation tactics on clients who don’t pay up and therefore choose not to lend. “Bank officers are not very well placed to do all the necessary due diligence: They don’t stay in the village, they don’t know the people, and they rotate frequently. Respectable banks are not in a position to compete with Kabuliwalas.” (Banerjee) Simply said, gathering info on customers would be too expensive and they can’t afford to be caught in an intimidation scandal. Looking at this situation in the market for Loanable Funds from traditional sources, such as banks or even micro finance institutions, the supply cure would shift inward (S1 to S2) because of the increased costs of production. Increased costs of production in this sense just means the costs of vetting a person and protecting themselves against a default. The shift in the supply curve would increase the price of loanable funds (P1 to P2) and decrease the quantity supplied (Q1 to Q2). This market would be under producing and is currently misallocating resources. There’s the possibility that this is, in fact, the equilibrium and prices are meant to be this high and that could explain the popularity of loan sharks.

Ashley Shin

The reason for the low supply of credit in developing countries is due to the high risk and high cost associated with offering those services. In most services, suppliers typically require a down payment for the borrower as collateral so that if the borrower defaults on the payment, they can seize the collateral instead. This system, however, does not work for the poor, since the poor generally have neither the credit nor the collateral to ensure suppliers that they would pay back any loans made to them. The firm, then, is risking their funds to lend to the poor, without guarantee that they would be able to make a profit, which increases the risk for the microfinance institutions (MFIs). Also, lenders often have limited information about the borrower, creating a problem of information asymmetry for these MFIs. For example, a borrower would know more about his capability to pay back the loan better than the MFI would, making the MFIs lose out on profit in the long run. This creates high risk for the institutions. This, however, is not the only problem with lending to the poor. There are also high costs associated with operations in developing countries for the poor. Namely, in order to ensure that borrowers are working on repaying their loans, institutions often have to follow up on the borrowers. Since institutions are often not aware of native dynamics, it may become difficult to find these borrowers; also, there is cost in trying to follow up with the loans. Abhijit V Banerjee and Esther Duflo, in their book, Poor Economics, also adds to this problem with the multiplier effect, a situation often encountered by formal banks, where “when the interest rate goes up, the borrower has more reason to… not repay the loan… that means the borrower needs to be monitored and screened more carefully, which adds to the cost of lending. This pushes the interest rate even further”. This leads to an upward spiral of costs of lending to the MFIs, making operations in developing countries unattractive for suppliers. While this is true, there are other reasons why interest rates have to rise to keep the MFIs running. Jayati Ghosh, in the Cambridge Journal of Economics, describes: “Rather than engage in costly screening of clients, it is easier for MFIs to charge excessive interest rates to everyone, through which they can absorb any losses on bad loans... As a result of these, high rates effectively became the only possible survival strategy for most MFIs”. The high interest rates, at the same time, also increase the risk of borrowers not being able to repay them. When done at a mass scale- with borrowers increasingly starved for money to repay their loans because of interest, and the high interest rates raised even higher, because it becomes a necessity for MFIs to keep in business- increase the risk of default and the subsequent instability of the microfinance sector. For these reasons, suppliers often find it difficult, risky, and costly to provide microcredit and microfinance services for the poor. The low supply of credit decreases the supply curve from S1 to S2, as shown in Figure 1 below. Ultimately, the effect is that price of loans increases from P1 to P2, and the quantity of loans in the market decreases from Q1 to Q2. This means that loans become increasingly more difficult to afford for the poor, and less accessible as well.

Figure 1: The supply curve shifts left from S1 to S2, increasing the price of loans and decrease the quantity of loans in the market.

HYUN DO CHA

Why is there such a low supply of formal credit in developing countries?

Figure 1: Initial demand curve D shifts left to D1 because the demand for an alternative good has increased; this has caused quantity supplied and quantity demanded to drop from Q to Q1

A notable hindrance to the formation of formal credit institutions, such as but not limited to commercial banks, in poor or developing countries, is the prevalence of the informal credit sector in said nations. According to the Global Development Research Center (GDRC), “stringent requirements for loans have systematically kept low income households out of the credit delivery network of commercial banks” (Srinivas). This has led to a reliance on the informal credit sector in the developing world, particularly due to the fact that not only are “income levels, land ownership and job status” mainly disregarded when “obtaining loans”, but also that trust was developed between the producer and consumer, as “loans were made on a face to face basis with personal knowledge and close proximity of the lenders and borrowers” (Srinivas). Representatives from the departments of Economics at Stanford University and University of California, Los Angeles - Pascaline Dupas and Anthony Keats - write on their report, Challenges in Banking the Rural Poor: Evidence from Kenya’s Western Province, that “service quality, fees, and trust are important and often overlooked factors [by the formal banking sector]” (Dupas). Given that the informal credit sector manages to fill this void, thus provide a more appealing alternative to formal credit, this causes a substitution effect, and causes demand in the formal credit sector to shift left, decreasing the quantity demanded in these developing countries.

Demetri Greco

Credit and lending to the poor can both result in long-term issues and long-term benefits. A small loan for the day could help create available funds to start a corner shop in India that could catalyze the start of a local chain brand. Except, in developing countries, the poor lack sufficient formal credit needed to grow their service, product, and businesses. From a data set of 18 different developing countries, less than 7 percent of loans come from banks in poor rural areas (Banerjee, Duflo 160). Majority of informal loans are taken from villages, family members, and, sometimes, risky loan sharks. Although formal banks and formal lines of credit offer lower interest rates, the flexibility of informal credit methods make them more attractive (Banerjee, Duflo 172). The main reason for the lack of insufficient formal credit from banks is due to the fact that lending to the poor is not worth the time and money. In Poor Economics, Banerjee and Duflo explain the costs that banks take on when lending to anyone. Interest rates cover expenses such as checking up on the borrower, managing different locations, employees, and “nudging the business in the right direction”. All of this takes ample amounts of time and time is money. In order to pay for all these expenses, “interest rates have to go up to cover them” (163). The small loans will a normal interest rate don’t effectively cover the complete cost of checking up on the borrower. Banerjee and Duflo state:

As a result, the smaller the loan, the larger the monitoring and screening costs will be as a fraction of loan size, and because these costs have to be covered by the interest collect, the higher the interest rate will be.

Similarly to insurance, formal credit creates the issue of adverse selection. The lender, the bank, doesn’t have complete information on how likely the borrower is to pay back the loan, so, therefore, monitoring is needed to ensure the banks collect their money. Costs of lending to the poor continue to rise as screening becomes a necessity. The pressure for banks to monitor risky clients and the miniscule interest rates induce upward pressure on the interest rates. Adding to the issue is the lack of saving in developing countries. The lack of savings results in a shift of the supply curve from S1 to S2, because the amount of savings is a factor of the supply curve. The decrease in supply puts upward pressure on the interest rate. The graph on the right shows an increase of interest rate from 5% to 6%. In addition, the demand decreases because the higher interest rates become less attractive. Demand decreases from 1,200 to 800.

Seok Tae

In the formal market, financial institutions tend to avoid small industries and small-scaled farmers because of their inability to satisfy the collateral requirement. Instead, they tend to target big industries and large-scaled enterprise, who are able to provide collateral in return for loans. However, by doing so, they are also ignoring potential successful people. “Providing access to financial services will stimulate the independence and self-development of poor households and micro-entrepreneurs.” The poor’s living condition would drastically increase and their economic conditions would improve; however this is not the case. In response to the lack of formal credit, these people rely heavily on relatives, savings, and friends. However, their financial aids are usually limited to some degree; even non-profit organizations provides limited financial services. “More than 80 percent of adults in advanced economies have an account at a formal financial institution—twice more than in EMDCs. Within EMDCs, the share of adults with an account or a loan at a formal financial institution is largely skewed toward the top income earners.” The actions of formal financial institution is essentially limiting the growth of the economy. They are suppressing the poor while supporting the growth of the wealthy. Eventually, the economic gap between the poor and the rich would grow exponentially leading to an economic inequality. This situation can be demonstrated through the lorenz graph. In this case, the lorenz curve would shift right as shown in the graph. The area between the line of equality and the curve would increase leading to larger economic inequality.

Joseph

The credit markets of developing countries are significantly different from those of developed countries. The people of such developing countries must resort to alternative methods when obtaining capital to start a business. Third world countries lack a structured credit system by which the majority of the people are capable to taking a loan. New methods like the microcredit has been introduced to solve such problems but its effects has not been significant.

Currently, there are several alternatives to what is natural in the developed credit market. According to Abhijit V. Banerjee and Esther Duflo note that “What is striking is how much the poor repay, compared to the rich, In Chennai, India, when the typical fruit seller reimburses the wholesaler at night for the 1,000 rupees’...she gives him 1,046.9 rupees on average.” With a average interest payment of 4.69 percent per day, such figures are unprecedented in the the developed world. Although microfinancing has been integrated to some degree, people resort to informal sources of credit that in one survey found an annual interest rate of 57 percent. Lending programs have been integrated before between the 1960s and 1980s in India but due to exceptionally high default rates, the programs were discontinued. The lenders are forced to take a different approach in which they must make extra measures to collect information to evaluate and enforce the credibility of the individual where a credit history may not exist. The multiplier effect may make matter worse where the high interest rates lead to more defaults which lead to even higher interest rates. The situation can be better evaluated by observing the loanable funds market. As the supply for loanable funds decrease with less and less banks willing to loan at such high default rates, the interest rates will correspondingly increase.

Robert Picard

What do the poor do to alleviate the problem of insufficient formal credit and what solutions can there be in developing countries? Is microcredit one of them?

The question of how to solve poverty has been on everybody’s mind recently in the last 30-40 years and the great question is, what should we do to help the poor in developed countries get richer and become better off? There is no simple yes no answer to this question, as CEO of Unitus- An NGO like Gramean Bank – says in response to “does credit really work?”. When microfinancing first started with the release of cell phones in the late 20^th century, people thought that this would become the solution to all the of the poor’s problems, but clearly, we are here in 2016 and things haven’t changed drastically. I believe the problem here has to more defined as well. Aggregately we want to think that if you do one thing then the other things occur. Cause and effect. But if we look at all the studies and textbooks on statistics, cause and effect is so rarely displayed that it gives us more insight on to the data at hand and the models at use. Because banks are shut and are very poor methods for the poor to access formal credit, the poor must and willingly do rely on microfinancing organizations like KIVA and Unitus for more options to explore investment opportunities (See Appendix A and B to see what banks look like in these developing communities).

Let’s analyse the problem a bit more. The economic theory holds that the supply and demand of sufficient formal credit is very low. “…in rural India, about two-thirds of the poor had a loan. Of these, 23 percent were from a relative, 18 percent from a money lender, 37 percent from a shopkeeper, and only 6.4 percent from a formal source.”. Now 6.4 percent, that’s a really low statistic. More than 600 percent borrow from a shopkeeper, 300 percent borrow from a money lender, and more than 400 percent borrow from a relative. This doesn’t really add up for some of the numbers. For more information about this crisis, please look at the supply and demand graph in the appendices. As we can clearly see, the problem is that the supply of credit is very low. But why would someone living in a developing country take a loan out from a loan shark who might chare them more than 10 fold what the bank and KIVA might charge them? Well, it’s a problem of trust too. As you’ll see in the rest of my paper, we’ll the other problems in these economies unravel, but the particular solution arrived at in a number of cases.

Appendices

Appendix A – Loanable Funds Market, where point j represents the equilibrium real interest rate

quantity of funds loaned out.

Supply of lenders

Real Interest

Rate (ir)

j

ir_j

Demand from borrowers

LF_j The Quantity of Loanable Funds

Where LF is the quantity of loanable funds at any given point

And j is the equilibrium.

Appendix B – The Investment Demand and Supply graph

Supply of capital

Nominal

Interest

Rate (N)

y

N_y m

N_m

N_z z Demand for investment

L I_m

Quantity of investment

Where m is the equilibrium of the nominal interest rate and the quantity of investment.

Notice the red vertical line that strikes through the x-axis due to banks not trusting the poor.

Where y is the point where the red line intersects the demand for investment curve and z is the point where the red line intersects the supply of capital curve.

Where L represents the imaginary quantity banks lend out to people who want to increase their income through capital investments in their industries.

The triangle shaded by the green lines represents dead weight loss.