The Unknowns of Microfinance Microentrepreneurs and Their Money: Three Anomalies Discussion Bilal Zia (World Bank)

Summary Paper lists some interesting questions: Paper lists some interesting questions: Why do people borrow so often and not save? Why do people borrow so often and not save? Why dont people undertake efficient joint production? Why dont people undertake efficient joint production? Why do people make sub-optimal investment and labor allocation decisions? Why do people make sub-optimal investment and labor allocation decisions? … and provides a list of possible answers … and provides a list of possible answers … and their take on the most likely answer … and their take on the most likely answer

Why dont people save? The puzzle: The puzzle: Overnight borrowing rates are tremendously high, so why dont people consume less today, and invest their savings into working capital tomorrow… Compounding these savings can help eliminate debt… Overnight borrowing rates are tremendously high, so why dont people consume less today, and invest their savings into working capital tomorrow… Compounding these savings can help eliminate debt… Reasons: Reasons: Self control problems – more severe at low wealth levels Self control problems – more severe at low wealth levels Lack of savings instruments Lack of savings instruments Intra-HH bargaining conflicts Intra-HH bargaining conflicts Complexity – people do not understand compounding (some new work on this is being done) Complexity – people do not understand compounding (some new work on this is being done)

Why dont people save? The puzzle: The puzzle: Overnight borrowing rates are tremendously high, so why dont people consume less today, and invest their savings into working capital tomorrow… Compounding these savings can help eliminate debt… Overnight borrowing rates are tremendously high, so why dont people consume less today, and invest their savings into working capital tomorrow… Compounding these savings can help eliminate debt… Reasons: Reasons: Self control problems – more severe at low wealth levels Self control problems – more severe at low wealth levels Lack of savings instruments Lack of savings instruments Intra-HH bargaining conflicts Intra-HH bargaining conflicts Complexity – people do not understand compounding (some new work on this is being done) Complexity – people do not understand compounding (some new work on this is being done) Agreed… but why is this a Microfinance specific problem? (people borrow from payday lenders, daily banks, etc.) Agreed… but why is this a Microfinance specific problem? (people borrow from payday lenders, daily banks, etc.)

Why dont people jointly produce? My take: My take: Diversification of risks – two cows are better than one. Diversification of risks – two cows are better than one. Hypothetical example assumes ex-ante knowledge of ex-post return! Not clear this is the case, especially in more complicated business transactions Hypothetical example assumes ex-ante knowledge of ex-post return! Not clear this is the case, especially in more complicated business transactions Tax based on social capital – dont want to destroy social capital… Tax based on social capital – dont want to destroy social capital… … then why do people still enter joint liability groups? … then why do people still enter joint liability groups? Gine and Karlan (2006) do show evidence of tax Gine and Karlan (2006) do show evidence of tax Also, amt. borrowed may not constitute the entire bread and butter of individual, whereas production typically does Also, amt. borrowed may not constitute the entire bread and butter of individual, whereas production typically does

Non financial market imperfections Improving conditions in related markets can help alleviate poverty better than simply focusing on improving finance… Improving conditions in related markets can help alleviate poverty better than simply focusing on improving finance… Agreed… but again, why is this Microfinance specific? Agreed… but again, why is this Microfinance specific?

Further Anomalies (I)… Pg. 3 of paper: … the picture is one of widespread and frequent short-term borrowing… own capital is not sufficient to finance a minimum scale of business that appears invariant Pg. 3 of paper: … the picture is one of widespread and frequent short-term borrowing… own capital is not sufficient to finance a minimum scale of business that appears invariant

Further Anomalies (I)… Pg. 3 of paper: … the picture is one of widespread and frequent short-term borrowing… own capital is not sufficient to finance a minimum scale of business that appears invariant Pg. 3 of paper: … the picture is one of widespread and frequent short-term borrowing… own capital is not sufficient to finance a minimum scale of business that appears invariant First Order Question: Why do microfinance enterprises not grow? First Order Question: Why do microfinance enterprises not grow?

Microenterprise Growth Inhibitors… Anecdotally, few microenterprises grow beyond subsistence… Why? Anecdotally, few microenterprises grow beyond subsistence… Why? Is it lack of entrepreneurial talent? Is it lack of entrepreneurial talent? Is it contract structure? Is it contract structure? Microfinance institutions focus on minimizing default… Yet, not clear that socially optimal investment allocation will have zero default… Microfinance institutions focus on minimizing default… Yet, not clear that socially optimal investment allocation will have zero default… If penalty for default v. high (socially ostracized, future borrowing disallowed, etc.) People might opt for safe investment rather than one that maximizes returns. If penalty for default v. high (socially ostracized, future borrowing disallowed, etc.) People might opt for safe investment rather than one that maximizes returns. Stuck in Safe Investment trap! Stuck in Safe Investment trap! Repayment begins immediately, but investments often take time to reap rewards. Credit constrained individuals may be unable to undertake high yield investments. Repayment begins immediately, but investments often take time to reap rewards. Credit constrained individuals may be unable to undertake high yield investments.

Further Anomalies (II)… If marginal returns are so high, why dont banks lend to them? If marginal returns are so high, why dont banks lend to them? HHs choose not to borrow (fear of formal, inflexible debt, etc.) HHs choose not to borrow (fear of formal, inflexible debt, etc.) Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty sharply…) Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty sharply…) Although returns are high, variance may also be very high. Although returns are high, variance may also be very high.

Further Anomalies (II)… If marginal returns are so high, why dont banks lend to them? If marginal returns are so high, why dont banks lend to them? HHs choose not to borrow (fear of formal, inflexible debt, etc.) HHs choose not to borrow (fear of formal, inflexible debt, etc.) Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty sharply…) Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty sharply…) Although returns are high, variance may also be very high. Although returns are high, variance may also be very high. This question particularly puzzling since Karlan and Zinman (2006) show that accepting marginally rejected loan clients IS profitable and welfare improving… This question particularly puzzling since Karlan and Zinman (2006) show that accepting marginally rejected loan clients IS profitable and welfare improving…