Ban on micro-finance; Consumption drops 20% in AP

Written by Renuka Sane | Susan Thomas | Updated: Aug 10 2013, 08:01am hrs
In recent decades, there has been a rapid growth in the micro-credit business by financial firms utilising business models such as the joint-liability structure to lend to low-income households. The higher levels of credit access ought to have been an unambiguously superior outcome. In reality however, these developments have been marred by concerns about consumer protection. Policy makers have grappled with these questions worldwide, and have often implemented a variety of interventions, ranging from relatively subtle rules on consumer protection to restrictions. The role for new kinds of micro-credit firms, and the optimal public policy response to these, has relevance worldwide.

The existing research evidence on these questions is drawn from three strategies: randomised trials, general equilibrium models and natural experiments. Randomised trials are inevitably limited by the magnitude of research budgets, general equilibrium models do not examine all channels through which credit can matter, and the existing papers which utilise natural experiments are often forced to use proxies for consumption. The contribution of this paper lies in utilising a large natural experimenta complete ban on micro-finance in the Indian state of Andhra Pradesh (AP) that has the population of Germanyand in having high quality measurement of consumption through a panel dataset of 150,000 households observed every quarter all over the country. The ban was imposed in only one state, giving us controls from other locations in the country.

The results suggest a fairly large negative impact of the ban on micro-finance. In AP, consumption dropped by 19.5 percent over the first four quarters after the micro-finance ban. The impact of the ban is visible across all income classesincluding those which use little micro-credit themselveswhich suggests general equilibrium effects. While the ban on micro-finance was initiated by policy makers in AP under the claim that this would help poor people, it has hurt everyone.

There are intriguing analogies between the experiment in APwhere a subset of society that was using micro-finance abruptly lost credit accessand the macroeconomics and finance literature on deleveraging (Eggertsson and Krugman, 2012). The deleveraging literature focuses on what happens when some borrowers in a country are highly indebted and face an abrupt shock to credit access. The difficulties faced by these borrowers impacts the economy at large, and the consequences are not restricted to just the set of borrowers. The natural experiment that we have examined in AP appears to have some similar characteristics. Only a subset of the population was borrowing from micro-finance institutions, but when an abrupt loss of micro-credit access took place, it generated negative consequences across all income classes in AP. There was an adverse impact upon welfare through reduced consumption and through enhanced consumption volatility.

A drawback of the analysis is that we only observe household aggregates at the level of geographical areas and income classes, rather than individual households. Record level data might reveal that welfare is improved without micro-finance, for certain households. For example, we know that for the income class with the highest use of micro-credit, there was a negative impact on food consumption, while for households in the income class with the lowest use of micro-credit, there was no significant impact. Since we lack household level records, we cannot distinguish between a bigger impact on the households that directly used micro-finance, and indirect effects on their peers in the same income class. When such data is eventually released, these effects could be measured.The findings in this paper suggest that the overall average treatment effect associated with banning micro-finance in Andhra Pradesh was negative. One lesson is that a blunt policy instrument, such as a complete ban of micro-finance, is inadvisable. In the global debate about the welfare consequences of for-profit micro-finance, this would suggest that extreme government restrictions are ill-advised. Thus, even though this analysis does not rule out the potential presence of market failure in the form of weak decision making by some poor people, the optimal response to market failures involves a more subtle approach of consumer protection, rather than the blunt instrument of a ban. These questions are important avenues for future research.

Extracted from the Indira Gandhi Institute of Development Research report The real cost of credit constraints: Evidence from micro-finance