In my last column, I argued that reforms to relax short-term financing constraints for small producers can have a high payoff in terms of economic benefits. Directly improving the business environment for small firms seems more consistent with avowed goals of inclusive growth than letting in large multinationals, though the latter may provide a different set of benefits that come with size and global experience. I looked at the recent development of the factoring industry in India as something to be encouraged and widened.
The topic of financial inclusion is worth considering more broadly than just improving small businesses? short-term financing. Access to financial services is so limited in India that there are any number of areas for reform and expansion. As always with finance, the worry is that expansion will result in instability, but careful institutional reform can minimise the potential risks of reform. A look at some of the proposals for reform of financial sector components, as mentioned in the Union Budget last month, suggest that much is going on in terms of a detailed clean-up and modernisation of legislation, some of which goes back to the 19th century. Besides individual legislative reforms, it is useful also to step back and think about how to serve the objective of inclusive financial sector development.
Perhaps the place to start is households rather than firms. The number of households is much larger than the number of firms, so addressing their needs should get to the core of inclusion goals. Household-level financial experience may also be a natural precursor and training ground for entrepreneurs. In that sense, the focus of microfinance on potential entrepreneurs may be misguided. In fact, recent research by economists such as Abhijit Banerjee and Esther Duflo suggests that microfinance loans are more often for household needs than for business formation or expansion. It even turns out that poor people end up paying a lot for simple services such as having a mechanism for financial savings.
In some controlled experiments, if the rural poor are able to have savings in a bank it has a positive effect on expenditures on education and preventive health care. In other cases, the poor might spend more on consumer durables such as televisions, which sounds less virtuous. The general point is, however, that access to this most basic of financial services allows the poor to manage their lives better, even if it does not produce any Ambanis or Birlas. A further lesson is that financial inclusion should focus on simple, low-risk financial services for the poor, before trying to turn microfinance into an imitation of venture capital.
If there is an obvious demand, why is it not being met? In the case of lending to the poor (or to the rich, for that matter), there are risks which may not be easily measurable and manageable. But why don?t banks do more to provide financial access? Why is India so woefully under banked? It seems that the ?entry cost? for people who have no experience in financial services is quite high, as are other transaction costs of dealing with a bank. And for banks, the cost of adding such customers, as well as the cost of maintaining their accounts, makes them unattractive.
The government has tried to solve the problem by pushing for more public sector bank branches, and this has helped, but often just opening a branch does not solve the ?last mile? problem for potential customers who are poor, and incentive structures within the public sector are not conducive to banks trying particularly hard to serve customers of many kinds (in a somewhat different context, what Rakesh Mohan termed ?lazy banking?).
Is there a solution? Several developments make one hopeful. In addition to the attention being given to financial sector legislative reforms, which can remove archaic rules and impediments to innovation, technological change can significantly reduce transaction costs. The ability to keep track of financial and personal information on smart cards lowers monitoring and management costs. Because India is large and heterogeneous, issues of security and interoperability have made technological solutions slow to take hold compared to countries such as Kenya, but clearly the obstacles can be overcome. The government can move things along by helping to create the needed technology platforms, rather than setting numerical targets that are difficult to monitor and enforce, and may be distortionary in any case.
One area where the government and the Reserve Bank of India should have more confidence is in increasing the level of competition. Competition can increase instability, but if it is transparent and well-regulated, this should not be a threat. The global financial crisis originated in parts of the financial sector where there was little competition, lack of transparency and poor regulation. In the case of increasing access for the poor to financial services, the rewards seem to far outweigh the risks, suggesting the need for rapid reform.
The author is professor of economics, University of California, Santa Cruz