The Unknowns of MicrofinanceThe Unknowns of MicrofinanceMicroentrepreneurs and Their Money: Microentrepreneurs and Their Money:

Three AnomaliesThree Anomalies

DiscussionDiscussion

Bilal ZiaBilal Zia

(World Bank)(World Bank)

Summary 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 don’t people undertake efficient joint production? Why don’t people undertake efficient joint production? • Why do people make sub-optimal investment and labor Why do people make sub-optimal investment and labor allocation decisions? allocation decisions?

… … and provides a list of possible answersand provides a list of possible answers

… … and their take on the most likely answerand their take on the most likely answer

Why don’t people save? Why don’t people save? The puzzle: The puzzle:

• Overnight borrowing rates are tremendously high, so why Overnight borrowing rates are tremendously high, so why don’t people consume less today, and invest their savings don’t people consume less today, and invest their savings into working capital tomorrow… Compounding these savings into working capital tomorrow… Compounding these savings can help eliminate debt… can help eliminate debt…

Reasons: Reasons: • Self control problems – more severe at low wealth levelsSelf control problems – more severe at low wealth levels• Lack of savings instrumentsLack of savings instruments• Intra-HH bargaining conflicts Intra-HH bargaining conflicts • Complexity – people do not understand compounding (some Complexity – people do not understand compounding (some new work on this is being done) new work on this is being done)

Why don’t people save? Why don’t people save? The puzzle: The puzzle:

• Overnight borrowing rates are tremendously high, so why Overnight borrowing rates are tremendously high, so why don’t people consume less today, and invest their savings don’t people consume less today, and invest their savings into working capital tomorrow… Compounding these savings into working capital tomorrow… Compounding these savings can help eliminate debt… can help eliminate debt…

Reasons: Reasons: • Self control problems – more severe at low wealth levelsSelf control problems – more severe at low wealth levels• Lack of savings instrumentsLack of savings instruments• Intra-HH bargaining conflicts Intra-HH bargaining conflicts • Complexity – people do not understand compounding (some Complexity – people do not understand compounding (some new work on this is being done) new work on this is being done)

Agreed… but why is this a “Microfinance” specific Agreed… but why is this a “Microfinance” specific problem? (people borrow from payday lenders, daily problem? (people borrow from payday lenders, daily banks, etc.) banks, etc.)

Why don’t people jointly produce? Why don’t people jointly produce? My take: My take:

• Diversification of risks – two cows are better than Diversification of risks – two cows are better than one. one. • Hypothetical example assumes ex-ante Hypothetical example assumes ex-ante knowledge of ex-post return! Not clear this is the knowledge of ex-post return! Not clear this is the case, especially in more complicated business case, especially in more complicated business transactionstransactions• “ “Tax” based on social capital – don’t want to Tax” based on social capital – don’t want to destroy social capital… destroy social capital… • … … then why do people still enter joint liability then why do people still enter joint liability groups? 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 Also, amt. borrowed may not constitute the entire “bread and butter” of individual, whereas production typically and butter” of individual, whereas production typically does does

Non financial market imperfections Non financial market imperfections

Improving conditions in related Improving conditions in related markets can help alleviate poverty markets can help alleviate poverty better than simply focusing on improving better than simply focusing on improving finance… finance…

Agreed… but again, why is this Agreed… but again, why is this “Microfinance” specific? “Microfinance” specific?

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

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

First Order Question:First Order Question: Why do microfinance Why do microfinance enterprises not grow?enterprises not grow?

Microenterprise Growth Inhibitors… Microenterprise Growth Inhibitors… Anecdotally, few microenterprises grow beyond Anecdotally, few microenterprises grow beyond subsistence… Why? 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, Microfinance institutions focus on minimizing default… Yet, not clear that socially optimal investment allocation will have not clear that socially optimal investment allocation will have zero default… zero default… • If penalty for default v. high (socially ostracized, future If penalty for default v. high (socially ostracized, future borrowing disallowed, etc.) borrowing disallowed, etc.) People might opt for “safe” People might opt for “safe” investment rather than one that maximizes returns.investment rather than one that maximizes returns.• Stuck in “Safe Investment” trap! Stuck in “Safe Investment” trap!

Repayment begins immediately, but investments often Repayment begins immediately, but investments often take time to reap rewards. Credit constrained individuals take time to reap rewards. Credit constrained individuals may be unable to undertake high yield investments.may be unable to undertake high yield investments.

Further Anomalies (II)… Further Anomalies (II)… If marginal returns are so high, why don’t banks If marginal returns are so high, why don’t banks lend to them? lend to them?

• HHs choose not to borrow (fear of formal, inflexible HHs choose not to borrow (fear of formal, inflexible debt, etc.) debt, etc.) • Banks lend based on Average Product rather then Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty Marginal Product (diminishing returns may set in pretty sharply…) sharply…) • Although returns are high, variance may also be very Although returns are high, variance may also be very high. high.

Further Anomalies (II)… Further Anomalies (II)… If marginal returns are so high, why don’t banks If marginal returns are so high, why don’t banks lend to them? lend to them?

• HHs choose not to borrow (fear of formal, inflexible HHs choose not to borrow (fear of formal, inflexible debt, etc.) debt, etc.) • Banks lend based on Average Product rather then Banks lend based on Average Product rather then Marginal Product (diminishing returns may set in pretty Marginal Product (diminishing returns may set in pretty sharply…) sharply…) • Although returns are high, variance may also be very Although returns are high, variance may also be very high. high.

This question particularly puzzling since Karlan This question particularly puzzling since Karlan and Zinman (2006) show that accepting and Zinman (2006) show that accepting marginally rejected loan clients IS profitable and marginally rejected loan clients IS profitable and welfare improving… welfare improving…