Ebook Do interest rates matter? Credit demand in the Dhaka slums
The advent of microfinance lending in the last two decades has been hailed as a key development in the fight against poverty. The New York Times (1997) editorial page, for example, has promoted microfinance as “a much-needed revolution” and “the world’s hot idea for reducing poverty,” and the United Nations General Assembly recognized the trend by marking 2005 as the International Year of Microcredit. Microfinance involves new banking institutions that work in poor communities, aiming to achieve both financial viability and transformational social impacts. New credit contracts have led to surprisingly high loan repayment rates (most established microlenders can claim repayment rates well above 95 percent), and economists have focused on the way that the contracts mitigate adverse selection and moral hazard, problems that undermined alternative attempts to lend to poor households without collateral (e.g., Stiglitz, 1990;Laffont and Rey, 2003; Rai and Sjöström, 2003).
But high repayment rates are insufficient to drive a revolution. The key to the expansion of microfinance globally, it is argued, depends on the success of microfinance as a commercial phenomenon, free from subsidy (Drake and Rhyne, 2002; Robinson,2001). The promise hinges as much (or more) on the ability to contain costs and to price loans at interest rates that are high enough to generate profits. Once profitability is in hand, microlenders can expand globally with minimal external support. The logic of this part of the microfinance revolution is built on the idea that poor households are willing and able to pay interest rates for loans that fully cover the costs of lenders. A corollary of this logic is that the poorest borrowers, who also tend to be the most expensive to serve, will pay the highest prices for capital.
Implicit in this argument is a key – and untested – assumption: that poor households of the kind that take advantage of microfinance are not very espensive to changes in interest rates. Specifically, it is argued that poor households primarily seek access to credit, not necessarily “cheap” credit. When poor households are not very sensitive to price changes, prices can be raised without fear of losing the core customer base and suffering from mission drift.2 When that is so, microfinance institutions can offer credit at a sufficiently high interest rate to cover their operating costs and at the same time not merely skim the cream by appealing only to the most eligible borrowers.
In this paper, we test this something- for-nothing view. We take advantage of an unexpected price increase imposed by a lender in the slums of Dhaka to examine the degree to which poor households reduce their borrowing when faced with a higher interest rate.
Other than Karlan and Zinman (2005), we know of no other econometric estimates of interest elasticities for customers in the microfinance market.3 The main methodological difficulty is that the schedule of interest rates seldom varies within a given program, and, when it does change, it does so for everyone across the board. Thus it is typically impossible to disentangle the effect of the interest rate change from broader changes occurring simultaneously (e.g., macroeconomic shocks). It may be possible to compare clients of different institutions who face different interest rates at any given moment, but then researchers face the question of why some customers selected one institution and why others selected another. It is also difficult to disentangle the effects
of non-price differences among programs.
We use the administrative records of SafeSave, an innovative microfinance institution operating in the slums of Dhaka, to address this question. Identification is based on unanticipated between-branch variation in the interest rate. At the time of our study, SafeSave operated three urban branches, with slightly different products and prices in one of the branches. By comparing times at which product rules changed in two locations but not in the third, we can make inferences about the sensitivity of customer behavior to interest rates. The SafeSave data allow a clean comparison based on an unexpected policy change made within a single institution that maintains a uniform philosophy and operating protocol throughout.
Our results suggest that borrowers are in fact highly sensitive to interest rate changes. After controlling for generally upward trends in loan demand, the implied elasticities of loan demand with respect to changes in the interest rate are in the range -0.73 to -0.88, with estimates as low as -1.04. We also find that less wealthy households (as measured by initial savings balances) are particularly sensitive to the interest rate increase (an elasticity of -0.86 compared to -0.26), and consequently that the bank’s portfolio shifted slightly away from its poorest borrowers when it increased the interest rate. The rate increase helped SafeSave to improve its financial condition, but not without a cost in terms of outreach to the poorest clients.
The paper is organized as follows. Section 2 reviews the prior literature and debates on interest rates. Section 3 provides details on SafeSave. Section 4 summarizes our data. Section 5 outlines our identification strategy. Section 6 presents results on the interest elasticity of loan demand. Section 7 concludes.
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