DEVELOPMENT ECONOMICS

DEVELOPMENT ECONOMICS

DEVELOPMENT ECONOMICS

Sponsored by a Grant TÁMOP-4.1.2-08/2/A/KMR-2009-0041 Course Material Developed by Department of Economics,

Faculty of Social Sciences, Eötvös Loránd University Budapest (ELTE) Department of Economics, Eötvös Loránd University Budapest

Institute of Economics, Hungarian Academy of Sciences Balassi Kiadó, Budapest

DEVELOPMENT ECONOMICS

Author: Katalin Szilágyi

Supervised by Katalin Szilágyi January 2011

ELTE Faculty of Social Sciences, Department of Economics

DEVELOPMENT ECONOMICS

Week 11

Credit markets in developing countries

Katalin Szilágyi

Credit markets

• Credit market imperfections as a

characteristics of developing countries

• Imperfect information

• Involuntary default vs. voluntary, stategic default?

• Imperfect enforcement

• Rule of law, institutions?

Demand for loans

• Fixed capital: new venture, increase in capacity

• Working capital: regular liquidity injection

• Consumption loan: sudden drop of income or unexpected costs

• Insurance: pooling risks

Typical feature: agriculture loans

• Formal (institutional) creditors:

• Banks

• Specialized credit institutions

• Major problem: lack of information

• Asymmetric information is a problem if motivation of debtors and creditors are

different (e.g. consumption vs. investment)

• Discrimination against the poorest: collateral demanded, illiquid collaterals not considered

Case study: Thailand

• Problem: poor peasants have access to credit only through local informal

creditors, interest rates very high

• From 1966: state intervention to

promote formal credit (egalitarian and development purposes)

• Share of informal credit dropped from 90% to 50% (1975)

• But: the poorest still have no access to credit

Case study: Thailand

• Local informal creditors have better

information on the debtors, and debtors have better incentives to repay (reputation)

• Formal institutions provide loans for working capital (not for consumption smoothing or fixed capital investment)

• Interest differential is huge (12–14% on formal, 25–60% on informal loans

• Reflects monitoring costs and monopolistic position

Advantages of local informal creditors

• More flexible on collateral (can consider land, even labor)

• Better information on debtors

• Better access to formal credit

• Typical informal creditors

• Communities of friends or relatives

• Voluntary communities of credit and risk- sharing

• Suppliers of production inputs (owners of land)

• Buyers of production goods (traders, millers…)

Theory of informal credit

markets

Theories of informal credit markets

• Monopolistic creditors

• Explanation for high interest rates

• Not much empirical support (only in very small communities)

• Risky credit

• High interest rates may only reflect opportunity costs

• High risk of default (voluntary and involuntary)

• i: interest rate on formal loans L: amount of loan, p: probability of repayment r: interest rate on informal loan

• Zero-profit condition: p (1+ r ) L – (1+ i ) L = 0 → i = [ (1+ r ) / p ] – 1

• Imperfect enforcement may also be a problem

• Empirical experiences: default is rare

Theories of informal credit markets

• Default and fixed-capital loans

• Default is more likely with higher loan amounts and more risky projects

• Higher risk premium decreases the probability of repay

• Creditor may lose contact with debtor

Theories of informal credit markets

• Default and collateral

• Non-standard collateral

• land

• labor

• food, food stamps etc.

• Differences in valuation

• If debtors value the collateral more, no motivation for strategic default

Theories of informal credit markets

• Example: farmer’s land as collateral

• Value for debtor (farmer): VS, value for creditor (landlord): VB

• Farmer’s loss in case of default: F

• Farmer repays if

L (1+i ) < VS + F

• Landlord wants his money back if

L(1+i ) > VB

• Credit is repaid if

VB < VS + F

Theories of informal credit markets

• If both value the collateral high, interest rate can be high

• Default can be strategic (voluntary)

• More relevant feature of

consumption loans

Theories of informal credit markets

• Default and rationing

• Debtor would prefer higher amount of loan

• Creditor would like to make loans to many, and ask for high

interest

• Profit-maximizing

amount for debtor: A

Theories of informal credit markets

• Assume debtor makes decisions for N periods

• Participation constraint: f(L) – L (1+i ) ≥ A

• If always repays: N x [ f(L) – L (1+i ) ]

• If doesn’t repay: f(L) + (N – 1 )A

• Condition to repay: N x [ f(L) – L (1+i ) ] ≥ f(L) + (N – 1)A

• Or: f(L) – [N /( N–1)] L (1+i ) ≥ A (more stringent than the participation constraint)

• Lower N makes the problem more severe

Theories of informal credit markets

Asymmetric information and rationing

• Debtors with different degrees of riskiness (can creditors tell the difference?)

• 2 types (safe and risky), equal population share

• Expected gain from safe debtors: R – (1+i ) L and i₁ = R/L – 1

• Expected gain from risky debtors: p [ R’ – (1+i ) L ]

and i₂=R’/L – 1

Theories of informal credit markets

Asymmetric information and rationing

• Result: i₂ > i₁

• Which interest rate to chose for creditors?

• П₂ = p (1+i₂ )L – L

• П₁ = 0,5 i₁ L + 0,5[ p (1+ i₁)L – L ]

• Creditor chooses lower rate if p < R /(2R’–R)

Theories of informal credit markets

Default and enforcement

• Default is less likely if debtor is more forward-looking

f(L) – L(1+i) > f(L) – [N/(N – 1)]

L(1+i) ≥ A

Theories of informal credit markets

Default and enforcement

• Enforcement depends on debtor’s reputation (social pressure)

• High costs of monitoring in bigger communities is bad for debtors

• Strategic or involuntary default?

Theories of informal credit markets

Interlocking contracts:

• Creditor and debtor related by more than just the loan

• Regular business relation (landlord and farmer trader and landlord)

• Transaction costs are lower

• Enforcement is easier

Alternative credit policies

• Traditional formal institutions are not suitable

• Micro-information (local knowledge) needed

• Solutions:

• Rely on informal institutions

• Design formal microfinance institutions

Extending formal credit through informal creditors

• Advantages:

• Informal creditors are more flexible with collaterals

• Informal creditors have better access to loans

• Have good local knowledge

• Competition is expected

• Local communities can help

Extending formal credit through informal creditors

• Disadvantages:

• Monitoring costs

• Collusion of local players

Microfinance

• Formal credit relying on communal information

• Grameen Bank: microcredit to groups

Grameen model

• Advantages:

• Sequential lending

• Collective accountability

• Self-selection

• Shared monitoring costs

Grameen model

• Disadvantages:

• Sequential lending: co-ordinated default

• Over-insurance

• Rigid schemes

Grameen model

• Viability:

• Administrative costs are high

• Activities are broad (not restricted to finance)

• Solvent institutions

• Performance

• Difficult to measure

• Additional benefits at a relatively high cost

• Identification of poor

• Educational and cultural improvements

• Spillover effects