Topic 3: Credit Markets in Developing Countries
22/10 and 29/10
Nobel prize, Abhijit Banerjee, Esther Duflo and Michael Kremer. Taking economics to the
field of policy making
Introduction
Credit markets do not work. Due to things such as lack of insurance - any negative shock
really easily tips the farmers finances over – no access to banks so money lenders can
charge really high interest rates. The farmers do have assets, the houses have electricity,
they don’t live in extreme poverty so there is something making these markets fail. Farmers
are now planting commercial crops such as cotton instead of crops they can feed their
families which makes them more susceptible to shocks in the economy.
- Why credit market failure in developing countries is so important?
Farmer suicides due to debt: around 200000 farmer suicides due to debt since 1997.
The latest NSSO (59th round) has made the following observation that, “an Indian farmer’s
household has an average debt of Rs.12,585. The Punjab farmers top the list with Rs.41,575
Kerala with Rs.33,907, Haryana Rs.26,007, Andhra Rs.21965
In fact, Andhra Pradesh witnessed highest percentage of farmers under indebtedness (82.0
per cent) followed by Tamil Nadu (74.5 per cent) and Punjab (65.4 per cent). In Karnataka
61.6 percent of farmers are now indebted. In Karnataka 61.6 percent of farmers are now
indebted. Farmers taking loans from money lenders is highest (29 per cent) followed by
Banks (27 per cent) co-operative society (26 per cent) finally from government (3 per cent)
Credit in Nepal. Besley et al (2001)
Table 1 and 2: Informal money lenders play a really important part in urban as well as rural
areas. Money lenders tend to be landlords in rural areas or a shop owner in an urban area.
Inn urban areas most people travel less than an hour to borrow money either from a formal
or informal lender.
Table 3: Social capital plays an important role in rural and urban areas.
Theory
The key rule of the credit market is to links savers to investors. All forms of financial
intermediation, bonds.
What is so special about credit markets?
- Matches talents and skills with resources. In the context of the development world
it’s like for example having a kid that is really brilliant so the parents borrow money
to be able to send the child to school.
- Helps in formation of skills.
- Savings, and investment are therefore key to growth.
- Consumption smoothing which is really important in everyone’s life
Otherwise, your economic outcome is dependent on how much wealth you start out with,
and not innate talent. So credit markets are important for individuals and economies to
reach their full potential. Otherwise if I am not able to borrow we are stuck in a poverty
trap, for example these woman who sell bangles, they would like to scale the business up
, with a shop, but if they can’t borrow money they won’t be able to do so therefore not
earning enough therefore stuck in a poverty trap.
Why are credit markets particularly likely to be imperfect?
- The act of buying & paying up are separated in time
- Some people might be unable to repay
- Some people might be unwilling to repay (asymmetry of information problem)
- Taking people to court is costly.
- There is limited liability - legal limits to how much you can punish there is no credit
score, you don’t end up being black listed
Anticipating borrowers can lie and cheat with little consequences, lenders are more careful
than other sellers. They decide to lend less or do a few things to tell bad and good
borrowers apart:
- Screen (corresponds to adverse selection)
- Monitor (corresponds to moral hazard)
- Threaten to cut out future loans (corresponds to enforcement or commitment
problems)
- Obtain collateral (like a “hostage”)
Implications: Credit markets don’t function efficiently.
Stylized facts
Fact 1. High interest rates in LDCs: rural areas 52%, urban areas 28-68%. Compare to US
rates: 6-14% during 1980-2000.
These high interest rates cannot all be explained by default – the risk of the borrower
(explains at most 7-23% of level of the interest rates)
Fact 2. Informal lenders supply 20-30% of capital needs of small scale firms in urban/semi-
urban areas in India.
In rural areas, a study showed (Dasgupta, 1989) professional moneylenders provide 45% of
credit
Fact 3. A wide range of interest rates prevailing in the same area with no apparent arbitrage
Siamwalla et al (World Bank Economic Review, 1990): study of rural credit markets in
Thailand, found informal sector annual interest rate to be 60% whereas formal sector rate
ranged from 12-14%.
Fact 4. Borrowers are able to borrow only up to a limit for a given interest rate, and are not
given a larger loan even if they are willing to offer a higher interest rate. The very poor are
unable to borrow at any interest rate (Credit rationing)
One explanation for the high interest rates is monopoly. Any market with really high prices
are due to monopoly. This explanation doesn’t really work here, if you look at the data there
are loads of sellers, cooperatives, banks, private lenders, and still a really high interest rate.
However, why charge high interest rates since that kills loan demand? What is the informal
sector doing? Also, public sector banks are present so monopoly power is restricted
More convincing answer - transactions costs creates natural entry barriers.
22/10 and 29/10
Nobel prize, Abhijit Banerjee, Esther Duflo and Michael Kremer. Taking economics to the
field of policy making
Introduction
Credit markets do not work. Due to things such as lack of insurance - any negative shock
really easily tips the farmers finances over – no access to banks so money lenders can
charge really high interest rates. The farmers do have assets, the houses have electricity,
they don’t live in extreme poverty so there is something making these markets fail. Farmers
are now planting commercial crops such as cotton instead of crops they can feed their
families which makes them more susceptible to shocks in the economy.
- Why credit market failure in developing countries is so important?
Farmer suicides due to debt: around 200000 farmer suicides due to debt since 1997.
The latest NSSO (59th round) has made the following observation that, “an Indian farmer’s
household has an average debt of Rs.12,585. The Punjab farmers top the list with Rs.41,575
Kerala with Rs.33,907, Haryana Rs.26,007, Andhra Rs.21965
In fact, Andhra Pradesh witnessed highest percentage of farmers under indebtedness (82.0
per cent) followed by Tamil Nadu (74.5 per cent) and Punjab (65.4 per cent). In Karnataka
61.6 percent of farmers are now indebted. In Karnataka 61.6 percent of farmers are now
indebted. Farmers taking loans from money lenders is highest (29 per cent) followed by
Banks (27 per cent) co-operative society (26 per cent) finally from government (3 per cent)
Credit in Nepal. Besley et al (2001)
Table 1 and 2: Informal money lenders play a really important part in urban as well as rural
areas. Money lenders tend to be landlords in rural areas or a shop owner in an urban area.
Inn urban areas most people travel less than an hour to borrow money either from a formal
or informal lender.
Table 3: Social capital plays an important role in rural and urban areas.
Theory
The key rule of the credit market is to links savers to investors. All forms of financial
intermediation, bonds.
What is so special about credit markets?
- Matches talents and skills with resources. In the context of the development world
it’s like for example having a kid that is really brilliant so the parents borrow money
to be able to send the child to school.
- Helps in formation of skills.
- Savings, and investment are therefore key to growth.
- Consumption smoothing which is really important in everyone’s life
Otherwise, your economic outcome is dependent on how much wealth you start out with,
and not innate talent. So credit markets are important for individuals and economies to
reach their full potential. Otherwise if I am not able to borrow we are stuck in a poverty
trap, for example these woman who sell bangles, they would like to scale the business up
, with a shop, but if they can’t borrow money they won’t be able to do so therefore not
earning enough therefore stuck in a poverty trap.
Why are credit markets particularly likely to be imperfect?
- The act of buying & paying up are separated in time
- Some people might be unable to repay
- Some people might be unwilling to repay (asymmetry of information problem)
- Taking people to court is costly.
- There is limited liability - legal limits to how much you can punish there is no credit
score, you don’t end up being black listed
Anticipating borrowers can lie and cheat with little consequences, lenders are more careful
than other sellers. They decide to lend less or do a few things to tell bad and good
borrowers apart:
- Screen (corresponds to adverse selection)
- Monitor (corresponds to moral hazard)
- Threaten to cut out future loans (corresponds to enforcement or commitment
problems)
- Obtain collateral (like a “hostage”)
Implications: Credit markets don’t function efficiently.
Stylized facts
Fact 1. High interest rates in LDCs: rural areas 52%, urban areas 28-68%. Compare to US
rates: 6-14% during 1980-2000.
These high interest rates cannot all be explained by default – the risk of the borrower
(explains at most 7-23% of level of the interest rates)
Fact 2. Informal lenders supply 20-30% of capital needs of small scale firms in urban/semi-
urban areas in India.
In rural areas, a study showed (Dasgupta, 1989) professional moneylenders provide 45% of
credit
Fact 3. A wide range of interest rates prevailing in the same area with no apparent arbitrage
Siamwalla et al (World Bank Economic Review, 1990): study of rural credit markets in
Thailand, found informal sector annual interest rate to be 60% whereas formal sector rate
ranged from 12-14%.
Fact 4. Borrowers are able to borrow only up to a limit for a given interest rate, and are not
given a larger loan even if they are willing to offer a higher interest rate. The very poor are
unable to borrow at any interest rate (Credit rationing)
One explanation for the high interest rates is monopoly. Any market with really high prices
are due to monopoly. This explanation doesn’t really work here, if you look at the data there
are loads of sellers, cooperatives, banks, private lenders, and still a really high interest rate.
However, why charge high interest rates since that kills loan demand? What is the informal
sector doing? Also, public sector banks are present so monopoly power is restricted
More convincing answer - transactions costs creates natural entry barriers.
