Download Microfinance and poverty Thorsten Beck Executive summary: While

Microfinance and poverty
Thorsten Beck1
Executive summary: While theory is ambiguous, empirical evidence points to finance being
pro-growth and pro-poor. While the effects of microcredit differ across individuals of
different profile and needs and the aggregate effects are limited, there is evidence for
important indirect effects of financial deepening on poverty alleviation. These indirect effects
come through reallocation of resources and pulling more people into the formal labor markets.
It is therefore important to distinguish between two concepts – Finance for the Poor, where
we should look beyond credit to other important financial services for previously unbanked
population segments and Finance and Poverty Alleviation, where we should focus on longterm indirect effects of financial deepening on economic transformation and consequent
poverty reduction.
1. Finance and poverty – the macro-link
Economic theory is not unambiguous on the relationship between financial deepening and
changes in income inequality and poverty reduction. On the one hand, some models imply
that financial development enhances growth and reduces inequality. These models show that
financial imperfections, such as information and transactions costs, are especially binding on
the poor who lack collateral and credit histories. Thus, any relaxation of these credit
constraints will disproportionately benefit the poor. Furthermore, these credit constraints
reduce the efficiency of capital allocation and intensify income inequality by impeding the
flow of capital to poor individuals with high expected return investments (Galor and Zeira,
1993; Aghion and Bolton, 1997; Galor and Moav, 2004). From this perspective, financial
development helps the poor both by improving the efficiency of capital allocation, which
accelerates aggregate growth, and by relaxing credit constraints that more extensively restrain
the poor, which reduces income inequality. On the other hand, some theories predict that
financial development primarily helps the rich. According to this view, the poor rely on
informal, family connections for capital, so that improvements in the formal financial sector
inordinately benefit the rich. Greenwood and Jovanovic (1990) develop a model that predicts
a nonlinear relationship between financial development, income inequality, and economic
Professor of Economics and Chairman of European Banking Center, Tilburg University and
CEPR fellow.
1
development. At low levels of development, only the rich can afford to access and directly
profit from better financial markets. At higher levels of economic development, many people
access financial markets so that financial development directly helps a larger proportion of
society. This view is also consistent with accounts of economic historians for both the U.S.
and Mexico that show that in the early days of financial development in both countries, the
benefits accrued mostly to bank owners and persons and enterprises linked to them (Haber,
2005).
In general, the empirical evidence has been consistent with a pro-growth and pro-poor effect
of financial development. Aggregate evidence has established a dampening impact of
financial deepening on income inequality and poverty levels. Specifically, Beck, DemirgucKunt and Levine (2007) show that countries with higher levels of financial development
experience faster reductions in income inequality (as measured by the Gini coefficient and
income share of the poorest 20% of the population) and poverty levels (as measured by the
headcount ratio). This relationship goes beyond a simple correlation, as the authors control
for other country characteristics and possible omitted variable and reverse causation bias with
instrumental variables and panel techniques. And the relationship is not only statistically, but
also economically significant, as shown with a comparison of Chile (Private Credit to GDP =
47%) and Peru (Private Credit to GDP = 17%). In Chile, the percentage of the population
living on less than $1 decreased at an annual growth rate of 14% between 1987 and 2000. In
Peru, the Headcount increased at an annual growth rate of 14% over the period 1985 to 2002.
Cross-country comparisons suggest that if Peru had enjoyed Chile’s level of financial
intermediary development, Headcount would have increased by five percentage points less
per year, which implies that the share of the population living on less than one dollar a day in
Peru would have been 5% in 2002 rather than the actual share of 12% of the population.
These results are consistent with other work that shows a negative link between financial
development and the level of income inequality and poverty, including Singh and Huang
(2011) for Africa. Specifically, Li, Squire and Zou (1998) and Clarke, Xu and Zou (2006)
show that countries with higher levels of financial development have lower levels of income
inequality, while Honohan (2004) shows that even for the same average income, societies
with deeper financial systems have lower absolute poverty levels. They are also consistent
with Claessens and Feijen (2012) who show that financial deepening is associated with a
reduction of undernourishment through higher agricultural productivity.
Cross-country comparisons have the advantage of providing a good indication of the
economic size of such relationships. However, there are still concerns of omitted variable,
measurement and reverse causation biases that cannot be completely controlled for in such a
setting. Critically, given the relative crudeness of cross-country data and different levels of
measurement quality, it is difficult to explore the channels and mechanisms through which
finance impacts income poverty.
2. Access to finance – the micro-links
Conventional wisdom still has it that any impact of financial deepening on poverty reduction
has to come through direct access to finance for the poor. This is also consistent with theory,
which argues that credit market imperfections prevent the poor from borrowing to invest
more in their own education or the education of their children, which hinders their access to
higher paying jobs (Galor and Zeira, 1993). Similarly, financial imperfections prevent the
poor from becoming entrepreneurs are particularly binding on the poor because they lack
collateral and because their incomes are relatively low compared to the fixed costs of
obtaining bank loans (Banerjee and Newman, 1993). These arguments have been behind the
microcredit movement.
2.1. Microcredit – benefits and risks
The literature on access to credit and household welfare has provided mixed results. One of
the first studies by Pitt and Khandker (1998) of Grameen Bank and two other MFIs in
Bangladesh showed a small but significant and positive effect of the use of credit on
household expenditures, household assets, labor supply and the likelihood that children attend
schools. Subsequent analysis by Morduch (1998), however, using alternative estimation
techniques shed doubt on these findings. Coleman (1999) gauges the effect of branch
expansion of a MFI in Northern Thailand and exploits the fact that six communities had been
identified as future locations for village banks, and that there was a list of self-selected
applicants for loans from the to-be-established village banks. Comparing these borrowers-inwaiting with actual borrowers of existing banks in other villages, Coleman found no
significant impact of credit on physical assets, savings, production sales, productive expenses,
labor or expenditures on health care or education. In a similar study, Cotler and Woodruff
(2008) compared small scale retailers receiving loans from a Mexican microfinance lender
with retailers that have been selected to receive such loans in the future and found a positive
and significant effect of the microlending program on sales and profits only for the smallest
retailers, but a negative effect on larger retailers’ sales and profits.
On a more positive note, Karlan and Zinman (2010) find that expanding consumer credit in
South Africa helped beneficiaries increase income and consumption and keep jobs. On the
other hand, a similar exercise in Philippines (Karlan and Zinman, 2011) that expanded credit
to microentrepreneurs did not show any positive effect on borrowers’ business, but increased
their personal standing within communities and access to informal finance.
More recent evidence has shown differential effects of credit on individuals and households
with different characteristics, linked with different uses of credit. Specifically, Banerjee et al.
(2010) find for a randomized branch expansion program of an MFI in urban India that only
one in five clients used the loans to start up a business and these clients also cut back on
temptation goods, such as alcohol and tobacco. Similarly, existing household businesses that
gained access to credit increased durable expenditures, most likely related to their businesses,
while new clients that did not start businesses consumed more non-durable goods. A similar
exercise in rural Morocco (Crépon et al., 2011) also found differential effects, with existing
businesses reducing consumption and increasing savings, while non-entrepreneurs increasing
consumption. No additional start-up businesses could be attributed to microcredit, which
might point to other constraints beyond finance holding back potential entrepreneurs. Finally,
an attempt at computing the aggregate effects of microfinance has shown large distributional
but very small aggregate effects on growth (Buera, Kaboski and Shin, 2011).
In summary, the initial expectations on microcredit being able to pull millions out of poverty
by giving them access to credit has not been fulfilled. This is partly related to the fact that a
large part of borrowers use credit for consumption rather than investment purposes, as for
example documented by Johnston and Morduch (2008). It can also be explained by the fact
that other constraints within the business environment might be more binding, a topic we will
return to below. Finally, it might be explained by the fact that credit is not the most
immediate financial service that the poor need, a topic we will turn to now.
2.2. Microfinance – looking beyond credit
Early on, critics of microcredit (calling it rather microdebt) pointed to risks of
overindebtedness. In addition, financial diaries - documentation of financial transactions of
the poor over longer time periods – show that poor households see credit and savings as
substitutes, where the former has a large pay-out at the beginning of the contract, while the
latter has the payout at the end, and focus more on the cash flow (Collins et al., 2009).
Therefore, the emphasis has been recently on other financial services, including on savings.
Dupas and Robinson (2011) explore the expansion of savings accounts to assess the impact
on microentrepreneurs and document higher investment among female, though not male
entrepreneurs that gain subsidized access to savings accounts. Ashraf et al. (2010) show that
the introduction of a commitment savings product in the Philippines led to a shift towards
female-oriented durable good consumption.
Another financial service that has recently gained attention is insurance, especially
agricultural and health insurance. Gine et al. (2010) find mixed results from the introduction
of weather insurance in India, where farmer shift toward more rain-sensitive crops that are
riskier but also more profitable. However, farmers with insurance do not increase their input
use. Several other research projects are currently on-going in this area.
A final financial service that has been rather under-researched and often undervalued by IFIs
and policy makers are payments services that help the poor link to the market economy.
Anzoategui et al. (2011) find for El Salvador that receiving remittances has a positive impact
on the use of formal saving but not credit services by households. The introduction of M-Pesa
in Kenya has motivated several research projects; Mbiti and Weil (2011) find that M-Pesa use
increases frequency of sending transfers, decreases the use of informal saving mechanisms
such as ROSCAS, and increases the probability of being banked.
In summary, other financial services might as important for the poor as credit, although we
have to learn much more about their relative impact.
2.3.Finance and Poverty Alleviation – indirect channels
In addition to direct benefits of access to financial services, there might also be important
indirect effects. If financial deepening reduces the cost of credit and improves allocation of
scarce capital across the economy, this can have an impact on the structure of economy.
While there is no firm evidence that direct access to credit is always welfare improving for its
recipients, there is some tentative evidence that financial deepening can reduce income
inequality and poverty alleviation through indirect channels. Still on the aggregate crosscountry level, Beck et al. (2011) find that that the negative relationship between financial
depth and changes in income inequality goes through enterprise and not household credit.
Assuming that access to formal credit by microenterprises is more likely to be captured by
household credit, this suggests that the pro-poor nature of financial deepening is primarily
linked through indirect effects. However, this study is subject to the same caveats on crosscountry comparisons already discussed above. Gine and Townsend (2004) compare the
evolution of growth and inequality in a DGSE model with the actual development in the Thai
economy and show that financial liberalization and the consequent increase in access to credit
services can explain the fast GDP per capita growth, rapid poverty reduction and initially
increasing but then decreasing income inequality. Underlying these developments are
occupational shifts from the subsistence sector into the intermediated sector and
accompanying changes in wages. Net welfare benefits of increased access are found to be
substantial, and, though they are concentrated disproportionately on a small group of talented,
low wealth individuals who without credit could not become entrepreneurs, there are also
benefits to a wider class of workers because eventually wage rates increase as a result of the
enhanced access to credit by potential entrepreneurs. Beck, Levine and Levkov (2010) find
similar evidence for the U.S., where branch deregulation in the 1970s and 1980s resulted in
lower income inequality. Credit expansion following deregulation led to an increase in labor
demand, which fell disproportionately on unskilled, lower-income households whose wage
rates and working hours increased. These labor market reactions to financial liberalization
can thus explain the tightening in income inequality. In addition, recent evidence also
suggests that financial deepening can contribute to employment growth in developing
countries, consistent with the studies for Thailand and the U.S. (Pagano and Pica, 2011). This
line of research on indirect effects of financial deepening on poverty reduction through
capital reallocation and labor market effects is still in its early days. The fact that two studies
with very different methodologies (micro-based DGSE and difference-in-difference
regression model) and two very different countries (Thailand and U.S.) result in very similar
findings, however, suggests that such effects are indeed important.
2.4. Financial institutions for the poor
The debate on the channels through which financial deepening can help reduce poverty also
concerns the financial institutions that are most conducive to help reduce poverty. For the
aggregate concept of Finance and Poverty Alleviation, working through indirect effects,
banks and other non-bank institutions providing long-term finance, such as contractual
savings institutions, are important, as are financial markets. For expanding outreach to the
poor, the focus has been for a long time on microcredit institutions, both for costs and
technology reasons. MFIs have a much lower cost base than brick-and-mortar banks, are
geographically and socially closer to their client and have lending techniques, such as group
lending that might be more appropriate for the poor. A few papers have explored possible
efficiency-outreach trade-offs in microfinance institutions (e.g., Cull et al., 2008; Hermes et
al. 2011). Cull et al. show that the institutions that focus on the poorest segment of the
population face the highest costs, which translates into high interest rates and low
profitability, which ultimately does not make them interesting for private investors. Similarly,
Hermes et al. provide evidence for a trade-off between outreach and efficiency among MFIs.
More recently, however, the institutional focus has widened beyond classical microcredit
institutions. The cooperative model where members are both savers and borrowers and tied
through common social or geographic bonds has been successful both in the developed world
(see Germany, Austria, Netherlands etc.) but also in the developing world.
While banks have been long seen as incapable of going down-market, recent developments
have shown the contrary, as described by Beck et al. (2011) for Africa. Many commercial
banks have therefore progressed past traditional products and delivery channels and recently
adopted new products and delivery channels. In The Gambia, Oceanic Bank offers deposit
collection services, providing traders and other small-scale businesses with a condaneh (or
box, in the local parlance) in which they store their daily revenue and which is picked up in
the evening by a bank employee. In Ghana, Barclays Bank has piloted an initiative to make
microloans to susu collectors for on-lending to the clients of the collectors. Commercial
banks have also initiated cooperative efforts with MFIs or directly started them. One
successful example is the partnership between Ecobank and ACCION International in
Cameroon that was formed in April 2010. Absa has moved into South Africa’s
microfinance market and, in partnership with CompuScan, built Microfinance Enterprise
Service Centers, which are freight containers functioning as rural mobile lending outlets.
Finally, recent innovations have opened up new delivery channels for financial services that
have also broadened the universe of possible financial service providers, with telecom
companies, such as Vodafone entering the payment service market.
2.5. Conclusions
Taken together, the empirical evidence so far suggests an important difference between two
concepts – Finance and Poverty Alleviation and Finance for the Poor. By changing the
structure of the economy and allowing more entry into the labor market by previously
unemployed or underemployed segments of the population, finance helps reduce income
inequality and poverty, as discussed above. By doing so, financial deepening can help
achieve more inclusive growth and also help overcome spatial inequality in growth benefits.
It is thus important to understand that the effects of financial deepening on employment and
poverty alleviation do not necessarily come through the “democratization of credit” but rather
a more effective credit allocation. This also implies that microcredit is not necessarily the
most important policy area to reap the benefits of financial deepening for poverty alleviation.
For the poor to benefit directly from financial sector deepening and broadening (Finance for
the Poor concept) it is important to look beyond credit to other financial services that are
needed by the poor, such as simple transaction or savings services. While it should be a goal
to achieve access to basic transaction services for as large a share of the population as
possible to thus enable them to participate in the modern market economy, the agenda in
boosting access to credit should focus on improving the efficiency of this process, replacing
access through political connection and wealth as it still happens in many developing
countries with access through competition. By channeling society’s resources to the most
credit-worthy enterprises and project, the financial system can enhance inclusive growth.
The evidence so far also suggests that even when talking about outreach to the poor (Finance
for the Poor concept), we should look beyond microfinance institutions to a broader set of
financial institutions, including banks. Technology has revolutionized the economics of retail
banking, which suggests looking beyond traditional financial institutions to new delivery
channels for financial services.
3. Methodological remarks
When assessing the impact of finance (be it direct or indirect) on poverty, the main challenge
is the identification of cause and effect and - even more importantly – to be able to control for
unobserved effects. Take the example of two countries, one of which is experiencing
financial deepening and sees poverty level fall, while the other is not. Can the drop in poverty
be attributed to financial sector deepening or some other policy reform undertaken
simultaneously? Has the reduction in poverty resulted in higher demand for financial services
and thus financial sector deepening? Econometricians have developed sophisticated models
to address these challenges, but even then there are limitations related to data availability and
measurement biases. Researchers have therefore increasingly focused on country-level
studies, which allow to control for measurement biases as data come typically from one
source and allows to control for unobservable country-level factors. However, even there it is
difficult to link a relatively general phenomenon, such as financial depth to specific outcomes
such as poverty reductions. Researchers have therefore been looking for specific policy
changes that were implemented in a staggered and “quasi-randomized” manner, i.e.
orthogonal to the outcome of interest, within a country. Alternatively, one can consider
differential effects of a policy introduction on sub-national entities of different characteristics.
The important thing to note is that such “experiments” can be hardly planned in advance, as
they are mostly subject to political processes. Institution building on a more micro-level, on
the other hand, could be implemented somewhat under the control of researchers in a way
that allows meaningful assessment of the impact.
A similar challenge arises when measuring the effect of access to finance on the individual
level. Comparing an individual before and after gaining access to financial services does not
control for other changes. Comparing individuals with and without access does not control
for selection bias. By randomly assigning people to the treatment (access) and control (no
access) groups and comparing outcome variables before and after the treatment, randomized
experiments can control for such observable and unobservable effects. Randomized control
trials (RCTs) have been extensively used to link access to finance to welfare results on the
micro-level and many of the findings described above are based on such RCTs.
There are several short-comings of such RCTs, as pointed out by many observers (e.g.
Ravallion, 2011) and not limited to RCTs on microcredit. First, there is the issue of external
validity; what works in India might not work in Pakistan, what works in rural areas might not
work in urban areas. In addition, RCTs are being undertaken in small areas; rolling the
treatment out to larger areas or even a whole country might trigger second and third round
effects whose direction is not clear (Buera et al., 2011). Second, RCTs measure mostly shortterm immediate effects, partly explained by the fact that participating MFIs do not want to
leave the control group unserved for too long. However, to measure the immediate impact, it
can still be considered the “gold standard”. As they are very costly, their use also faces
budgetary limitations. As alternative, quasi-experimental set-ups, exploiting certain
restrictions on lending programs, staggered introductions or changes in the program might
provide the necessary exogenous variation and allow proper identification of the effects.
4. Conclusions
By now, there is solid evidence that financial deepening can contribute to poverty alleviation.
The debate is still on the channels. There is also a realization that the impact of finance can
help on several levels, the aggregate level, where financial depth can help transform
economies and thus pull millions out of poverty through effects on labor markets, but also on
the micro level, by giving people access to the necessary financial services. This also points
to different policies having effects on different levels. Fostering financial depth through the
necessary macroeconomic and institution building policies can ultimately make an important
contribution to poverty alleviation. Enhancing competition within the financial system can
foster the necessary financial innovation that drives outreach to previously unbanked
population. Helping specific financial institutions increase outreach in a sustainable manner
can have a direct impact on the institution and its clientele, but also on the whole financial
system through demonstration effects (though possible anti-competitive effects from marketdistorting support have to be avoided). Evaluating such interventions and policies become
increasingly difficult as we move from the micro to the macro-level.
What does this imply for impact evaluation of IFC interventions? It is important to pin down
the different transmission channels of impact and the different aggregation levels. First, is the
intervention aimed at changing behavior (e.g., more savings, different consumption patterns,
more efficient use of capital or empowerment of women) and/or directly at increasing welfare?
If the latter is the case, it important to state how this effect is to come about (e.g., higher
profits of microentrepreneurs, better health or more stable consumption). A second important
step would be to clearly lay out the time horizon, over which such an effect can be expected
and whether it is sustainable (e.g. permanent behavioral changes)? Third, the effects might
come about on different aggregation levels. There can be direct (and more immediate and
short-term) effects on the client-level.
There can also be effects for the broader community through second-round effects on product
and labor markets, though it is not always clear whether these effects are strictly positive. By
helping financial institutions, interventions can also have an impact on the financial sector,
through efficiency gains, demonstration effects and higher competition, effects, though, that
might take longer to materialize. It is important to state these different channels and effects
and identify indicators through which changes can be appropriately captured.
Beyond interventions on the level of the financial institution, IFC also undertakes broader
policy interventions (e.g. credit registries), which can also have effects through different
channels and over different time horizons. This is discussed in more depth in the SME
Finance and Poverty note.
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