Perplexed about Over-Indebtedness – Part 1

For the past year or so I’ve been thinking a lot, and talking to a lot of people, about over-indebtedness: are microlenders getting a lot of borrowers in trouble? The process has been both intriguing and frustrating. I’ve found it devilishly hard to get a grip on this question, starting with the basics: what do we mean by “over-indebtedness” in the first place? I’ll use this and some subsequent blogs to think out loud on the subject. Readers who insist on coherence or conclusions should stop right here.

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I’m worried about over-indebtedness, not just curious about it. Here are some reasons:

1. Eighteen months of reading about financial crises, irresponsible subprime credit, desperate borrowers, toxic assets, and bubbles of various descriptions have sharpened our awareness that not all credit is good.
2. Microcredit delinquency trended upward worldwide during the first half of 2009, and reached scary levels in a few countries.
3. Microlending has expanded very rapidly in some countries, fueled in part by a flood of cross-border debt and equity. Such expansion puts risk management systems under stress.
4. Competition is heating up in a lot of markets. MFIs racing for market share sometimes lower their credit standards. And borrowers may be more willing to default with one lender if they can then turn to another lender for their next loan.
5. My last reason for concern is a more subtle one. Any credit operation will always leave some borrowers worse off: the only way to completely avoid getting borrowers in trouble is to do no lending at all. IF we are confident that microcredit lifts millions of its clients out of poverty, then we should be willing to accept some substantial level of collateral damage in the process.

But the current state of research does not justify confidence that the benefits are that dramatic. It may be that microcredit (and savings) helps most clients, not to escape poverty, but to better cope with it, for instance by smoothing consumption or dealing with shocks. If the benefits of microcredit are more modest than once thought, then we ought to be willing to tolerate a lower level collateral damage in the form of over-indebted borrowers.

All of the above are reasons to think that widespread over-indebtedness might be a problem. But none of them tells us whether it is a problem in fact. The core practical question is, “how can we figure out whether there is serious over-indebtedness in a given microfinance market?”

Next installment: How should we define “over-indebtedness”? Does it just mean non-repayment?


10 September 2012 Submitted by Rati Tripathi (not verified)

Dear Sir, Thank you for looking into this. This is a serious topic and deserves serious dedicated attention. Where microfinance was reviled by the non profit world in the first few decades, now a Vikram Akula gets to meet a Timothy Geithner on this 2 day state visit to India. Why must we swing from one extreme to another? Rati Tripathi (a former microfinance researcher in India)

10 September 2012 Submitted by Daniel Rozas (not verified)

This is an important post, and I too have been thinking a lot about the topic and what it says about microcredit in general. I see over-indebtedness along a range of scenarios:

1. At the far end, one could say a household is over-indebted when total repayment (principal plus interest) exceeds total cashflow minus core expenses (food, minimal housing).

2. The middle-of-the-road case would be when a household does have sufficient cashflow for repayment, but doing so would require reducing their standard of living to a level below what the household had prior to undertaking the loan(s). As an example, foregoing school fees, selling a useful asset, etc.

3. The most common case — a household that is able to make loan repayments without significantly affecting their standard of living, but the effect of the loan is such that their ability to weather moderate economic shocks becomes significantly compromised.

Note that in all cases, I’m considering cashflow comparisons over the term of the loan, presuming that short-term cashflow variations can be dealt with relatively easily by tapping informal markets, such as moneylenders, family, etc.

The first two types of over-indebtedness are relatively easy to identify and thus should also be fairly easy to avoid. It is the latter which concerns me most, since it is largely invisible, and yet it raises important questions about the role of microcredit itself. When smoothing income streams, debt and savings can appear similar (saving down and saving up, in Rutherford parlance). And when there are no changes in a household’s economic situation, the two approaches really aren’t so different. The key difference is in the outlier periods, when a regional- or country-level shock causes a decline in the household’s economic situation. A savings-driven household can combine reduction of expenses and tapping savings to get through such a period. A credit-driven household has more limited choices — first, its access to more credit may be reduced (presumably, MFIs aren’t as keen/able to lend during such periods). More importantly, its ability to reduce expenses is also limited, since with an outstanding loan, it in effect has to continue to fund its prior expenses. Thus, during economic shocks, the belt-tightening required for a credit-driven household is greater than for a savings-driven one.

This naturally brings to mind the appropriateness of credit (micro or otherwise) as an income-smoothing device. I’m not one to denounce it outright, but normally, I’d expect savings to take a front-seat to credit when it comes to smoothing. Doing otherwise would be akin to promoting credit cards over bank accounts in developed economies — something no financial educator would endorse.

When the primary argument for micro-credit was income generation — removing the obstacle of capital constraint to enable the poor to undertake gainful economic activities they otherwise wouldn’t be able to do — the appropriateness of credit was self-evident. That is the main purpose of credit. But now that it’s widely acknowledged microcredit is largely an income-smoothing tool, it appears to me that credit ought to take a backseat and savings become the primary area of focus.

I’m not suggesting dispensing with micro-credit altogether — it has an important role to play, especially in asset- and productivity-enhancing roles such as housing and education, and yes, economic enterprise. Even when dealing with short-term household-level shocks, it may be a useful mitigator when savings are insufficient. However, it seems inconsistent to me that microcredit would continue to be promoted, especially by DFIs and other public funders, as the primary answer to most poor people’s financial needs. Microcredit has proved a great boost in demonstrating that financial services can be sustainably provided to many of the world’s poor — the next step should be to insure that the services provided are the right ones, not just the easy ones.

10 September 2012 Submitted by Ester KI (not verified)

I think MFI should have more information about the microborrowers, and share it with other MFI, in order to solve this problem of people going to the next MFI to ask for a loan, as they are trapped in debt.

Another issue I have considered is the fact that microentreprises are not as stable as big companies, or companies where you are not the owner and you have more responsibilities and your salary is not always fixed. If you work for others, in normal conditions, you will have a fixed source of income.

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