Why the poor need economic reform
The Economic Times, 12 Oct 2004
Nimai M Mehta
Seeking to improve on the long and sorry history of state-allocated credit
and subsidy schemes, policy makers in India and elsewhere in the
developing world have enthusiastically embraced the new mantra of
micro-finance for the poor.
Thus, a recent article in these pages (“The jingle of loose change”, ET,
July 26) offers a vision of micro-finance for the poor along the lines of
the Verghese Kurien-inspired “operation flood” in milk-supply.
Through substantially increased participation to be jointly engineered by
micro-finance agencies, banks, panchayats, regulators and the RBI, a
deluge of doodh (milk) or fungible money for the poor is promised, while
malai (cream) or large interest rate spreads are assured from the churning
to participating banks.
While micro-finance seeks to alleviate existing supply constraints in the
market for credit, more fundamental limitations affecting the poor’s
demand for credit need to be addressed.
The success of any credit programme — whether macro or micro — is based on
the ability (and willingness) of individuals to convert fungible value
into durable, income-earning goods or assets. It is this condition that
ultimately determines the possibility for individuals to enjoy sustained
growth in income and consumption over time.
The poor, however, suffer severe entrepreneurial handicaps that have
limited their ability to convert funds into productive assets. These
handicaps are the combined result of conditions in the informal and formal
In the formal sector, the entrepreneurial handicaps are rooted in an
investment environment, characterised by corruption, heavy regulatory and
tax burdens, factor market rigidities, trade restrictions and price
These conditions, operating jointly, have systematically penalised the
productive use of resources in the formal economy and worked to drive
economic activity into the illegal/informal sector.
The same conditions, furthermore, impose a de facto ceiling on the growth
of enterprises operating out of the informal sector, where investment
activities by the poor are plagued by insecure rights to property, illegal
status of business, and uncertain enforcement of contracts. Hence the
uncertain and rapidly diminishing returns over time typical to the large
informal sector in India.
It is primarily these handicaps, and not a general dearth of savings, that
have kept the cost of funds high for the poor in developing economies and,
by worsening the risk profile of investments undertaken by the poor, have
denied them access to capital funds at “normal” or market rates.
To corroborate this point, a consistent finding from extensive field
interviews conducted by this author during a study on micro-finance and
informal markets in the Philippines, was that the high cost of funds
available from moneylenders was never an absolute constraint for the
enterprising poor, provided they had access to secure investment
The common observation of large interest rate spreads in existing markets
for micro-credit is also a reflection of the insufficient opportunities
for the poor to use their funds productively. It’s also clear evidence of
the fact that economic liberalisation would disproportionately benefit the
The poor, who face very low opportunity costs for their savings overall
and at the margins — due to rapidly diminishing returns from investments
in the informal sector —, are willing to accept the below-market interest
rates offered by banks on their deposits.
A closer look into the informal market for savings in developing
countries, including India, suggests some key lessons that can be
summarised thus: one, the poor suffer severe handicaps in their productive
use of funds; two, these handicaps, in turn, generate a demand for credit
that is of a high-risk and hence commands a higher than market price for
funds that are made available to the poor; and three, the poor need
economic reforms more than the rich if their ability to employ resources
productively is to be increased.
While the mobilisation of savings to provide low-cost loan capital for
micro-lending is clearly important, raising the overall returns to
entrepreneurial efforts ought to carry greater policy weight.
Only genuine reform that removes the host of entrepreneurial handicaps
suffered by the poor and allows them to profitably accumulate
income-earning assets will succeed in raising their income and consumption
The rural versus urban divide over reform or the rich versus poor mandate
for reform is specious and only serves the electoral logic. The urgent
challenge before the Indian polity is one of securing a vibrant and secure
investment environment overall.
Make no mistake about this — the poor in India are as much, if not more,
in need of a better investment environment than are the urban rich or
(The author is Visiting Scholar, Centre for Civil Society, New Delhi)
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