Why the poor need economic reform

Why the poor need economic reform

Nimai M Mehta
The Economic Times , 12 Oct 2004


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 sector.

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 distortions.

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 possibilities.

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 poor.

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 possibilities.

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 foreign investors.

((The author is Visiting Scholar, Centre for Civil Society, New Delhi)