<b>Raghav Gaiha &amp; Katsushi Imai:</b> The crisis of the sub-prime

Why poverty will rise

As crisis-hit banks cut back on lending to agriculture and raise interest rates for the poor, poverty levels will rise.

That the rampaging financial crisis has turned into a crisis of confidence is beyond dispute. Despite extensive interventions by governments and monetary authorities, the supply of credit has shrunk, stock markets have recorded dramatic losses, and a major downturn in the global economy is highly probable. Commodity prices have eased from recent peaks and large exchange rate realignments have occurred. However, there are few investigations of the (potential) effects of this crisis on the poor and undernourished. A notable exception is a recent World Bank Study (Weathering the Storm: Economic Policy Responses to the Financial Crisis, November, 2008). As this is essentially a broad brush treatment, and abounds in vague generalisations, a distillation of recent empirical evidence on the linkages between finance and poverty is given here. Attention is also drawn to the potential of appropriate design of microfinance schemes to ensure that the trade-off between financial viability of MFIs and outreach is minimised. In the recent literature, financial development is measured as credit by financial intermediaries to the private sector divided by GDP (or private credit-to-GDP). Thus, with some caveats, private credit captures the amount of credit channelled from savers, through financial intermediaries, to private firms/entities. [For further details of these studies and our own analysis, see Katsushi Imai, Raghav Gaiha and Ganesh Thapa (2008) “Financial Crisis in Asia and the Pacific Region: Its Genesis, Severity and Impact on Poverty and Hunger”, Economics Discussion Paper Series (EDP-0810), University of Manchester]. Briefly, the main findings are:

 

 

 

Greater financial development is associated with poverty reduction. In fact, 60 per cent of the impact of financial development on the poorest quintile works through aggregate growth and 40 per cent through reduction in income inequality.

 

Moreover, (i) private credit has about one quarter of the impact of GDP per capita on undernourishment. This is large, given that private credit also increases GDP per capita substantially. (ii) Agricultural productivity/yield is an important channel and accounts for 26-55 per cent of the impact of private credit on undernourishment. (iii) Private credit contributes to productivity by enabling greater use of fertiliser and tractors — about 60-63 per cent of the impact of private credit on productivity is due to these two inputs. (iv) The distribution of banking outlets—as a measure of access to credit— makes a difference too.

So, to the extent that credit contracts—especially agricultural credit— there are likely to be significant unfavourable effects on agricultural yields and poverty.

Another important channel is microfinance. It allows the poor to protect, diversify and increase sources of their income. Besides, it mitigates vulnerability to extreme fluctuations that are a feature of their daily lives. Loans, savings, and insurance smooth out income fluctuations and stabilise consumption levels even during lean periods. Some important findings are: (i) Individual-based MFIs seem to perform better in terms of profitability, but the fraction of poor borrowers and female borrowers in the loan portfolio is lower than that for group-based institutions. (ii) A rise in interest rates, above a certain threshold, leads to a worsening of portfolio quality in case of individual-based lending, whereas this is not the case for the group-based institutions. (iii) Individual-based MFIs, when they grow larger, focus increasingly on wealthier clients (mission drift) but group-based MFIs are less so. Hence design of MFIs matters—especially when there is some apprehension that their financing may be cut.

In fact, a recent review (E Littlefield “Microfinance and the Financial Crisis”, CGAP, November, 2008) lays bare this apprehension. Many MFIs are financed by local and international banks. The latter have begun withdrawing loan offers, cut credit lines, or raised interest rates. The rate increases have been steep in some regions-for example, 450 basis points in South Asia. Arguably, it would not be long before domestic banks pull back too.

In conclusion, before the carnage gets worse, there is little risk of overstating the case for a financial architecture that offers greater protection to the poor and vulnerable.

Raghav Gaiha is a Visiting Fellow at the Centre for Population and Development Studies, Harvard University; and Katsushi Imai is a Lecturer in Economics at University of Manchester