Small-scale entrepreneurs in developing countries frequently rely on moneylenders for their working capital. They borrow on a daily or a weekly basis, at extortionate interest rates. Development economists have long been puzzled by the ubiquity of such borrowing: “why do these entrepreneurs not save a little bit and then borrow less, given their implicitly high risk-free rate of return to savings”, the researchers ask.
The researchers gave money and a few lessons in finance to market vendors in India and Philippines who were carrying debt at high interest rates, and then checked to see when — and whether — these individuals went back to moneylenders to begin a fresh cycle of high-interest loans.
A clear pattern was seen: “most vendors fall back into debt within six weeks, and two years later the likelihood and volume of borrowing at high interest rates is nearly identical for treatment and control vendors”, the researchers said.
“A brief, focused financial education training does little to mitigate this effect.”
Why do borrowers seem unable to save their way out of debt and, even after getting a windfall grant that lifts them out of their current debt, fall back into borrowing at some point in the following months? The researchers identified five possible explanations, based on data from the experiments.
– One, that the entrepreneurs have such high returns to investment that continuous borrowing at high interest rates is justified from the perspective of long-term profit maximisation. The survey results did not, however, show any marked improvement in the profitability of vendors who received debt relief; nor did they stop borrowing as they approached diminishing returns to investment.
– Two, that they have inconsistent preferences, such as “present biases or temptation challenges”. But the data did not bear this out.
– Three, that borrowers lack a saving technology, like a bank account, to accumulate capital. In the event, they may be falling prey to family pressures or lack of self-control. This hypothesis has been proposed by several others; the researchers could not satisfactorily complete an experiment to test its validity.
– Four, that the vendors did not understand the long-term cost of repeated borrowing at high interest rates. The financial training offered focused on this possibility. In India, vendors with higher mathematical ability were found to be less likely to return to moneylenders in the first follow-up survey.
– Five, that vendors frequently suffer income shocks, which forces them to return to borrowing to ease their financial situation. There was weak evidence to suggest that vendors who were more likely to experience an income shock were less successful at staying out of debt.
Study experiments were conducted in urban market set-ups in Chennai and Cagayan de Oro in the Philippines. The suitable candidates included individuals who were decisionmakers of their businesses, borrowed consistently from moneylenders (at more than 5% per month), and had an outstanding of $ 100 or below in the Philippines and $ 50 or less in India with moneylenders. These vendors were imparted financial training in batches and given money grants to compensate for their debt. Follow-up surveys were conducted between 4-6 weeks after debt payoff and two years.
The results of the study will be helpful to legislators, who must keep in mind issues such as financial literacy while framing policies that primarily affect underprivileged sections of society, the researchers say. If the return to borrowing from moneylenders is a result of unabsorbed income shocks, the follow-up surveys paint a picture of how debt is filling the place that should have been occupied by the insurance market.