The challenge of financial inclusion
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Inclusion is likely to top the agenda of Indian finance in 2014. Reserve Bank of India (RBI) governor Raghuram Rajan has indicated that financial inclusion will be a key priority. The central bank has constituted a committee headed by Nachiket Mor, which is expected to submit its recommendations shortly. The move by RBI to devise a new framework for issuing bank licences has also been greeted by calls to consider alternative banking models that can target the needy more effectively.
While financial inclusion appears as a noble goal in itself, recent history shows that efforts to drive financial inclusion can be counterproductive unless handled well.
The subprime mortgage crisis in the US that wreaked havoc on the global financial system had its origins in the forced drive for inclusion. It led government-backed agencies to lend to customers with limited ability to repay.
India’s microfinance crisis is another such example. The fact that microfinance institutions (MFIs) operated in under-served areas led to regulatory forbearance in the initial years, leading to excessive lending before the eventual bust.
The dangers of reckless credit expansion in the name of financial inclusion should serve as a cautionary tale for policymakers today. Financial inclusion can be a worthy goal only insofar as it helps reduce poverty levels sustainably. Given that the roots of poverty often lie outside the realm of finance, easing access to credit without addressing real economy constraints is unlikely to either boost growth or help fight poverty. Efforts to drive greater financial inclusion can, in fact, end up harming rather than benefiting those in whose name such efforts are launched: the poor and the vulnerable.
It is better to err on the side of caution in the case of financial inclusion because the empirical evidence on the impact of inclusionary policies is quite mixed. A recent report on financial inclusion by the World Bank shows that the impact of financial inclusion strategies has been quite modest globally. While access to basic financial services does help the poor, throwing easy credit at them rarely raises prosperity in a sustainable way.
The history of the microfinance industry illustrates the limited potential of credit interventions. Studies that assessed the impact of MFIs in recent years found very little impact of microfinance loans on either the growth of microenterprises or on poverty levels. In contrast, the so-called social banking model of yore, involving state-directed credit interventions in developing countries such as India seemed to have had a greater impact both in raising growth and in denting poverty.
The problem with such state-directed efforts, as India discovered, is that lending becomes highly politicized. As a result, while such a model can help in mobilizing savings, it adversely affects asset quality of state-owned banks, posing a threat to the stability of the financial system.
There are thus no easy short-cuts to financial inclusion. Ambitions for financial inclusion need to be tempered because the financial system can grow only as fast as the rest of the economy. Given India’s income levels, it is not doing either much worse or much better than its peers as far as key parameters of financial inclusion are concerned. A cross-country survey by the World Bank shows that 7% of Indians reported taking a loan from a financial institution in the past year and 11% reported saving at a formal financial institution. These figures are roughly similar to the average of lower middle-income countries. The proportion of persons taking formal financial loans is roughly the same across the developing world but the proportion of savers is more skewed, with richer developing countries such as China having a much larger ratio of savers.
Given the low proportion of people who save regularly, India must turn its attention to access to savings. A microsavings account offers the poor a viable alternative to the sundry agents of shadowy financial institutions. It can also boost their ability to invest in their farms or enterprises. In the Philippines, for instance, farmers using commitment savings accounts, which involve relinquishing the use of the deposits for a certain period of time, reported improved use of inputs and better crop sales, according to a recent study. If well-designed inflation-indexed products are available, that can also help boost the savings rate even while lowering gold and real estate investments.
To be sure, credit products can also benefit from innovations. But many of the problems plaguing India’s credit markets lie outside the realm of finance. Better land titling systems and digitization of land records, for instance, can open up access to credit much more than any financial innovation can. It seems far safer and sensible to focus on designing and delivering better savings products to the poor.
India’s ambition of financial inclusion can do with a dose of realism about what the financial sector is capable of achieving.
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