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April 17, 2024

Restructuring microcredit contracts

Should microfinance programs offer larger financial packages to microenterprises?

Tyler Smith

A vendor in Lahore, Pakistan, does business over the phone.

Source: sigalavaca

In the late 20th century, proponents of microfinance had high hopes that small loans to small businesses would be key to lifting people in developing countries out of poverty. Subsequent research poured cold water on the idea that microcredit was a panacea, but advocates have learned from this work and are now exploring ways to structure microfinancial arrangements so that they have a lasting impact.

In a paper in the American Economic Review, authors Faisal Bari, Kashif Malik, Muhammad Meki, and Simon Quinn found that hire-purchase contracts—in which the borrower's share of ownership grows as repayments are made—significantly increased microenterprise assets and profits.

The findings come from a field experiment in Pakistan in which small entrepreneurs with sufficient experience in business were offered financing for business assets, where the asset itself formed the collateral for the loan. This hire-purchase arrangement allowed small businesses to finance assets worth four times the usual microcredit borrowing limit. The researchers compared this treatment group to a control group that received a zero interest loan at the usual borrowing limit.

Figure 3 from the authors’ paper shows the impact of the hire-purchase contracts on household monthly consumption expenditures (left panel) and monthly spending on schooling, such as school fees, books, and other necessities (right panel).

Figure 3 from Bari et al. (2024)

In each panel, the dotted line represents the empirical cumulative distribution function (CDF) for the control group, and the solid line represents the empirical CDF for the treatment group. The CDF depicts the share of the sample at a given level of spending or lower. For instance, roughly 40 percent of the treatment group spent $200 or less on monthly consumption expenditures, while roughly 50 percent of the control group spent $200 or less on monthly consumption expenditures. 

Each panel shows that the treatment group’s CDF is shifted to the right of the control group. This implies that more people in the treatment group spent higher amounts on household consumption and schooling.

The results stand in stark contrast to most previous research on microfinance, according to the authors. Their study contributes to a growing literature suggesting that with appropriately sized and designed financial assistance, microfinance can indeed make a meaningful, long-term impact on poverty.