For most people finance is an obscure, alien subject. And the immediate assumption — if you’re talking about finance — is that you care only about helping the rich get richer.
Yet, research shows that well-developed financial systems are associated with more rapid growth and better income distribution. A well-functioning financial system gives households and businesses access to credit and allows them to link-up with the modern, formal economy. It gives people access to savings and insurance for a more secure life. And then there is the ‘empowerment’ dimension of finance, which gives ordinary people access to opportunities that allow them to live a more dignified life.
In India successive governments have emphasised the role of finance in promoting equitable growth. With the majority of India’s poor living in rural areas, policies aimed at financial inclusion have understandably had a rural focus. Today, India has a vast network of State-owned banks, regional rural banks and cooperative banks that are mandated to intermediate savings and credit for investment, particularly in the countryside and for weaker segments. And while there has been increased competition and liberalisation in India’s financial sector since the early Nineties, some key features of credit planning — quantitative credit targets and subsidised credit — persist for the rural poor and other disadvantaged segments.
Paradoxically, access to finance on affordable terms remains woefully inadequate for large segments of India’s population, particularly for the rural poor. According to a recent study on India by the World Bank and the National Council of Applied Economic Research, some 70 per cent of rural poor households do not have a bank account and 87 per cent do not have access to credit from a bank or other formal institution.
{{/usCountry}}Paradoxically, access to finance on affordable terms remains woefully inadequate for large segments of India’s population, particularly for the rural poor. According to a recent study on India by the World Bank and the National Council of Applied Economic Research, some 70 per cent of rural poor households do not have a bank account and 87 per cent do not have access to credit from a bank or other formal institution.
{{/usCountry}}A key problem is that the government’s imperative of deficit financing has driven banks to divert financial resources to safer government bonds. Also, there are perhaps not enough incentives for public sector banks to do business, particularly with the poor. Procedures for opening an account or seeking a loan are made cumbersome and costly. And banks invariably demand collateral, which the poor lack. Not surprisingly, money-lenders, who charge exorbitant rates of interest remain a strong presence in rural India.
The challenge of ensuring that all Indians have access to the financial services they need is clearly enormous; micro-finance programmes can make an important contribution to meeting this challenge. Estimates suggest that Indian micro-finance currently reaches about 12 million customers directly through credit services. This, however, is sorely inadequate in a country where 300 million people live in poverty. In contrast, micro-finance in Bangladesh is believed to reach more than 60 per cent of the poor across the country.
Some fresh thinking on the subject is necessary. There is a need to build strong micro-finance institutions. This entails improving governance, professional management, strengthening internal controls and accounting practices, and introducing low-cost ways of doing business. The biggest hope on cost reduction comes from new technology — for example, transferring funds via mobile phones or debit cards for the poor.
These efforts must go hand-in-hand with improvements in transparency. This means better information to both clients and lenders on interest rates, loan problems, and operating practices.
A third priority is for micro-finance to expand beyond credit into a wider range of financial services for the poor, including savings, insurance, money transfer, remittances, etc. Today, only a few micro-finance institutions in India are seriously offering insurance or remittance services, even though the demand for such services has increased.
Governments need to ensure that regulatory and supervisory policies genuinely support access to finance for the poor. One common temptation is to impose ceilings on the rate of interest that can be charged on micro-loans. While such ceilings may appear to ensure cheap credit for poor people, in practice, they reduce the supply of credit, especially to the poor, who are driven instead to borrow from money-lenders whose rates are not capped and whose collection methods are notorious. Interest rate ceilings can also reduce the transparency of the cost of credit to borrowers, as lenders evade the caps by adding various service charges and application fees.
The RBI’s recent decision to leave interest rates on micro-finance to the discretion of the lending banks is praiseworthy. However, the challenge remains to implement this policy uniformly across all states. Micro-finance can clearly play an important role in improving access to finance for India’s poor, it is not a substitute for an efficient formal financial sector. After all, over the longer run, micro-finance clients will need to graduate to banks where they can access standard loans of larger sizes. So, along with efforts to expand sustainable micro-finance, a new wave of reforms is needed to improve the efficiency of India’s banks and other formal financial institutions so they can serve under-served sectors in a profitable and sustainable manner. Our estimates suggest that this could raise India’s GDP growth by at least 2 percentage points a year — with a significant impact on poverty reduction.
The writer is Vice President, South Asia Region, World Bank