How Sensitive are Service Users to Changes in Interest Rates?

There is a general perception that service users‘ demand for loans do not change much when interest rates increase and that microfinance institutions can raise interest rates without losing clients or suffer mission drift (CGAP, 2003; Dehejia, Montgomery and Morduch, 2005; DFID, 2006). Dehejia et al., (2005) argue that service users are not sensitive to increases in interest rates because they have ample surpluses to mitigate the effect of higher interest rates. The forgoing argument is countered by the position that demand does not change much with increases in interest rates due to the overwhelming demand over supply for credit, especially in most rural communities in developing countries.

There is a general impression among sustainability advocates that poor entrepreneurs earn enough to afford interest at market rates and does not significantly erode the gains of the poor. Morduch (2008) claims the microfinance movement is driven by the singular assumption that poor households have high economic returns to capital. Consequently poor

89 households are capable of paying the high interest rates that microfinance institutions charge in order to survive without donor assistance. Several studies support Morduch‘s argument. CGAP (2002) cites studies in India, Kenya and the Philippines that found average return on investments by micro-businesses ranged from 117 to 847%. Morduch (2008: 3) reports some recent findings that confirm that poor entrepreneurs earn high returns. Returns on male- owned retail businesses in Mexico ranged from 20% to 33% per month. Returns were even higher for businesses identified as financially constrained—70% to 75%. Morduch (2008: 4) next cites a study by Del Mel, McKenzie and Woodruff (2008) in Sri Lanka. This randomized study confirmed findings of the Mexican study: real returns to capital were about 60% per year. Using such findings as basis of charging high interest rates is flawed because the studies have obvious limitations, which Morduch himself concedes. For instance, the studies do not show how they impute costs for own labour. In countries characterized by high unemployment and considerable under-employment, one can easily impute zero price for own labour. Returns to capital will be drastically reduced if own labour is taken into account. Morduch says the studies focus on average returns to capital and conceal the heterogeneity within the population and the fluctuations in returns on capital as a result of seasonality and other factors. Perhaps most surprising of all is the finding that for female-owned businesses average marginal returns to capital was almost zero (Del Mel et al., 2008). Considering that most microfinance service users are women, this finding casts doubt on the validity of the argument on charging high interest rates.

Interest rate sensitivity does vary according to the socio-economic status of service users. Dehejia et al. (2005) conducted a study in the slums of Dhaka in Bangladesh to assess borrowers‘ sensitivity to increases on interest on loans. Using data from SafeSave (a credit cooperative) the study found that poorer service users were more sensitive to changes in

90 interest rates than the less poor borrowers. This meant that when interest rates increased the bank‘s portfolio shifted away from the poorest borrowers (ibid). Further analysis suggested that poorer service users reacted to increases in interest rates by borrowing smaller loans more frequently and repaying loans more quickly than before. This finding contradicts the findings of the CGAP (2002) study. The study does not give much information of the context in which the SafeSave operates. For instance, were there any microfinance interventions available to the poorer categories of people? In other words did poorer service users have alternative financial services? This could explain why they borrowed smaller amounts. Not much contextual information is available to throw light on the findings of the study.

Other studies have contradicted the findings of Dehejia et al (2005). Karlan, Kutsoati and Oliver (2007) conducted a randomised field experiment in urban Accra, Ghana, to assess people‘s sensitivity to interest rate changes. Entrepreneurs were more likely to apply for loans at lower interest rates than at higher interest rates. When the sample was disaggregated along socio-economic lines, poorer service users did not appear to be sensitive to interest rates. Karlan et al (2007) surmised it was probable that the poorer entrepreneurs could not tell the difference between high and low interest rates due to illiteracy. On the other hand, it could be that their profit margins were high enough for high interest rates to significantly affect their demand for loans.

The above studies clearly indicate that poor people‘s responsiveness to interest rate increases is mixed: it varies in the various contexts. The studies suffer from an important defect; they do not give much explanation with regard to how contextual factors influence service users‘ observed decisions. In addition, are there other occurrences within the interventions that that affect service users‘ ability to make informed choices? Do service users themselves have the

91 ability to react to increases in interest rates? The next section attempts to address these questions.