MICRO-MACRO LINKAGES IN
FINANCIAL MARKETS:
The impact of financial liberalisation on access to
rural credit in four
African countries
Paul Mosley*
1.
Introduction
2.
Linkage
between macro-reform and local financial
markets: a simple model
3.
Tests
of the model: evidence from four African countries
4.
Conclusions
and recommendations
Bibliography
Abstract
Almost every programme of economic reform contains
a financial liberalisation component; but little work has been done to assess
the effects of financial liberalisation on access to credit in individual
markets. We present a model of this
linkage, which predicts that conventional financial de-repression will have no
significant effect on the price and availability of credit in the informal
sector, but that financial innovation in the informal sector will affect such
availability considerably. We test this
proposition specifically against data for the period of financial reform in
four African countries: Uganda, Kenya, Malawi and Lesotho. Such reforms had significant effects on
interest rates, but except in Uganda these effects did not feed through into an
increase in savings rates or in access to rural credit. Such access was, however, favourably
influenced by institutional innovation on the supply side of the market for
small-business and small-farm credit.
Likewise, in two of the case-study countries - Malawi and Uganda -
financial de-repression had insignificant effects on poverty and privatisation
of the bottom end of the credit market on its own had disastrous effects, but
expansion of the supply of smallholder credit had a highly positive
poverty-reduction effect.
1.
Introduction
Especially since
the end of the 1980s, almost every programme of national economic reform, in
industrialised as well as developing and transitional economies, has contained
a financial liberalisation component. The logic of financial liberalisation, in
the simple sense of decontrol of interest rates, is to augment the supply of
savings and increase the efficiency of investment by enabling interest rates to
perform their screening function more effectively. This orthodox view of
financial liberalisation is illustrated in Figure 1: if the interest rate is
allowed to move from its controlled to its equilibrium level, the supply of
savings will increase from s1 to s2, the investment-savings gap (and the dependence
on overseas sources of finance which it implies) will disappear, and so also
will the dubious investment projects which were profitable at the old interest
rate r1 but not at the new rate r2. Hence the quality
of the entire investment portfolio and in time the growth rate of the economy
will increase. An increased growth rate, in due course, will bring down the
supply-of-savings curve and the equilibrium interest rate.
The
experience of financial liberalisation, as conveyed by a range of reviews including
those of this project, has of course not always conformed to this prior
expectation. Those econometric tests which demonstrate a significant positive
influence of financial de-repression on growth (for example Arestis and
Demetriades 1997) are largely confined to industrialised countries. By
contrast, in a number of developing and transitional countries undergoing
financial reform, savings and investment have not increased (Gibson and
Tsakolotos 1992) the availability of bank credit has not expanded (Nissanke
1990 and Kariuki 1995 for Africa; Cho and Khatkhate 1989 for Asia; Mosley 1996
for eastern Europe) and the vulnerability of banking systems to collapse
appears to have been augmented ( Diaz-Alejandro 1985; Lopez-Cortes 1998).
Although not all of these studies rigorously trace through the link between
cause and effect, there is room for anxiety about how the linkages between
financial-sector reform and economic welfare work out for particular
interest-groups.
This
is not surprising, since financial markets in developing countries vary in a
number of ways from the simple model of Figure 1. The most important of these
is that individuals on both sides of the market suffer from imperfect information about individuals
on the opposite side (Akerlof 1970, Rothschild and Stiglitz 1976, Stiglitz and
Weiss 1981): lenders do not know if borrowers will pay loans back, savers do
not know if their money is secure in particular institutions, and neither party
has any means of finding out. These problems assume major practical importance
in developing countries where many potential borrowers cannot offer collateral
and bank failures are common, and where, as a consequence, market failure and
market fragmentation is widespread in the financial sector. In such an environment
conventional financial liberalisation, by definition, can only make a limited
contribution; for financial liberalisation can only ‘unleash’ markets for
financial services if such markets already exist. As a consequence, two gaps
exist in our understanding. At the analytical level, we need to know the effect
of liberalisation on access to credit in
individual markets, since information on what has happened to the supply of savings or credit in the modern sector (the issue tackled by the
authors listed above) will not tell us whether financial reform has increased
access to credit by farmers, or the urban informal sector, or the poor
generally. At the practical level, we can see that reform, if it is to tackle
the problem of imperfect information, needs to include institutional
developments which create new financial markets and regulate the markets which
exist, rather than simply removing directed credit and interest-rate controls;
but what should this additional level of reform consist of? Existing attempts
at institutional development sponsored by aid donors, as we shall see, have
consisted for the most part of attempts to develop markets in government debt
and the shares of commercial companies ; however, by the argument already
developed, these on their own are unlikely to impact in any serious way on
non-formal credit markets, and it is necessary to specify the type of policy
and institutional developments which will improve access to credit by the poor
in particular.
This
paper seeks to fill these gaps in relation to four poor African countries. We
construct a simple model which attempts to understand how financial-sector
reforms have impacted on the rural economy of African countries, and how that
impact can be increased. A particular concern is whether and how the access to
credit of poor rural people (rather than simply access to credit as a whole)
has been affected by financial reforms. The general line of argument will be
that financial-sector reform, in the conventional sense of liberalisation, has
bypassed more than half the economy of most African countries, but that reform
of a different kind, emanating mostly from the NGO sector, now promises to
reach the poor and dispossessed in a much more effective way, providing that orthodox financial-sector
reform does not neutralise it. This kind of reform essentially consists of
institutional innovation on the supply side, but state intervention both by way
of direct supply of credit and by way of intermediation continues to be needed
at the bottom end of the market.
2.
Linkage
between macro-reform and local financial markets: a simple model
As
discussed above, the aim of conventional financial-sector reform (i.e.
liberalisation) is to augment the supply of savings and to improve the quality
of investment by enabling the rate of interest to perform its screening
function, as depicted in Figure 1 above. Debate about whether this has happened
has so far been focussed on the supply and price of credit in the modern sector: plantations, mines, large
multi-national businesses. We wish to extend the discussion to the non-formal
financial sector to examine the interlinkage between the two components of the
financial sector.
Accordingly,
in Figure 2 we set the two parts of the
financial sector side by side, in the two left-hand segments of the diagram.
Segment (a) is simply a photocopy of Figure 1: a depiction of the process of
financial de-repression in the modern sector. Segment (b), is the non-formal
financial market, supplied principally by traditional moneylenders, lending
short-term to a selected group of known borrowers, mainly for consumption, at a
high multiple of the modern-sector interest rate[1].
As discussed earlier, uncertainty about future rates of return and about the
repayment intentions of borrowers is a crucial determinant of the terms of
access to this market. The supply curve, let us assume, is S1: this
is a cost curve, reflecting the costs of borrowing (or taking deposits),
administration and potential default due to the moneylender’s inability to
predict the borrower’s repayment intentions. If borrowers are risk-neutral, let
us assume, the demand curve is D2 : as in part (a) of the diagram,
this is a marginal efficiency of capital function, but its position is only
subjectively and uncertainly known by borrowers, and D2 represents
the mean of the probability distribution of outcomes, in which event the
interest rate will be at r3, some way above the modern-sector
interest rate. In those extreme cases where risk-aversion forces borrowers to
take a pessimistic view of possible outcomes, the demand curve for finance
sinks from the expected value of the marginal efficiency of capital (D2)
to its minimum possible value (D1) and, if the supply curve remains
at S1, the capital market fails in that locality.
We can now introduce new
actors into the story. The government at
least regulates the market for modern-sector credit, and if financial-sector
reform takes the conventional form of de-repression, as assumed up to this
point, then interest rate liberalisation will raise the price, even if it also
increases the quantity, of such credit as moneylenders supply to the informal
sector. This is the first link between the formal and the informal parts of the
financial sector: however, there are potentially others:
·
1 If governments, being unable to control the
activities of the traditional moneylender[2],
wish to make a scapegoat of him, they may drive the traditional moneylender
into the black market (as in Indonesia), in which event the supply curve of
informal credit (S1 in part (b) of the diagram) will move upwards.
·
2 NGOs or government agencies may seek to enter the
market for informal-sector credit in competition with the traditional moneylender.
Increasingly often, in doing so, they have been able to introduce a new lending
technology which both reduces the costs of supplying credit to small borrowers
at any specified level of output (say from S1 to S2 in Figure 2b) and broadens the
range of financial services available to the borrower, from short-term
consumption loans to known individuals to loans of various maturities, savings
and insurance services for all comers[3].
The lending technologies of the so-called ‘microfinance revolution’ are now the
subject of a large literature (Yaron 1990, Christen, Rhyne and Vogel 1994,
Otero and Rhyne 1995, Hulme and Mosley 1996
); opinions vary on what is essential and what is expendable within what
is now a huge range of experiments, but most would agree that freedom to charge
market interest rates, intensive supervision of loan repayment at or near the
borrower’s premises, availability of savings and/or insurance facilities and
‘incentives to repay’ are key elements in the necessary package. If such
innovations are successful in bringing down the supply curve of credit in the
informal sector, then various beneficial things are likely to happen: the
budget constraint of small farmers and informal-sector small businesses is
likely to be moved outwards (as in the top right-hand part of Figure 2),
productivity-raising technologies such as hybrid seeds and power tools can be
adopted, labour absorption is likely to
increase (from L1 to L2
in the same diagram), and through both channels poverty may be reduced, as in
the bottom right-hand part of the same diagram. The rate at which poverty is
reduced will depend on the rate of labour absorption (DL), the ratio of
poor to nonpoor among the beneficiaries (P/NP) and the change in average
incomes, if any, among the beneficiaries.
·
3 Potentially, the profit opportunities offered by
the new microfinance technologies (e.g. borrowing at 10% or less and lending at
40% at very low levels of default) ought also to be attractive to the formal
financial sector (commercial banks, venture capital houses, etc); should this
happen, it would further reduce the formal/nonformal interest rate
differential. However, there is little sign yet of this kind of linkage yet:
except in parts of Latin America, most microfinance continues do be done by
traditional moneylenders, NGOs and government agencies only. The reluctance of
commercial financial houses to enter the field appears strange, given the
profits available (and being made by some micro-finance institutions, such as
the BRI unit desas); it appears to be due to high levels of subjective risk
(Baydas, Graham and Valenzuela 1997; Montagnon 1998) augmented by sheer
ignorance and by a shortage of individuals able to act as go-betweens and
present the financial results of microfinance institutions in a form digestible
by commercial banks. Once the link does materialise, the current disconnection
between formal and informal sectors will melt away. For as long as restrictions
persist, however, on the channels by which the savings of the formal sector can
be transferred to borrowers in informal markets, it is by no means to be
expected that any increases in saving or in formal-sector interest rates will
influence the conditions of borrowing in informal financial markets. This is a
hypothesis that we shall seek to test in the next section.
·
4 Changes in regulatory procedure (for example,
changes in the rules governing the minimum capital requirement for banks to be
established, or for NGOs to be allowed to take savings deposits) will affect
the supply curve for informal sector credit. On the simplest analysis,
relaxations in regulatory procedure will lower the barriers to entry and move
the supply curve downwards; if, however, this results in bankruptcies among
microfinance institutions, the curve will jump back up again, restricting
access to credit markets.
The
following predictions emerge from the above analysis:
1.
Financial
de-repression in the formal sector, of itself, will have no significant effect
on the price and availability of credit in the informal sector.
2.
Other
forms of financial sector reform (e.g. changes in minimum capital requirements)
may have a substantial influence on the price and availability of credit in the
informal sector.
3.
Financial
innovation on the supply side of the informal sector (e.g. microfinance or
institutional linkages with roscas) will have, possibly with a lag, a
substantial effect on the price and availability of credit in the informal
sector.
4.
Changes
in the price and availability of credit in the informal sector, due either to
financial innovation or other causes, will have substantial effects on informal
sector investment, technology and poverty levels.
3.
Tests
of the model: evidence from four African countries
(i) Overall patterns
Table 1 gives an
indication of the character and sequence of financial-sector reform over the
period 1985-97 in four poor African countries: Uganda, Kenya, Malawi and
Lesotho. The initial conditions of these countries varied: Malawi in the early
1980s was almost control-free (to the point where it appeared as the most
virtuous country in a league table of distortions in 44 developing countries
listed in the World Bank’s 1983 World
Development Report); Kenya was moderately control-free, having removed
controls on interest rates in 1983; but Uganda and Lesotho, at this stage,
retained substantial restrictions both on domestic interest rates and overseas
capital movements, with these restrictions in the case of Lesotho being
interlocked with those imposed by the South African government.
The
thrust of government-induced financial reform thereafter was similar, although
the pace of implementation varied. The pressure from the World Bank was
identical in all cases: deregulate interest rates and keep them positive in
real terms, eliminate credit subsidies, broaden the range of financial
liabilities offered by the government and private companies, and increase the
share of the private sector in financial markets: essentially the de-repression
and diversification shown in Figure 2a. The response of the government to these
proposals is shown in Table 1:
Table
1. Financial-sector reforms in four African countries,
1985-97
|
|
Reforms carried out |
|
|
|
(i) orthodox adjustment |
(ii) design innovations on the supply side |
|
Kenya |
Interest rate controls removed, 1983 Kenya Commercial Bank partly sold to public, 1988 Capital Markets Authority established, 1987 |
Kenya Rural Enterprise Programme established by USAID,
1989 Kenya Rural Enterprise Programme’s banking
activities converted into a bank,1998 |
|
Uganda |
Interest rate controls removed, 1993 Selective credit subsidies removed, 1994 |
Commercial bank (Centenary Bank) moves into
microcredit provision, 1992 |
|
Malawi |
Interest rate controls removed,1985 Existing state microfinance institutions
(Smallholder Agricultural Credit Administration and Mudzi Fund) dissolved and
re-established under new private company (Malawi Rural Finance Company), 1994 |
Establishment of Mudzi Fund lending to unsecured
rural businesses, 1990 |
|
Lesotho |
External capital controls removed concurrently
with equivalent changes in South Africa,1996 |
Lesotho Bank (state controlled) begins lending to
selected microfinance NGOs, 1995. |
As will be observed from
the table, ‘ conventional’ financial reforms in the four countries examined
came in two waves. Malawi and Kenya, which even at the outset of structural adjustment
had macro-policy regimes broadly acceptable to the IMF, removed all remaining
controls on interest rates in 1983 and 1995 respectively. (Prudential
regulation did not keep pace with the speed at which banking institutions were
created, and Kenya in 1986 experienced a serious banking crisis requiring the
closure of two banks and the restructuring of half a dozen others). By
contrast, Uganda, which liberalised its foreign exchange rate and price
controls in the late 1980s, left it until 1993 before removing controls on
domestic interest rates, and Lesotho, whose foreign exchange rate and money
supply are tied to that of the South African rand, never had occasion or
ability to impose formal interest controls. It did however offer a range of
subsidised lines of credit to small industries through the Basotho Enterprises
Development Corporation (BEDCO). Financial liberalisation, in such an
environment, principally took the form of the reduction (not the complete
withdrawal) of such subsidies over the period 1994-96.
Side by side with these
measures of conventional liberalisation came a range of measures to expand
institutional capacity. These were of two kinds: policies to diversify the
range of assets in circulation in formal financial markets (such as the
creation of Capital Markets Authorities in both Kenya and Malawi during the
late 1980s) and a range of institutional innovations in microfinance, which
impinged largely on informal financial markets. Except in Malawi (where the
Smallholder Agricultural Credit Administration operated, until 1993, purely as
a wing of the Ministry of Agriculture) these latter initiatives were NGO-
rather than government-inspired: examples include the Kenya Rural Enterprise
Programme family of institutions, the revitalisation of the co-operative
movement in Uganda and the Lesotho Bank NGO initiative of 1995. These will be
considered in more detail later in the paper.
In seeing to define the
effects of the various financial-market initiatives we use two sets of
indicators. In relation to the formal sector, we examine the trend of real
interest rates and savings, both of which liberalisation attempts to influence.
In relation to the informal sector, we use both the ‘volume of credit provided
by agricultural finance institutions’, which provides comprehensive figures
over a considerable period but covers almost entirely loans to better-off,
collateralised cash-crop farmers, and an index of access to credit derived from
a rural questionnaire survey conducted in 1997 in all four countries.
Indicators for the formal
sector are set out in Table 2. There has been some increase in real interest
rates since the onset of financial
liberalisation in all of the four countries sampled; however, only in Uganda
has this been associated with any improvement in the savings rate, which indeed
has fallen drastically in both Kenya and Malawi. This is consistent with the findings of Ostry et al. (1996) and a
range of authors reported in Gibson and Tsakalatos (1994): aggregate savings in
poor countries are typically very weakly responsive to domestic formal-sector
interest rates on account of opportunities for capital flight, the insecurity
of deposits in formal financial institutions and above all a lack of
deposit-taking institutions, willing to handle small sums, in rural areas.
These additional fragments of evidence in support of the hypothesis of
interest-inelasticity of savings will surprise few readers.
Table 2. Financial liberalisation: effects on formal sector
|
|
Period of intensive financial liberalisation |
Real interest rate: three years
three years prior to since reform reform |
Savings
rate: average for
average for three years
three years prior to
since reform reform |
||
|
Kenya |
1982-4 |
-5.0 |
2.1 |
18.0 |
13.0 |
|
Malawi |
1985-7 |
-13.1 |
-5.0 |
11.0 |
4.0 |
|
Uganda |
1992-4 |
-35.0 |
12.0 |
2.3 |
8.5 |
|
Lesotho |
1994-6 |
1.5 |
3.0 |
-10.5 |
-9.0 |
Source:
World Bank World Tables; Lesotho
Policy Framework Paper 1997-99;
Uganda Background to the Budget 1996-97;
Kenya Economic Surveys various.
What is of more interest
is the behaviour of the financial markets in the informal and rural sectors, as
summarised in Table 3. As shown there, the volume of agricultural credit, as
reported by the central statistical office, showed no significant change as
between the pre-financial reform period and the post-financial reform period in
any of our case-study countries, except in Malawi where the volume of
institutional farm credit sank sharply
during the period 1993-6 . (This episode will be examined in more detail
shortly, see Table 4 below and surrounding text.) However, we may also note
that during the periods of substantial expansion of activity by non-governmental
organisations (1990 to date in Kenya, 1990-1 in Malawi, 1992-6 in Lesotho) the
volume of institutional credit to the non-formal sector expanded sharply. These
expansions may be interpreted as shifts in the supply curve of informal sector
credit (S1 to S2 in the notation of Figure 2), rather
than liberalisations of its price.
Table 3. Financial liberalisation and institutional reform: effects on rural
financial markets
|
|
|
Overall
agricultural sector: estimated
credit disbursements ($ million, 1990 prices): |
Small-farm
agriculture only, post-reform (1992-7) |
||
|
|
1.Period of intensive financial liberalisation |
2. Average for 3 years prior to reform |
3. Average for three years since reform |
4. credit disbursements (%change in real terms) Based
on country totals |
5. access measure (%change in real terms) Based
on sample data only |
|
Kenya |
1982-4 |
190 |
182 |
+35 |
+24 |
|
Malawi |
1985-7 and 1994-6 |
121 |
109 |
+98 |
+120 |
|
Uganda |
1992-4 |
116 |
123 |
-67 |
+3 |
|
Lesotho |
1994-6 |
34 |
32 |
-29 |
+6 |
Sources:
for overall rural credit disbursements(columns 2 and 3):
Kenya, Statistical Abstracts various (‘total lending
to farm sector by Agricultural Finance Corporation, commercial banks and
co-operative credit societies’)); Malawi,
Statistical Yearbooks, various (‘Commercial banks advances to agricultural
sector’); Uganda, Financial Statement and
Background to the Budget; Central Bank of Lesotho.
For
small-farm credit disbursements:
Column
4: Kenya: ‘Loans to small farmers’ from Statistical Abstracts, various (e.g. 1991, Table 137)
Malawi: pre 1993 from Smallholder Agricultural
Credit Administration; post 1994 from Malawi Rural Finance Company (see further
table 4 below)
Column
5: the access measure used is percentage of
households sampled having access to any financial
service (savings, credit or insurance) . The data are derived in all cases from
survey questionnaires in one high and one low-potential area, namely the
regions of Dowa and Mwanza (Malawi) Bungoma and Tharaka (Kenya), Iganga and
Soroti (Uganda) Leribe and Thaba-Tseka (Lesotho). The survey was part of an investigation of African agricultural development financed
by the Gatsby Charitable Foundation (U.K.) conducted between January and August
1997, to be published as A Painful Ascent
(Routledge, 1999).
It is useful to
cross-check these findings with on-the ground surveys of access to financial
services, not only because more dollars disbursed does not necessarily mean
more people being able to access credit, but also because more people being
able to obtain credit is potentially quite consistent with a decline in credit
access among the poorest groups. We
have data on access to financial services amongst rural communities in each of
the countries examined, but only for a sample of two or three areas in each country,
as specified in the notes to Table 3, and only for the years 1992-97. These
data, summarised in the final column of Table 3 are broken down by recipient
household in Table 4. We discover:
(i) that
that in the two countries where NGO credit provision has increased sharply over
the 1990s - Kenya and Uganda - access,
in the shape of the percentage of households sampled who have access to
financial services - has risen, from 13
to 25 per cent in Kenya and from
9 to 21 per cent in Uganda. This increase is both supply- and demand-led: the
increase in density of NGOs is itself due partly to the spread of the green
revolution in maize, horticulture and small grains in Kenya and Uganda and to
the growth of rural non-farm industries stimulated by the green revolution.
This holds good both for rural households as a whole and for households below
the poverty line. Note that these data relate to financial services as a whole: access to credit alone is much
smaller than this.
(ii) that
in the two countries where there has been no sharp increase in NGO credit provision
- Lesotho and Malawi - the access percentage has in the former case remained
more or less stable and in the latter case fallen sharply. The reasons for this
are further considered on page 19.
(iii) that
access to credit by the poorest
income groups - the 10% at the bottom of the income distribution - did not
increase over the period 1992 - 97 , in spite of the improvement in access by
individuals below the poverty line.
Table 4. Four sample countries: access to rural credit 1992-97
|
|
% of sampled households with access to credit:
1992 |
% of sampled households with access to credit:
1997 |
Memorandum item: |
||||
|
|
Overall |
House-holds below poverty line only |
Poorest 10% by income |
Overall |
House-holds below poverty line only |
Poorest 10% by income |
Disbursements of unsecured credit by major NGOs (% change 1992-97) |
|
Kenya |
13.1
|
8.0 |
3.0 |
24.9
|
11.1 |
3.1 |
98 |
|
Uganda |
9.2
|
7.0 |
3.0 |
21.0
|
9.2 |
3.6 |
120 |
|
Lesotho |
10.1
|
6.1 |
2.0 |
12.6
|
8.1 |
1.9 |
6 |
|
Malawi |
12.0
|
8.0 |
1.9 |
8.1
|
5.6 |
0.9 |
-29 |
Source: survey
data, as for table 3, column 5.
Before
proceeding let us gather together the threads of the discussion so far.
Financial liberalisation has had the desired effect (from the point of view of
the Washington institutions) on real interest rates, but in most of the
countries we examine has had a neutral effect on savings (country-wide) and on
lending to informal and rural financial markets. Financial innovation in rural
locations, however, does have a strong and significant correlation with both
credit volume and availability. It is possible to argue that this financial
innovation on the supply side does have some synergy with financial
liberalisation of the conventional sort, in the sense that NGOs and other
microfinance institutions need to be free to charge whatever interest rates
they wish in order to cover the (at present very considerable) costs of
institution-building, supervision, experimentation and insurance. Intuitively,
however, we doubt whether this has ever been an important issue on the ground.
The Asian (especially South Asian) syndrome of stringently enforced controls on
interest rates in order to protect poor rural people from exploitation by
rapacious moneylenders[4]
has never been part of the African financial landscape .Freedom to charge
whatever the supplier desires for financial services has always existed, de facto in rural if not in urban
environments; it is the taking up of this freedom by suitably equipped
suppliers which is new, and subject to the caveat mentioned above, this owes
little to liberalisation at the macro-level.
We now wis