Written by Erica Field, Rohini Pande and John Papp, published by The Institute for Financial Management and Research (IFMR) in October 2009, 33 pages, available at: http://ifmr.ac.in/cmf/publications/wp/2010/34_Field_Flexibility_Repayment.pdf
This study examines whether the rigidity of microfinance loan repayment structures inhibits investment in microenterprises. The concern is that a strict repayment structure, designed to keep default rates low, discourages risk-taking, thus discouraging entrepreneurial behavior. In the study, a random set of clients is allowed a grace period of two months before repayment begins, thus relaxing liquidity demands and, theoretically, encouraging greater business investment, as opposed to the use of the loan principal for immediate needs such as schooling or health.
The study analyzes clients from Village Welfare Society (VWS), a microfinance institution (MFI) in the Indian state of West Bengal. The MFI loans only to women and typically charges an effective annual interest rate of 22 percent. Loans are generally repaid through fixed installments that begin two weeks after disbursement. The default rate of the MFI is low, reportedly 1 percent in 2006. For this study, loans were disbursed to 169 groups with five members each, 84 of which were granted the two-month grace period. Loan sizes ranged from INR 4,000 to INR 10,000 (USD 87 to USD 219). All groups were given 44 weeks after the first payment to repay the entire loan.
The main results are as follows: The likelihood of investing in a microenterprise is 8 percent higher for those given a two-month grace period. People who did not invest in microenterprise used the funds for purposes such as health, school or savings. The increased microenterprise investment is seemingly directed toward inputs, mainly inventory purchases and raw materials. The authors believe this is explained by the fact that, although raw materials can produce valuable returns, the demand for the finished product is uncertain. Therefore, raw materials are considered illiquid investments, and their purchase is risky. Thus, a two-month grace period provides a risk cushion that makes the purchase of raw materials more attractive. The “grace period group” is also twice as likely to start a new business.
These clients are also, however, more likely to default on their loan: 16 weeks after the final installment was due, 11 percent of the “grace period group” failed to repay in full, while only 3 percent of the control group failed to repay in full. Again, this is consistent with riskier investments having been made by those receiving a two-month grace period on repayment.
Lastly, the authors use survey data to reach two further conclusions: Firstly, those with a higher discount rate (those that place a relatively higher value on receiving money in the present even if it is less than they could receive in the future) are even more likely to default when given the grace period. Secondly, those who are more risk-averse have higher increases in business investment due to the the two-month grace period.
By Christopher Maggio, Research Assistant