Among the proposals announced by FM Sitharaman on Monday, an important element is the credit guarantee program to encourage microfinance institutions (MFIs) to lend to the urban poor.
There is no doubt that the urban poor have been under stress from the pandemic and the resulting economic restrictions. Several commentators have suggested a job guarantee scheme for urban areas to alleviate their distress.
This suggestion is based on the MGNREGA rural employment guarantee system. While MGNREGA has been helpful in alleviating rural distress during the unprecedented pandemic, we must not forget the great inefficiencies that normally flow from the standing law it creates.
Second, the replication of rural MGNREGA in urban areas poses several challenges due to the main differences between rural and urban employment. Unlike rural employment, urban employment is not seasonal. In addition, as skill levels vary widely in urban employment, having a single salary for all will not work as with rural MGNREGA.
Third, an unintended effect of an urban employment guarantee program would be to increase migration to urban areas. Given the differences in the cost of living, the salary under an urban employment guarantee program should be higher than that of a rural program. This difference would increase urban migration.
Contrary to the current conception, an unconditional allocation – such as the disastrous 2009 agricultural loan exemption – is mainly taken up by the least in difficulty and is therefore poorly targeted. Thus, while budgetary resources are spent, the effect on the economy is mitigated because the multiplier effect is minimal. In contrast, a fiscal intervention that uses several advantages offered by the financial sector is inherently more effective than unconditional cash transfers.
MFI data shows that around 2 crore of borrowers borrow from MFIs in urban and semi-urban areas. Thus, MFIs have a wide reach among the urban poor. MFIs know the borrowers and have the business model to access and serve the urban poor.
As the urban poor are typically migrants from other states, high-quality data on them is not available to undertake a targeted money transfer. However, when a loan is granted by the MFI and fully guaranteed by the government, this program simultaneously serves as a cash transfer intended for people in real difficulty and as liquidity support for people temporarily in difficulty.
Why? Because the MFI keeps a register of defaults, borrowers know that defaulting on a loan results in direct and indirect costs for the borrower. For example, research shows that even after the 2009 farm loan exemption, banks significantly reduced lending to defaulters.
Given these costs, only a borrower who is genuinely in difficulty would default on their loan despite the government guarantee. Thus, such a loan creates three categories of borrowers.
First, the people who are not in trouble now and therefore find no benefit in availing the loan.
Second, borrowers who are in difficulty due to the pandemic but will not be in difficulty when the loan is repayable. This category of borrowers would benefit from the loan now and choose to repay given the costs of default.
Finally, some borrowers who are currently in difficulty would continue to be so when the loan becomes repayable. This category of borrowers will avail themselves of the loan and will default on it. In the absence of repayment, the loan is actually a cash transfer.
Note that without the guarantee, the MFI would not lend to the second or third category of borrowers. However, with the guarantee, the MFI would not hesitate to lend to the second and third categories of borrowers.
This discussion thus clearly demonstrates that the secured loan effectively functions as a transfer of cash equivalents to people in real difficulty and liquidity support to people temporarily in difficulty. In addition, people not in difficulty will not benefit from the loan and are thus naturally eliminated.
Default costs are crucial in generating this separation. In the absence of such costs, such separation cannot be achieved. Since costs can only be imposed by allying with the financial sector, such a design helps target intervention on those most in need.
In fact, the enthusiastic adoption of the emergency credit guarantee loan program, as shown in a recent research report by CIBIL, illustrates the effectiveness of this design.
The financial leverage provided by the financial sector also helps to increase the size of the support that can be provided to people in difficulty. The specific scheme provides for loans up to 1.25 lakh. Such significant support cannot be achieved through direct cash transfers.
Finally, government guarantees create contingent liabilities that will be claimed in the future when the economy is in much better shape.
In short, the credit guaranteed by the government makes it possible to target the intervention and thus to use taxpayers’ money wisely. After all, treating taxpayer dollars with as much respect as their own is a key fiduciary responsibility of any economic decision-maker.
The opinions expressed above are those of the author.
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