Reading Report # 1

Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor?
Experimental Evidence from India.

- Erica Field, Rohini Pande, John Papp and Natalia Rigol

ECO603: Advanced Econometrics

Submitted to:

Chen Zhihong
Professor, SITE, UIBE

Submitted by:

Syed Nazrul Islam

Student ID: DE201760011

Dated: 25 October 2017

 Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor?
Experimental Evidence from India.
1. The question to be investigated and why it is meaningful:
The paper attempts to investigate the answer of the question whether the immediate repayment
obligations of the classic microfinance model inhibit entrepreneurship, and therefore blunt the
potential impact of microfinance.
Both in developed and developing countries, small businesses or enterprises play an important role
in engendering GDP. However, credit constraints are considered as a barrier for small business
expansion, where the returns to capital are high. Microfinance institutions come forward,
particularly in developing countries, to eliminate the credit constraints with great success in high
repayment rates. But, there is growing evidence that microfinance has had little impact on
microenterprise growth and poverty. The study, shed light to examine this claims focusing on
particular characteristics of microfinance contracts i.e. early initiation of repayment that has not
been demonstrated in any earlier papers. The study, therefore, is a meaningful one for researchers
for to get the micro picture of microfinance.
2. The assumptions of the paper and if they are legitimate:
The paper presumed that with perfect credit markets, introducing a grace period in microfinance
contract should not alter the investment behavior of the borrower. That is, clients are risk neutral. Based
on this assumption the paper describes the experimental design and then, using insights from client case
studies identify the likely effect on investment of a grace period contract. To check the validity of this
assumption, the paper conducts the experiment by dividing the samples randomly in two groups:
namely control group (initiate repayment as per classic microfinance contract) and treatment group
(initiate repayment with 2 months grace period contract). The assumption is appropriate for examining
the research question as the immediate repayment characteristic of classic microfinance model may
limit default and income growth. Moreover, it is also evidenced in the paper that more risk-averse
clients benefit more from a grace period contract.
3. The data set used in the paper:
The researchers conducted their study with Village Financial Services (VFS), an MFI that makes
loans to women in neighborhoods of Kolkata, India. The study randomly selected 169 five-member
loan groups to constitute a sample of 845 clients between March and December 2007. Eighty five
groups of the sample then randomly assigned to the control groups and 84 groups to the treatment
counterpart. They tracked sample respondents roughly for 3 years. They gathered information on
household business activities, socioeconomic status, and demographic status in 3 points in time: at
the beginning of the study (Survey 1), when borrowers completed experimental loan cycle (Survey 2),
and 2 years after the experiment ended (Survey 3).
4. The theoretic model:
The paper does not describe any specific theoretical model.
5. The empirical method:
To carry out the research, the paper constructs three empirical questions. Do poor credit-
constrained entrepreneurs have access to high return but illiquid projects, such that a grace period
changes their investment and profit? If yes, then does the effect of a grace period vary with
characteristics? Finally, does the introduction of such a contract increase risk for the MFI? To
precede the econometric analysis, they first conducted randomization check of the baseline data
(survey-1) which incorporates number of dummy variables.
Then, the researchers construct the following model to treat estimates are the average treatment
effects of being on a grace period contract:
yig= Gg + Bg + Xig + ig, (1)
where yig is the outcome of interest and Gg is an indicator variable that equals one if the group was
assigned to the grace period contract. All regressions control for stratification batch (Bg) and cluster
standard errors within loan group groups. Xig is a matrix of number of explanatory variables which
include marital status, religion, education, household size, household shock, loan size etc. Using OLS
method, the researchers investigates loan use differences and business formation by estimating equation
(1) and reports the results for control groups and treatment groups with grace period dummy. Using the
regression model (1) the paper also estimates (using OLS method) the impact grace period on long-run
profit, income and capital formation, and as well as on default.
The paper, then, conducted heterogeneity tests to examine the testable hypothesis regarding which types
of clients will be more likely to respond to a grace period using OLS method on equation (1).
Finally, the paper also did a supplementary estimation of returns to capital using the results above
estimated results. Their estimation uses de Mel, McKenzie, and Woodruff (2008) specification as-
PROFITSi = CAPITALi + HOURSi + , (2)
They instrument total capital by the grace period treatment and control for labor inputs by including
hours as a covariate.To estimate equation (2), the paper uses both OLS and 2SLS method.
6. The summary of results:
Most of the regression coefficients are found to be significant at 5% and 1% level of significance.
The estimated results show that the average grace period clients invest more of her loan in business;
and a significant decline in nonbusiness illiquid spending by the grace period clients. The effect of
grace period effects on business formation is found as low. However, the likelihood of starting a new
business is almost three times higher among grace period clients.
In estimating the long run effects of investment behavior of the two groups they find that grace
period clients report 57.1% higher profit and 19.5 % higher income and the differences are
significant statistically. Extension of the results to the study of grace period to business capital
reveals that microenterprises in grace period households are 81% higher and the difference is
significant. In addition, the paper finds a robust difference in default patterns between the two
groups. However, the result shows that the grace period clients are more likely to default than
regular clients. The heterogeneity analysis shows that risk-loving clients have higher profits but
they do not benefit from a grace period contract and the returns to capital are estimated as higher in
the risk-averse group. Finally, the paper draws a conclusion that the grace period contract
potentially encompasses two effects: a portfolio effect which makes illiquid investments more
viable and an income effect which increases total repayment time by two months, making it easier
for a client to accumulate income needed for repayment.
In summary, the results of the experiment indicates that debt contracts with early repayment
discourage illiquid risky investment and limit the potential impact of microfinance on
microenterprise growth and poverty.
7. The contribution and limitation of the paper and the possible extension:
As claimed by the researchers, the paper first documented experimentally the interaction between the
nature of high return investments available to the poor and microfinance contract flexibility. The
evidence in the paper supports the view that liquidity constraints limit microenterprises from
exploiting high returns to capital in a developing country setting. More important contribution of the
findings of the paper is that evaluating the economic impact of debt contract design can provide
valuable insights on entrepreneurial behavior and help identify alternative methods of reducing
liquidity constraints.
However, the paper seems have some limitations. More robust estimation can be drawn if the sample
were drawn on different parts of India. Different geographic setting may have different results as the
environment of business opportunities might be different. The paper also did not consider any
regulatory policy on microfinance that may hinder or engender business creation. Furthermore, the
sample only includes female borrowers who have less inclination of doing business. The paper may
be extended by including those parameters.
8. The publication information such as the journal, issue and year:
Researchers: (1) Erica Field ( Department of Economics, Duke University); (2) Rohini Pande
(Harvard Kenedy School, Harvard University); (3) John Papp (Heibridge Capital
Management, NY); and (4) Natalia Rigol (Department of Economics, MIT).
Journal Information: The American Economic Review, Vol. 103, No.6 (Oct. 2013),PP-2196-2226.