The Enduring Allure of Cheap Credit

Several months ago I was looking forward to attending a conference at ANU in which a number of honours and postgraduate students from universities around Australia would be presenting papers in their areas of research. One of the popular topics was microcredit in developing countries. Having written my own PhD thesis some decades ago on the topic of the financing of small businesses in Indonesia, I naturally took some interest in these presentations.

In an attempt to set the stage for some interesting discussion at the time of the conference, I asked some of these students, well in advance, to think about the following question:

‘Does the current sub-prime loans crisis in the US have any relevance to advocacy of microcredit in developing countries?’

To my considerable disappointment, none of them chose to respond to this intellectual challenge.

So: what is the relevance of that crisis?

The advocates of microcredit and small-scale lending in developing countries, including Indonesia, are always critical of banks for allegedly neglecting potential small-scale borrowers. They complain that the banks are only interested in large borrowers, and that they are too much concerned with the lack of adequate collateral able to be offered as security for loans by small businesses, peasant farmers, petty traders and the like. And they argue, in effect, that banks should not only lend in the absence of such collateral, but that they should also lend at very low rates of interest (perhaps supported by government subsidies).

The essence of the sub-prime loans crisis in the US is precisely that banks have allowed themselves to become heavily involved in lending to individuals or families who have no collateral to offer other than the houses they intend to buy with the proceeds of the bank loans. The amounts loaned were usually very large relative to the value of the house purchased, because the borrowers had little or no savings of their own to invest. The banks were so eager to lend that they were prepared to do so in cases where the individuals concerned did not even have regular employment!

The entirely predictable outcome of all this was that, when market interest rates began to rise, as they do from time to time, the borrowers found that they had insufficient cash flow to meet their now higher loan repayments. As a consequence, the banks began repossessing the houses, pushing down house values in the market, such that many borrowers found themselves not only without a roof over their head, but now having a residual debt to repay by virtue of the fact that the fire sale value of their house was less than the amount they had borrowed.

The implication is obvious. The banks that operated in this manner have harmed themselves and they have harmed the simple-minded families that they seduced into taking out loans far beyond their means to repay. Nobody gains from this behaviour in the long run, other than the mortgage brokers who set up the loans initially but retained no further interest in them. Responsible banks do not in fact make loans to individuals or firms unable to offer adequate security. But it is precisely this that the advocates of cheap bank lending to small and micro enterprises in developing countries want to see.

Indonesia already tried this experiment decades ago, most notably within the Bimas program, a fundamental component of which was cheap loans to farmers. No doubt very popular at the time, the program lost vast amounts of money as a result of non-repayment of loans. It is hardly surprising that commercial banks (other than those owned by governments, perhaps) do not wish to get involved in this kind of lending, despite a considerable amount of pressure from parliamentarians, NGOs, and even from the central bank, to do so. They should be congratulated for their prudent approach to business, not pilloried for their alleged lack of concern for the ‘little people’.