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FM’s policy of guaranteed loans to urban poor is superior to other welfare schemes

Among proposals announced by FM Sitharaman on Monday, an important element is the credit guarantee scheme to incentivise microfinance institutions (MFIs) to lend to the urban poor.

Undoubtedly, the urban poor have experienced stress due to the pandemic and consequent economic restrictions. Several commentators have suggested a job-guarantee scheme for urban areas to alleviate their distress.

This suggestion is based on the rural job guarantee scheme MGNREGA. While MGNREGA has been useful in alleviating rural distress during the unprecedented pandemic, we must not forget the large inefficiencies that stem in normal times from the permanent entitlement it creates.

Extensive research on MGNREGA provides evidence of such inefficiencies. In a democratic polity, permanent entitlements created by schemes such as MGNREGA, the National Food Security Act etc are hard to unwind. An urban job guarantee scheme would suffer the same fate.

Second, replicating the rural MGNREGA to urban areas poses several challenges because of key differences between rural and urban employment. Unlike rural employment, urban employment is not seasonal. Moreover, as skill levels vary significantly in urban employment, having one wage for all will not work as with rural MGNREGA.

Third, an unintended effect of an urban job-guarantee programme would be to increase migration into urban areas. Given the differences in the cost of living, the wage under an urban job-guarantee programme has to be higher than the rural one. This difference would increase urban migration.

In contrast to the current design, an unconditional dole – such as the disastrous farm loan waiver of 2009 – gets cornered mostly by the not-so-distressed and is therefore poorly targeted. Thus, while fiscal resources are expended, the effect on the economy is muted as the multiplier effect is tiny. In contrast, a fiscal intervention that utilises several benefits offered by the financial sector is inherently more efficient than unconditional cash transfers.

Data from MFIs shows that about 2 crore borrowers borrow from MFIs in the urban and semi-urban areas. Thus, MFIs have a large reach to the urban poor. MFIs know the borrowers and have the business model to access and service the urban poor.

As the urban poor are usually migrants from other states, high quality data on them is not available to undertake a targeted cash transfer. However, when a loan is given by the MFI and fully guaranteed by the government, this scheme serves as a quasi-cash transfer targeted to the genuinely distressed and a liquidity support for the temporarily distressed simultaneously.

Why? As the MFI keeps a record of default, borrowers know that defaulting on a loan generates direct and indirect costs to the borrower. For instance, research shows that even after the farm-loan waiver of 2009, banks significantly reduced lending to defaulters.

Given such costs, only a genuinely distressed borrower would default on her loan despite the guarantee from the government. Thus, such a loan creates three categories of borrowers.

First, individuals who are not distressed now and therefore find no benefit in availing the loan.

Second, borrowers who are distressed due to the pandemic but will not be in distress when the loan becomes repayable. This category of borrowers would avail the loan now and choose to repay given the costs of default.

Finally, some borrowers who are in distress now would continue to be in distress when the loan becomes repayable. This category of borrowers will avail the loan and default on it. Absent repayment, the loan is effectively a cash transfer.

Note that without the guarantee, the MFI would not lend to either the second- or third-category of borrowers. However, with the guarantee, the MFI would have no hesitation in lending to the second- and third-category of borrowers.

This discussion thus demonstrates clearly that the loan equipped with a guarantee works effectively as a quasi-cash transfer to the genuinely distressed and a liquidity support to the temporarily distressed. Also, the non-distressed will not avail the loan and are thereby naturally weeded out.

Costs of default are crucial to generating this separation. Absent such costs, no such separation can be obtained. As costs can only be imposed by allying with the financial sector, such a design helps to target the intervention to the genuinely needy.

In fact, the enthusiastic take-up of the Emergency Credit Guarantee Lending Scheme, as shown in a recent research report by CIBIL, illustrates the efficacy of this design.

The financial leverage provided by the financial sector also helps to increase the size of the support that can be given to the distressed. The specific scheme provides for loans up to 1.25 lakh. Such a sizeable support cannot be done using direct cash transfers.

Finally, the guarantees given by the government create contingent liabilities that will be claimed in the future when the economy would be in much better shape.

In sum, credit guaranteed by the government helps to target the intervention and thereby wisely puts taxpayer money to optimal use. After all, treating taxpayer money with as much respect as one’s own is a key fiduciary responsibility of any economic policymaker.



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Disclaimer

Views expressed above are the author’s own.



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