Microfinancing in Bangladesh: Impact on households, consumption and welfare

Abstract

This paper examines the welfare and distributional implications of microfinance institutions (MFIs) in Bangladesh in a general equilibrium framework. The major findings are that MFIs raise income and consumption levels of households, reduce income inequality and enhance welfare. This implies that microfinance is an effective development strategy and has important policy implications regarding poverty reduction, income distribution and achievement of millennium development goals (MDGs).

Introduction

Microcredit, particularly in developing countries has in the past few years received a lot of attention in the international community. For example, the 2006 Nobel Peace Prize was awarded to Muhammad Yunus (and Grameen Bank) for pioneering the idea of microcredit and setting up the Grameen Bank, a microfinance institution (MFI) in Bangladesh. The importance of microcredit is also noted in the United Nations World Summit Outcome Document, 2005, (United Nations, 2005) which states that “We [the United Nations] recognize the need for access to financial services, in particular for the poor, including through microfinance and microcredit…” The document stipulates that microcredit will help member countries achieve the millennium development goals (MDGs) of reducing poverty rates by 50% by 2015. Indeed, the year 2005 was declared the Year of Microcredit by the General Assembly of United Nations.

Worldwide, microfinance program has been designed in a way to reach the poor who are left out of the formal financial system. However, microfinance institutions are more than merely financial institutions. In addition to providing financial services, MFIs typically provide information related to basic education, health, hygiene, child immunization, disease prevention and environment. Surely, one cannot deny the role of microfinance in poverty reduction as it raises income and consumption of poor households (e.g., Khandker, 2005; Copestake, Dawson, Fanning, McKay, & Wright-Revolledo, 2005). But the multifaceted approach adopted by MFIs has a larger effect on any society in terms of achieving MDGs. The eight goals of MDGs are: poverty and hunger reduction, universal primary educations, female empowerment and gender parity, improvement of maternal health, reduction of child mortality, combating diseases, like HIV/AIDS, malaria and environmental sustainability. Now, accelerated human development can take place through financial and social empowerment of the poor, specifically, women. Microfinance programs are mainly directed towards women. Evidence shows that through microfinance women are empowered in terms of decision making, asset ownership and political and legal awareness (e.g., Hashemi, Schuler, & Riley, 1996; Cheston & Kuhn, 2002). This eventually enables women to make decision regarding the education and health of their children, specifically, of female children. Studies have found that the children of these women are guarded against starvation, disease and illiteracy (e.g., Wydick, 1999, Afrane, 2002).¹ These evidences support the idea that, over the last three decades MFIs have become an effective way of reaching a large scale of poor people and improving their welfare.² In order to achieve the MDGs it is important to reach vast majority of the poor of the world. In this sense, governments of developing countries can use MFIs as a way of reaching the poor people and their future generation and thereby achieving the MDGs.

This paper examines the welfare and distributional implications of microfinance in Bangladesh. Robinson and Lofgren (2005) assert that when modeling involves policy issues related to the financial sector, real-financial computable general equilibrium (CGE) models perform better than classic real-economy CGE models. Thus, following Robinson and Lofgren (2005) we construct two real-financial CGE models—namely the basic model and the extended model. In the basic model, there is only one type of financial institution—which we refer to as commercial banks. Commercial banks receive deposits and provide credit to their clients. However, the poor do not have access to the services provided by commercial banks. The extended model has both the commercial banks and the microfinance institutions. Unlike commercial banks, MFIs provide financial services to the poor. We find that the extended model produces a better outcome: consumption, income and welfare are higher and income inequality is lower for the extended model than the basic model.

This paper extends the existing literature in several ways. Specifically, an important difference between this paper and previous studies is that our analysis employs a general equilibrium framework. This contrasts with previous studies that generally utilize a partial equilibrium setting.³ Indeed, to the best of our knowledge, this is the first study that has analyzed impact of MFIs in a general equilibrium setting. Our approach has several advantages. First, it allows us to model the interaction of MFIs with the rest of the economy, in particular, with commercial banks and poor households. Second, it permits us to build a social welfare function and evaluate the impact of MFIs on the economy. Third, it helps us to evaluate MFIs and microcredit borrowers simultaneously. Another advantage of the general equilibrium approach is that we are able to show how services provided by MFIs affect income distribution in the economy. Finally, we are able to incorporate the sources of funds of MFIs and sources of demand for commodities produced by micro-entrepreneurs in the model. This allows us to show the impact of these financial institutions on the real sector. All these aspects have important policy implications. If enough resources are to be mobilized through international development institutions, donor agencies and other financial institutions (like, major international banks) to achieve the goal, set by Microcredit Summit 2006 (Daley-Harris, 2005), of making sure that at least 100 million poor people can live with more than a dollar a day by 2015 then indeed it is timely and relevant to perform a general equilibrium study of microfinance.

Another contribution of the paper is that it constructs a financial social accounting matrix (SAM) of Bangladesh. Our approach is motivated by Khan (2004, p. 47) who notes that, “A parsimonious financial CGE model for Bangladesh (is) … the goal of the next phase of CGE modeling for poverty analysis. … The incorporation of financial SAM with important financial instruments, … (is) a necessary part of the modeling process.”⁴ To test the empirical implications of the general equilibrium model of Bangladesh it is necessary to have a real-financial SAM of Bangladesh. Existing literature does not represent any such SAM for Bangladesh.

The paper uses Bangladesh as a case study. There are three reasons for this. First, the idea of microfinance was pioneered in Bangladesh. Over the last two decades the number of MFIs in Bangladesh has increased from less than 50 to nearly 1000, an increase of about 1900% (CDF, 2005). Currently, MFIs in Bangladesh serve about 11 million households. Daley-Harris, Pollin, and Montgomery (2007) assert that, by studying the case of Bangladesh, ‘the world's most saturated microfinance market’, it would be possible to predict what could happen in other cases if MFIs are constructed with the same care as in Bangladesh. Second, Bangladesh has a financially thin market. Domestic credit provided by the banking sector is around 40% of its GDP. This compares with more than 250% of the GDP in the U.S. and Japan (World Bank, 2005). A large portion of the Bangladesh population—over 80%, is unable to obtain any financial service from the traditional banking sector. The third reason for focusing on Bangladesh is that poverty is prevalent in Bangladesh. According to the Human Poverty Index (United Nations Human Development Programme, 2005), Bangladesh ranked 86 out of 103 developing countries. In the year 2000, 83% of the population in Bangladesh lived on less than $2 a day while 36% lived with less than $1 a day.

The rest of the paper is organized as follows. Section 2 provides description of the real-financial computable general equilibrium model of Bangladesh. Section 3 provides data information, Section 4 analyses the computational findings and Section 5 discusses policy implications and concludes.