Curbing the dangers of underground lending in Asia
At some point, most of us have to borrow. In Asia like anywhere else, access to capital is essential to help people invest in their futures and improve their lives aEUR" to pay school fees, perhaps, or buy fertilizer to increase crop yield. But the capital can come at a cost that would seem imprudent or even extortionate.
Banks usually deny loans to poor households and small entrepreneurs, by and large an unprofitable population for conventional lenders. Asia's poor typically live in remote areas and incur high transaction costs in borrowing. Often, the only available option is to deal with a moneylender or a loan shark. In other words, go "underground."
Borrowing from underground sources, however, rarely results in a fair or sustainable financial relationship. (Underground sources, however, rarely offer the borrower a fair shake.) When there is demand for loans and few options, households and business people will often accept steep interest rates without question. They are likely to soon be trapped in a cycle of debt. Indeed, this predatory industry imposes immense costs on entire societies. Policymakers recognize the challenge, but despite good intentions, their interventions fall short of solving the problem.
We wondered about the scale and severity of the problem, hoping that a clearer understanding would point to more effective solutions. Since this lending occurs outside the formal banking sector, official records on the rates charged and collection methods used are virtually absent. So we looked at a range of "unofficial" information: newspaper articles, anecdotal evidence, estimates and reports from numerous sources. The result, "Underground Lending: Submerging Emerging Asia," demonstrates the severe consequences and assesses strategies for addressing them.
In India, indebtedness to moneylenders and loan sharks has been cited as a major contributor to suicides among farmers. Facing a poor harvest after a failed monsoon, many are unable to repay the high-interest loans they took out to cover upfront costs. In WenzhouaEUR"known as the heart of the underground banking industry in ChinaaEUR(TM)s Zhejiang provinceaEUR"several entrepreneurs committed suicide or were "disappeared" after defaulting on loans. Reliance on underground lending has developed in other Chinese communities as well, with similar social problems the result. The violence meted out by Thai loan sharks after a borroweraEUR(TM)s payments fell two days behind was captured on video. It became national news, sparking several investigations.
Typically, underground loans are small and shorter-term than the conventional variety, with interest rates quoted on a daily or monthly basis. Our study found that rates in Thailand reached as high as 3 percent per day, or 1,095 percent per year in simple interest. In China and India, underground lenders demand as much as 180 percent per annum.
While we can't be certain how many people are victim to these predatory practices and usurious rates, we know that the underground lending industry is sizable in many Asian countries. We estimate its scale at $780 billion (9 percent of GDP) annually in China, $471 billion (26 percent of GDP) in India, and $172 billion (47 percent of GDP) in Thailand. In the case of China, overall lending activity outside the formal banking sector (including underground lending) is much larger, amounting to almost half of GDP.
The size of underground lending markets and their adverse impacts are not being ignored. Governments in the countries we examined have implemented or proposed a number of policies to curb the boom. Nonetheless, they have encountered varying levels of success. Some policies have produced unintended consequences, reinforcing the structural factors that drove people to underground lending instead of diminishing them.
In our study, we discussed how government policy can more effectively address the negative side of underground lending by taking a market-economy approach. The central idea is to create a more competitive environment and expand access to formal funding sources, such as microcredit institutions. With the elimination of interest rate controls and lending mandates, banks can charge market-based rates, making cost recovery possible when lending to customers who usually borrow underground. That may hike prevailing rates in the formal sector for such customers. Compared to underground rates, however, these levels would amount to a discount for low-income borrowers.
We also recommend making credit records more available through either public or private credit bureaus so that formal lenders can determine credit risk and better serve this population. To displace underground lenders, governments can increase the competition from formal sources with policies that reduce the risk and increase the reward for banks and microcredit providers that lend to the poor.