Financial inclusion

Mystery of capital and demonetisation of currency


Picture credit: Business Standard, Nov 10, 2016

If you follow Stuart Rutherford or Jonathan Morduch’s work, it is quite apparent that the poor lead complex lives and constantly deal with financial decisions. Most people associate poverty with the absence of savings, which is a flawed assumption. The poor do save, but they do so in assets that are illiquid, or cannot be transformed easily into capital. For instance, a house is an asset, but not when it does not have property documents that are recognised in formal markets. This restricts the ability of the house to be traded outside of known circles, and limits their ability to transact in formal financial systems.

This illiquidity is not unknown to the poor and to overcome it,they do one of two things. “Farm out their liquidity” to neighbours i.e. give their money to a neighbour in need so they would respond appropriately in their own time of need. And they bury cash in a pot in their homes, or store it in a hole in the wall or under a mattress. For a long time, this behaviour appeared to be caused by a lack of access to formal institutions. Research now shows that people tend not to use formal financial services for savings, although they may borrow from these institutions <;. Underlying this low usage of accounts is the lack of trust in formal financial institutions. They would much rather trust the local savings groups, or dig up that pot in their house when they needed money for emergency.

As much as this is true for poor households, this holds water for the large set of enterprises that are classified as “informal” or “unorganised”. While statistics for the sector are far from accurate, surveys suggest that about 86-92.4% of the work force is engaged in the informal sector. Most of these institutions lack access to formal credit and operate in largely a cash based economy. Schneider and Buehn, in their article titled “Corruption and shadow economy: like oil and vinegar, like water and fire?” state that in country contexts where corruption is rife, institutions may choose to remain informal. This informality brings with it the ability to escape bureaucracy and avoid paying a fine to a corrupt official, but it also means undercapitalisation and lower benefits to the economy in the long run.

How does all of this link with the recent demonetisation conducted by the Indian government? There are two ways to ensure that the shadow economy does not exist. One, is to nudge informal enterprises to formalise, to ensure that property titles are clear, etc. The second is to reduce corruption. Tackling one of these without addressing the other does not solve the problem since they both are part of a vicious cycle that feed off each other. In what causes inconvenience to many, but breaks this vicious cycle in the long run, the Indian government’s move to demonetise currency tackles both challenges with one stroke. The benefits can be explained by examining some of the mysteries, which make it harder for poorer and informal economies to compete with more formal ones that Hernando Soto outlines in his book “The Mystery of Capitalism”.

  1. The mystery of missing information: We don’t know the extent of the cash economy. One can have estimates, but it is hard to know accurately. Until people declare this so we are able to capture the number accurately. Until September 30, the government had a scheme for voluntary disclosure of their income. Assuming that there would still be people that did not declare their incomes, demonetising currency leads to a state where people could either forego the value of their currency or exchange existing notes for new ones that are recognised. The latter solves the problem of missing information.
  2. The mystery of capital: In order to unlock the value of assets, one needs to “go beyond physics to touch the hen that lays the golden eggs”. Revealing one’s earnings in the process of exchanging notes that are defunct, one ends up revealing the sources of income and where the capital is generated
  3. The mystery of political awareness: We have known that there is a lot of value in the informal sector, but have not known how to benefit at a macro level from this wealth. If we assume that there is benefit in dealing with a closed circle to meet one’s financial needs, Metcalfe’s law dictates that a larger network would yield higher benefits to the actors involved. (For e.g. one telephone is useless, two is better, but when everyone in the world has a telephone, you change society)

None of these, however, ensure that what caused the problem in the first place does not re-occur.

What does the government need to do to ensure demonetization is successful?

  1. Ensure that the poor are not inconvenienced in the transition to new currency
  2. Solve the problem of corruption in the long run: there is nothing currently that prevents small enterprises and households from being targeted by corrupt officials in the aftermath of the demonetisation to ensure they continue to fill their pockets
  3. Ensure banks are accessible and use the interaction to build trust with customers
  4. Make it easier and cheaper to transact without cash

We must remember the words of Ronald Coase in his speech titled, The task of the society:

Economics, over the years, has become more and more abstract and divorced from events in the real world. Economists, by and large, do not study the workings of the actual economic system. They theorize about it. As Ely Devons, an English economist, once said at a meeting, “If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, ‘What would I do if I were a horse?’”

Let’s actually go and study horses before we scream success (or failure) from rooftops.


India’s $1.3 bn crop insurance

The Guardian’s headlines this morning stated “Thousands of farmer suicides prompt India to set up $1.3 bn crop insurance scheme”. The programme is meant to be a direct response to news of farmer suicides in rural areas, with two successive years of drought. Amongst various reports is one that states that over 300,000 farmers have committed suicide since 1995. News of such deaths is indeed tragic and while it must be examined closely to address the underlying issues, the structure of the current crop insurance scheme does little in this regard.

One can understand the urgency to woo the agricultural community in the light of protests held earlier last year on a bill that made it easier to take over farm land for large projects. Second, the results of two state elections, Delhi and Bihar make the upcoming five elections; i.e. Tamil Nadu, West Bengal, Kerala and Assam in 2016 and that of Uttar Pradesh in 2017, extremely important. It is no coincidence that all of these have large farming communities. Also, data shows that all of these states have shown a high level of farmer suicides in the past decade (see chart below).


While it is right to sit up and respond to this statistic, elections notwithstanding, would the new Pradhan Mantri Fasal Bima Yojana (PMFBY) be the right solution?

What does the PMFBY entail?

The highlights of the scheme are as follows:

i) There will be a uniform premium of only 2% (of the value of the crop) to be paid by farmers for all Kharif crops and 1.5% (of the value of the crop) for all Rabi crops. In case of annual commercial and horticultural crops, the premium to be paid by farmers will be only 5% (of the value of the crop). The balance premium will be paid by the Government to provide full insured amount to the farmers against crop loss on account of natural calamities.

ii) There is no upper limit on Government subsidy. Even if balance premium is 90%, it will be borne by the Government.

iii) Earlier, there was a provision of capping the premium rate which resulted in low claims being paid to farmers. This capping was done to limit Government outgo on the premium subsidy. This cap has now been removed and farmers will get claim against full sum insured without any reduction.

iv) The use of technology will be encouraged to a great extent. Smart phones will be used to capture and upload data of crop cutting to reduce the delays in claim payment to farmers. Remote sensing will be used to reduce the number of crop cutting experiments.

The PMFBY is slated to replace the existing two schemes i.e.. National Agricultural Insurance Scheme (NAIS) as well as Modified NAIS (MNAIS). The target is to increase uptake of crop insurance from 23% to 50%.

Challenges with the current design:

Before analysing whether the crop insurance programme would actually result in a reduction in farmer suicides, it is important to state that insurance can play a role in reducing distress faced by a farmer in case of crop failure.

Variability in weather and uncertainty of crop yields has been a challenge across the world for farmers. In India, it is exacerbated due to the changing climatic conditions, combined with a set of farmers that is extremely dependent on the weather for farming. Add to this, poor economic conditions of most farmers and a lack of adequate cushion to deal with crop failures and one has a situation of agrarian distress. At the macroeconomic level, there are other issues that further contribute to this dismal situation. Revenues have been stagnant, while cost of inputs has been increasing. Most farmers do not have access to formal, institutional credit (less than 15% access institutional credit) and have land holding that are extremely small, limiting the use of technology and further impacting yield.

However, the challenges that existed with the NAIS continue to exist with the current crop insurance scheme since it is still yield based and not weather based.

  1. Yield based schemes are hard to administer since the systemic nature of agricultural risk goes against the working of insurance policies (i.e. the belief that the event would impact only a small section of the insured population), making it hard to calculate premium and indemnity
  2. There is a scope for moral hazard, especially when the proportion of subsidy borne by the Government is higher than that borne by an individual
  3. There are challenges of viability due to the uncapped subsidy offered by the State

It would be much better to have a weather based insurance product that pays indemnities based on realisation of an index which is correlated with actual losses. This would also be automatically triggered reducing the claim payout time.

If the government is truly serious about addressing agrarian distress, they should also address the challenge of access to timely, institutional credit and ensure an easy claim settlement process.

Will this reduce farmer suicides?

It is simplistic and populist to assume that the launch of a crop insurance policy would reduce the number of suicides. While insurance is an important component to reduce distress faced by a farming household, the causes that result in a suicide may be far more varied. In a study conducted by Shamika Ravi and Mudit Kapoor, less than 5% of the farmer deaths were found to be due to debt or bankruptcy. In fact, in an op-ed, the authors state that “In stark contrast,  poor health, mental and physical, accounted for 30% of all suicides..”. In fact, as a country, poor health leads to seven times more suicide than debt or bankruptcy.

Given this statistic, the current government should perhaps consider improving the health system and addressing mental health issues rather than stop at the populist measure of crop insurance schemes. That would lead to a happier farming community and perhaps a happier population.

(Picture source: The Guardian)




2015 Brookings Financial and Digital Inclusion Report: good news for India

The Brookings Institute released their 2015 report on financial and digital inclusion, which compares digital financial usage and access across 21 countries including India. Amongst other things, we certainly have cause to celebrate in India, for ranking number 1 in country commitment to both digital and financial inclusion. Also, India is the only country to have completed targets in key policy areas that were outlined as a part of the May 2015 ‘Maya Declaration on Financial Inclusion’.
The biggest contributor to this has been the new payment bank licenses and the fact that the new licensees include telecommunication operators, thereby bridging the gap between the Ministry of Telecommunications and the Department of Financial Services. The report also points out that women can benefit from greater access to mobile money and we may well see a reduction in the gender gap in financial access. Further, the usage of smart phones might result in a higher uptake than regular phones.
Both in terms of financial inclusion as well as increased digital usage, India is certainly on the cusp of exciting times. Given the intuitive nature of smart phones and their increasing importance in ensuring uptake of financial services, the next step for the government might well be to remove barriers to availability and affordability of smart phones. We would do well to refer to a 2011 study in Brazil which pointed out that a reduction of taxes by 1 bps led to a doubling of the subscriber base. We would do well to realise that the smartphone is possibly no longer a luxury but a necessity. In the meanwhile, we should uncork the bubbly for a job well done.

Too much praise, far too early

In the valedictory address at the International Conference on National Payments Schemes organised by NPCI, delivered by Mr. Mundra, Deputy Governor of the Reserve Bank of India, there was considerable focus on the linkage between payments systems and financial inclusion. (Full speech can be accessed here). While the Reserve Bank of India, in the past few years, has for the most been making policies that encourage financial inclusion, the speech delivered reveals that there continues a gap in understanding the complex lives of low income households and the role that banks, amongst other financial institutions can play, as opposed to the current role that they do play. The danger in not acknowledging this gap is implementation failure, yet again.

Myth 1: Financial inclusion in its simplest form refers to banking inclusion where the endeavour is to link the unbanked population with the formal banking system by opening their bank accounts

Financial inclusion, at its simplest form, could mean access to any financial product from the formal financial system. It is patronising to think that the point of entry has to be a bank account. While this might be desirable from a banker’s point of view, the reality is that several bank accounts continue to remain dormant. It is limiting to define financial inclusion as merely access to a bank account, when there could be multiple factors that prevent customers from using the account in their day to day lives.

Myth 2:  To inculcate the banking and savings habit amongst the people, it is important that all individuals have bank accounts where funds could be held – which initially could be through remittances in form of direct benefit transfers under the Central /State Government schemes.

Bankers assume that low income households do not save and the habit needs to be “inculcated”. Secondly, the statement assumes that DBT can help build a savings balance. Most DBTs are subsidies that are passed on by the government for essential services like LPG, scholarship, etc. It would be naive to believe that this is money that a low income household can afford to keep idle in a savings bank account.

Myth 3: The PMJDY scheme launched by the Government of India has achieved stupendous success in linking the unbanked with the banking system. Bank accounts have been opened for nearly 99.99 per cent of the households in India which has brought in 150 mn new customers coming into the banking system fold while nearly 135 mn RuPay debit cards have also been issued.

While the current government has been posting numbers on their website regarding number of accounts opened and cards issued, the PMJDY is beginning to show it’s weaknesses. (See article on this here, and here). One can call this skepticism, but the claim that 99.99% of the households in India now have a bank account is odd, when just six months ago, bankers were the biggest barriers to opening bank accounts as indicated by Amy Mowl and Camille Boudot in their barriers to banking paper in 2014. (Reference:

Second, the Financial Inclusion Insights study revealed that most individuals are not comfortable with digital inclusion and lack trust and most bank accounts continue to remain dormant. The study was released in December 2014, so the shift in sentiment in just 5 months is implausible.

Myth 4: Aadhaar based payments, through linkage of biometric identifier with bank accounts, is facilitating the benefit payments to bank accounts of millions of beneficiaries, and will have significant on financial inclusion efforts in the country.

The Supreme Court re-confirmed in March this year that citizens of India cannot be denied benefits if they lack an Aadhar card (see article here). Despite this ruling, financial institutions, seem to continue to see this as an important step to financial inclusion.

What strikes me as a challenge is that none of the above address operational issues faced by low income households, which can act as a higher barrier to use.

What actually needs to be done in the payments space?

Usage and uptake of any service improves when customers see the relevance of the service in their lives. For far too long, financial institutions have seen provision of services such as an ATM card as an add-on benefit. If one truly expects low income households to begin using payments platforms, the following steps need to be taken:

1) Allow withdrawal from any ATM without charging a fee

2) Remove/increase cap on ATM withdrawals for all accounts

3) Allow for multiple withdrawals without charging a fee, even if the amount withdrawn is small

4) Allow ATMs even in remote, rural India to be open 24×7. Anecdotal evidence suggests that in rural India, following a spate of crimes, ATMs operate at the same timings as banks

5) Engage customers , especially from low income households, in a manner that helps build their trust towards digital platforms: this could include providing clear and speedy recourse mechanisms when transactions fail, protecting the rights of the customers and assuring them of speedy service at all times.

The work done in the payments space is not even a complete foundation to ensure that it has an impact on financial inclusion. It would be fool hardy to provide praise far too early: that can be a sure indicator of impending failure.

Trust, finance and urban low income households

At the heart of providing a loan is the ability of the lender to judge the borrower on his/her ability and willingness to repay. This seems fairly rhetorical, until one begins to apply the principle to the lives of small businesses and low income households. Or even regular transactions that take place in one’s everyday lives. One of the small luxuries of living in India, and one that I take for granted, is the ability to give my clothes to be ironed by a couple that has a small push cart at the end of the road. Almost every road and bylane has the local ironing guy, or the istri-wala, who regularly takes clothes, irons it for anything between Rs. 2-5 and returns it in an hour. I have a running account with the couple that iron our clothes because they never have change. And there is always an outstanding balance, which is adjusted against the next day’s potential lot of clothes to be ironed. The transaction amount may be small, but in allowing this adjustment, there is an implicit judgement that I make on the couple and their ability to appear the following day at our doorstep. Of course, one would argue that their livelihood depends on it and so on, but with their mobile cart, they could very easily choose to relocate to another part of the city and find similar clients. Yet, they never do so.

Several low income households have a similar account with the local kirana store where they purchase regular goods for consumption. There are similar mini loans that take place in everyone’s lives, every single moment. The extent to which we use our social network for financial transactions is immense, if we were to make a minute note of each and every rupee that exchanges hands. In rural India, where people are tied to their land, one is almost born into a social network, which has its downside, but can also act as a cushion in times of need. It is not unusual in rural Tamil Nadu to host a dinner or lunch, which is pretty much a fund raiser, for an event in someone’s life. The daughter attaining menarche, someone starting a new business. All of these are events when it is expected that people will contribute money, with the understanding that it will be reciprocated in their times of need.

In urban India, where movement is easier and the possibility of becoming anonymous in a large crowd is higher, one would expect that such relationships do not exist or exist to a lesser extent. However, low income households in urban India are not the homogeneous entity that they are often painted out to be. In more settled habitations or authorised slums, social networks tend to be far more established, often taking the form of active small businesses. The transient slums, on the other hand, are home to a population that is far more vulnerable and inevitably marginalised from all kinds of networks, including social networks that often act as a proxy to financial systems. Understanding the lives of urban low income households can yield a wealth of information that can be used for financial product design.