microfinancing in bangladesh: impact on households, consumption and welfare

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Journal of Policy Modeling 30 (2008) 1083–1092 Available online at www.sciencedirect.com Microfinancing in Bangladesh: Impact on households, consumption and welfare Rubana Mahjabeen Department of Economics, University of Kansas, 415 Snow Hall, Lawrence, KS 66045, USA Received 1 March 2007; received in revised form 1 September 2007; accepted 1 December 2007 Available online 9 February 2008 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 consump- tion 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). © 2008 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved. JEL classification: D58; G21; O17; O53 Keywords: Microfinance institutions; Commercial banks; Real-financial computable general equilibrium model; Bangladesh “Lasting peace cannot be achieved unless large population groups find ways in which to break out of poverty. Microcredit is one such means.” The Norwegian Nobel Committee, 2006. 1. 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 Tel.: +1 785 864 2860; fax: +1 785 864 5270. E-mail address: [email protected]. 0161-8938/$ – see front matter © 2008 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved. doi:10.1016/j.jpolmod.2007.12.007

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Page 1: Microfinancing in Bangladesh: Impact on households, consumption and welfare

Journal of Policy Modeling 30 (2008) 1083–1092

Available online at www.sciencedirect.com

Microfinancing in Bangladesh: Impact onhouseholds, consumption and welfare

Rubana Mahjabeen ∗Department of Economics, University of Kansas, 415 Snow Hall, Lawrence, KS 66045, USA

Received 1 March 2007; received in revised form 1 September 2007; accepted 1 December 2007Available online 9 February 2008

Abstract

This paper examines the welfare and distributional implications of microfinance institutions (MFIs) inBangladesh in a general equilibrium framework. The major findings are that MFIs raise income and consump-tion levels of households, reduce income inequality and enhance welfare. This implies that microfinance isan effective development strategy and has important policy implications regarding poverty reduction, incomedistribution and achievement of millennium development goals (MDGs).© 2008 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

JEL classification: D58; G21; O17; O53

Keywords: Microfinance institutions; Commercial banks; Real-financial computable general equilibrium model;Bangladesh

“Lasting peace cannot be achieved unless large population groups find ways in which tobreak out of poverty. Microcredit is one such means.”

The Norwegian Nobel Committee, 2006.

1. Introduction

Microcredit, particularly in developing countries has in the past few years received a lot ofattention in the international community. For example, the 2006 Nobel Peace Prize was awarded toMuhammad Yunus (and Grameen Bank) for pioneering the idea of microcredit and setting up theGrameen Bank, a microfinance institution (MFI) in Bangladesh. The importance of microcredit is

∗ Tel.: +1 785 864 2860; fax: +1 785 864 5270.E-mail address: [email protected].

0161-8938/$ – see front matter © 2008 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2007.12.007

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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 documentstipulates 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 Yearof Microcredit by the General Assembly of United Nations.

Worldwide, microfinance program has been designed in a way to reach the poor who are leftout of the formal financial system. However, microfinance institutions are more than merely finan-cial institutions. In addition to providing financial services, MFIs typically provide informationrelated to basic education, health, hygiene, child immunization, disease prevention and environ-ment. Surely, one cannot deny the role of microfinance in poverty reduction as it raises income andconsumption of poor households (e.g., Khandker, 2005; Copestake, Dawson, Fanning, McKay,& Wright-Revolledo, 2005). But the multifaceted approach adopted by MFIs has a larger effecton any society in terms of achieving MDGs. The eight goals of MDGs are: poverty and hungerreduction, universal primary educations, female empowerment and gender parity, improvementof maternal health, reduction of child mortality, combating diseases, like HIV/AIDS, malariaand environmental sustainability. Now, accelerated human development can take place throughfinancial and social empowerment of the poor, specifically, women. Microfinance programs aremainly directed towards women. Evidence shows that through microfinance women are empow-ered 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 decisionregarding the education and health of their children, specifically, of female children. Studies havefound 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 decadesMFIs have become an effective way of reaching a large scale of poor people and improving theirwelfare.2 In order to achieve the MDGs it is important to reach vast majority of the poor of theworld. In this sense, governments of developing countries can use MFIs as a way of reaching thepoor 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 thefinancial sector, real-financial computable general equilibrium (CGE) models perform better thanclassic real-economy CGE models. Thus, following Robinson and Lofgren (2005) we constructtwo real-financial CGE models—namely the basic model and the extended model. In the basicmodel, 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 nothave access to the services provided by commercial banks. The extended model has both thecommercial banks and the microfinance institutions. Unlike commercial banks, MFIs providefinancial services to the poor. We find that the extended model produces a better outcome: con-sumption, income and welfare are higher and income inequality is lower for the extended modelthan the basic model.

This paper extends the existing literature in several ways. Specifically, an important differ-ence between this paper and previous studies is that our analysis employs a general equilibrium

1 Some excellent case studies regarding these issues have been complied by Klobuchar and Wilkes (2003).2 See Morduch and Haley (2002) for a survey of literature.

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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 ina general equilibrium setting. Our approach has several advantages. First, it allows us to modelthe interaction of MFIs with the rest of the economy, in particular, with commercial banks andpoor households. Second, it permits us to build a social welfare function and evaluate the impactof MFIs on the economy. Third, it helps us to evaluate MFIs and microcredit borrowers simul-taneously. Another advantage of the general equilibrium approach is that we are able to showhow services provided by MFIs affect income distribution in the economy. Finally, we are able toincorporate the sources of funds of MFIs and sources of demand for commodities produced bymicro-entrepreneurs in the model. This allows us to show the impact of these financial institutionson the real sector. All these aspects have important policy implications. If enough resources are tobe mobilized through international development institutions, donor agencies and other financialinstitutions (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 morethan a dollar a day by 2015 then indeed it is timely and relevant to perform a general equilibriumstudy 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, “Aparsimonious financial CGE model for Bangladesh (is) . . . the goal of the next phase of CGEmodeling for poverty analysis. . . . The incorporation of financial SAM with important financialinstruments, . . . (is) a necessary part of the modeling process.”4 To test the empirical implicationsof the general equilibrium model of Bangladesh it is necessary to have a real-financial SAM ofBangladesh. 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 ideaof microfinance was pioneered in Bangladesh. Over the last two decades the number of MFIsin 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’smost saturated microfinance market’, it would be possible to predict what could happen in othercases if MFIs are constructed with the same care as in Bangladesh. Second, Bangladesh has afinancially 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). Alarge portion of the Bangladesh population—over 80%, is unable to obtain any financial servicefrom the traditional banking sector. The third reason for focusing on Bangladesh is that povertyis prevalent in Bangladesh. According to the Human Poverty Index (United Nations HumanDevelopment Programme, 2005), Bangladesh ranked 86 out of 103 developing countries. In theyear 2000, 83% of the population in Bangladesh lived on less than $2 a day while 36% lived withless than $1 a day.

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

3 Examples of studies that employ a partial equilibrium framework are Paxton and Thraen (2003), Khandker (2005)and Copestake et al. (2005). See Brau and Woller (2004) for review of the literature.

4 Advantage of CGE models in poverty analysis has been depicted by studies like, Stifel and Thorbecke (2003) andDorosh and Sahn (2000).

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2. Description of the real-financial CGE model of Bangladesh

2.1. The basic model

The economy comprises of six types of agents: households, firms, government, central bank,commercial banks and rest of the world. We categorize households by income and location: therural poor, the urban poor, the rural rich and the urban rich. We consider three main productionsectors namely, agriculture, industry and service. We assume that firms are engaged in industry andservice sector. We also assume that agriculture production is performed by rural household. Eachsector produces a commodity for consumption: agricultural commodity, industrial commodityand service.

The factors of production are labor and capital. Excess supply of labor is a chronic phenomenonin Bangladesh. We capture this feature of the Bangladesh economy by assuming that the level ofemployment is determined by the demand for labor. Both labor and capital are sector specific.Fig. 1 displays the structure of the real side of the economy. All domestic prices are assumed to

Fig. 1. Production technology and flow of marketed commodities.

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be flexible and set in the domestic market. We assume that the prices of tradable are exogenouslydetermined by the world market.

We now describe the financial side of the economy. The basic model depicts the economywithout the MFIs. We assume that there is no credit rationing. Commercial banks have threesources of funds: deposits from households, deposits from firms and loans from the central bank.The funds are then used to provide loans. There are two types of loans—short-term loans and long-term loans. We assume that producers do not have adequate funds to cover the cost of labor andother inputs, and therefore, take a short-term loan from the commercial banks. Unlike short-termloans which are a form of working capital, long-term loans are meant for investment expenditures,consumption, house building, etc.

2.2. The extended model

We extend the basic model in two important ways. We add another type of financial inter-mediary, the microfinance institutions, provider of the financial services to the poor and onemore production sector, micro-enterprise, operated by the poor entrepreneurs. Similar to the othersectors, micro-enterprise sector produces a commodity. For exposition, we refer to it as micro-commodity. Micro-enterprise sector incorporates various activities, like, poultry, cow rearing,handcrafts, weaving, tailoring, rice processing, etc. Domestic prices of the commodities producedby the micro-enterprises are determined by the supply and demand of these goods in the domesticmarket. These products are non-tradable. In Bangladesh micro-entrepreneurs are mostly the ruralpoor households and so it is in this model. Rural households are the main consumers of the goodsand services produced by these micro-enterprises. For production purposes, micro-producers needcapital and labor. Supply of labor for this sector mainly comes from rural poor households. Similarto the basic model, we assume that the level of employment is determined by the demand for labor.

MFIs in Bangladesh typically do not borrow from the central bank. They have three sources offunds: deposits of clients, foreign aids and loans from commercial banks. We incorporate this inthe model by assuming that MFIs obtain funds through deposits held by rural poor households,loans from commercial banks and foreign loans. These funds are then used to provide two typesof loans: micro-loans and small housing loans. Micro-loans are short-term and for the purposeof working capital. MFIs provide small housing loans to rural poor households for building orrepairing houses. We assume that, MFIs use group lending method to provide micro-loans. Forsimplicity, it is assumed that each group consists of two micro-entrepreneurs only. Similar to thebasic model it is assumed in the extended model that there is no credit rationing.

3. Data

The general equilibrium model of Bangladesh is based on the data set of the real-financialsocial accounting matrix of 1999–2000. The real side of the SAM for Bangladesh has beenbuilt on the basis of the SAM developed by Arndt et al. (2002). Existing literature does notrepresent any financial SAM of Bangladesh. Therefore, this study has constructed financial SAMsof Bangladesh. Due to the scarcity of data on MFIs, Grameen Bank, the largest and only formalMFI of Bangladesh is used to represent MFIs in this study. Most of the parameters and coefficientsof the model are calibrated from the base data of the real-financial SAM.

Table 1 displays the financial SAM of the basic model and Table 2 shows the financial SAM ofthe extended model. In both tables each row represents the sources of funds for an agent while eachcolumn displays the uses of funds by an agent. Appendix A outlines the financial balance sheets

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Table 1Financial SAM of Bangladesh (1999–2000)—basic model (Taka million)a

SAV HH FIRM GOV CB COMB ROW TOT

INVb 545,870 111,040 259,110 175,720HH 360,220 201,730 561,950FIRM 40,020 120,690 302,600 101,840 565,150GOV 23,700 32,290 17,381 17,862 59,320 150,553CB 91,580 58,001 149,581COMB 505,570 56,170 45,661 607,401ROW 121,930 59,710 181,640TOT 861,170 315,280 175,720 122,752 580,193 161,160DISc −299,220 249,870 −25,167 26,829 27,208 20,480

Sources: Bangladesh Bank (2003); Bangladesh Ministry of Finance (2004).Notes:

a Taka is the currency of Bangladesh.b Investment = INV, households = HH, firms = FIRM, government = GOV, central bank = CB, commercial

banks = COMB, rest of the world = ROW, total = TOT and discrepancy = DIS.c Due to difference in data sources, difference in classification, definition, valuation and timing of recording and

difficulties in agent identification uses and sources of funds do not always match in the data set. This is depicted asdiscrepancy on the last row.

those represent the financial structure of the economy and are used as the basis for constructingthe financial SAM of Bangladesh.

4. Computational findings

We now examine the welfare and distributional implications of MFIs in Bangladesh. Specif-ically, we compare the welfare, income, consumption and utility of households under the basicmodel (without the MFIs) and the extended model (with the MFIs). The social welfare func-

Table 2Financial SAM of Bangladesh (1999–2000)—extended model (Taka million)a

SAV HH FIRM GOV CB COMB MFI ROW TOT

INVb 583,378 148,548 259,110 175,720HH 364,715 201,730 14,581 581,026FIRM 40,020 120,690 302,600 101,840 565,150GOV 23,700 32,290 17,381 17,862 59,320 150,553CB 91,580 58,001 149,581COMB 505,570 56,170 45,661 237 607,638MFI 6,115 3,508 7,121 16,744ROW 154,943 59,710 214,653TOT 904,793 315,280 175,720 122,752 583,701 14,818 168,281DISc −323,767 249,870 −25,167 26,829 23,937 1,926 46,372

Sources: Bangladesh Bank (2003); Bangladesh Ministry of Finance (2004).Notes:

a Taka is the currency of Bangladesh.b Investment = INV, households = HH, firms = FIRM, government = GOV, central bank = CB, commercial

banks = COMB, microfinance institutions = MFI, rest of the world = ROW, total = TOT and discrepancy = DIS.c Due to difference in data sources, difference in classification, definition, valuation and timing of recording and

difficulties in agent identification uses and sources of funds do not always match in the data set. This is depicted asdiscrepancy on the last row.

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Table 3Percentage change in income, consumption and utility from the basic model to the extended model

Type of household Income Consumption Utility

Agriculture Industry and service

Rural poor 73 65 56 228Urban poor 60 65 70 288Rural rich 42 65 59 270Urban rich 72 65 75 266

Table 4Income distribution under the basic and extended model (household income as a percentage of total income)

Type of household Basic model Extended model

Rural poor 2 13Urban poor 2 16Rural rich 53 36Urban rich 43 35

tion is defined as the weighted sum of household utility.5 We assume that all households have aCobb-Douglas utility function.

Table 3 displays percentage change in household income, consumption and utility from thebasic model to the extended model. We find that, provision of financial services to the rural poor inBangladesh enhances income of all type of households, specially the rural poor the most, by 73%.Our results show that consumption of all households including the rural poor increased by morethan 50% for all commodities after we extend our CGE model of Bangladesh by including MFIsas another type of financial intermediary. We should mention that consumption of agriculturecommodities do include consumption of food. We also find that there is a 258% increase in thevalue of social welfare from the basic to the extended version.

Table 4 shows the distribution of income under the two models. Computational findings showthat provision of financial services to the poor enables the Bangladesh economy to reduce theincome inequality. Under the basic model, poor households (rural and urban) earned 4% oftotal income. However, under the extended model their share in total income increases to 29%.Changes in the household share in national income imply that there is a change in the magnitudeof the national poverty.

We end this section by discussing the effect of MFIs on the labor market and profits of thecommercial banks. The percentage change in labor demand from the basic to the extended modelis 14% increase in the agriculture sector and 41% increase in the industry and service sectors.These results depict that MFIs generate employment opportunities. Also, results show that theprofits of commercial banks increased by 50% and the MFIs earned positive profits (i.e., did notgo bankrupt) in the extended model.

5. Conclusion and policy implications

This paper examines the welfare and distributional implications of microfinance institutions(MFIs) in Bangladesh in a general equilibrium framework. We compare two CGE models:

5 The weight is defined as the product of the proportion of household disposable income spent on different types ofcommodities.

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basic model with only traditional commercial banks as financial intermediary and extendedmodel with commercial banks plus MFIs. The major findings are that MFIs: (i) raise incomeof all households, (ii) increase consumption of all commodities by all households, (iii) gener-ate employment, (iv) reduce income inequality and, (v) enhance social welfare. These findingssuggest that microfinance is one of the required critical interventions for empowering the poorpeople.

The results have the following important policy implications. First, in a country where povertyis prevalent government can use MFIs as a tool for poverty alleviation. Second, MFIs can fosteremployment generation, in particular for the poor. Third, for countries with thin financial marketsMFIs can be used as a way to reach the huge un-served market, which mainly consists of the poor.Fourth, as small-scale and micro-producers operate in private sector government can use MFIs alsoto empower the private enterprises. Fifth, governments of developing economies should considerthe distributional aspect of financial institutions, particularly of MFIs, as a way of reducingthe gap between the rich and the poor. Microfinance can supplement the existing fiscal policyand land reform system in lowering the income inequality within an economy. Finally, we canconclude that, microfinance is indeed an effective development strategy and government can useit as a way to enhance the standard of living of the poor and achieve millennium developmentgoals.

Acknowledgement

I am grateful to Elizabeth Asiedu for her helpful comments on this paper.

Appendix A. Financial balance sheets

See Tables A1 and A2 .

Table A1Symbolic financial balance sheet—basic model

Assets Liabilities

Central bankGovernment debt CurrencyLoans to commercial banks Reserves held by commercial banksForeign reserve

Commercial banksReserves held with the central bank Loans from the central banksLoans to firms Deposits held by households and firmsLoans to householdsGovernment debt

GovernmentPhysical capital Accumulated wealth

Debt to central bankDebt to commercial banksDebt to householdsForeign debt

Firms

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Table A1 (Continued )

Assets Liabilities

Physical capital Accumulated wealthDeposits held with commercial banks Debt to households

Loans from commercial banksForeign loans

HouseholdsPhysical capital Accumulated wealthDeposits held with commercial banks Loans from commercial banksCurrencyGovernment debtLoans to firms

Rest of the worldLoans to firms Accumulated wealthGovernment debt Foreign reserve

Table A2Symbolic financial balance sheet—extended model

Assets Liabilities

Central bankGovernment debt CurrencyLoans to commercial banks Reserves held by commercial banksForeign reserve

Commercial banksReserves held with the central bank Loans from the central bankLoans to firms Deposits of households, firms, MFIsLoans to householdsGovernment debtLoans to MFIs

Microfinance institutionsLoans to micro-enterprises Deposits held by rural poor householdsLoans to rural poor households Foreign loansDeposits held with commercial banks Debt to commercial banks

GovernmentPhysical capital Accumulated wealth

Debt to central bankDebt to commercial banksDebt to householdsForeign debt

FirmsPhysical capital Accumulated wealthDeposits held with commercial banks Debt to households

Loans from commercial banksForeign loans

HouseholdsPhysical capital Accumulated wealthDeposits held with commercial banks Loans from commercial banksCurrency Loans from MFIs

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Table A2 (Continued )

Assets Liabilities

Government debtLoans to firmsDeposits held with MFIs

Rest of the worldLoans to firms Accumulated wealthGovernment debt Foreign reserveLoans to MFIs

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