VULNERABILITY OF MICROFINANCE TO STRATEGIC DEFAULT AND COVARIATE SHOCKS: EVIDENCE FROM PAKISTAN

Authors


  • The authors are grateful to two anonymous reviewers of this journal; Lisa Cameron, Rients Galema, Niels Hermes, Yoko Kijima, Hisaki Kono, Robert Lensink, Fumiharu Mieno, Yasuyuki Sawada, Chikako Yamauchi; and participants of the 2009 Far East and South Asia Meeting of the Econometric Society, the 1st International Workshop on Microfinance Management and Governance, the University of Melbourne Microeconometrics Workshops, the Osaka University OEIO Seminar, the Keio University Public Economics Workshop, the FASID Hakone Conference on Development Economics, and the Japanese Economic Association Annual Meeting for their useful comments on earlier versions of this paper. All remaining errors are ours.

Abstract

This paper investigates the repayment behavior of borrowers of a Pakistani microfinance institution (MFI) using a unique dataset of approximately 45,000 installment records over the period 1998–2007. In early 2005, the MFI introduced reforms that included improved enforcement of contingent renewal. The reforms led to a healthy situation with almost zero default rates. We hypothesize that strategic default under the joint liability mechanism was encouraged by weak enforcement of contingent renewal and was one of the factors responsible for the pre-reform failure. To support this hypothesis, we show that before the reforms, a borrower's delay in installment repayment was correlated with other group members' repayment delays beyond the level explained by possible correlation of project failures due to locally covariate shocks. Such excessive correlation disappeared after the reforms, including the period after the 2005 Kashmir earthquake. The empirical evidence thus demonstrates the existence and seriousness of the strategic default under weak dynamic incentives.

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