Informal Lending in Emerging Markets

Abstract

Micro-entrepreneurs in emerging markets often rely on informal lenders for their routine borrowing needs. This paper investigates micro-entrepreneurs’ and informal lenders’ incentives to participate in a lender-borrower relationship in a market in which repayments are neither law-protected nor asset-secured. We consider a borrower who seeks a short-term loan, invests in a project, and repays in full using her project earnings if the project is successful. If the project fails, the borrower uses her outside option to repay over a period of time. The analysis uncovers an interesting effect of the borrower’s outside option on the loan rate offered by the lender - the loan rate first increases and then decreases with the borrower’s outside option. An important policy implication is that an increase in the outside option of the poor micro-entrepreneurs might actually reduce their surplus. Finally, we find that lenders in emerging markets may be more likely to engage in informal lending compared to those in developed or poorer markets.

Keywords: Informal lending, emerging market, relational contract

JEL Classification: D82, D86, G23