Financial decision making in rural India: poverty, financial literacy and investment decisions
by Lukas Valentin Semmler
Date of Examination:2016-05-12
Date of issue:2016-08-30
Advisor:Prof. Dr. Meike Wollni
Referee:Prof. Dr. Stephan Von Cramon-Taubadel
Referee:Prof. Dr. Oliver Mußhoff
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Abstract
English
Poverty remains a pressing problem in rural areas of the developing world. This is also true for India. Expanding the rural financial system with a focus on increasing access to credit has been an important approach for poverty alleviation in India. Nevertheless, there is empirical evidence and theoretical consideration that, credit markets fail for the poor in particular. Market failures can be either driven by moral hazard or adverse selection. In the case of moral hazard, the borrower can either devote insufficient effort to enable subsequent repayment (ex ante moral hazard) or he may voluntarily default (ex post moral hazard). His actions remain hidden. In both cases, the loan would not be repaid successfully. To avoid default, lenders may demand collateral in a form that the poor cannot provide. Adverse selection describes the process of relatively more risky borrowers selecting into loan commitments. If the lender cannot observe the riskiness of potential borrowers, due to information asymmetry, he may demand a higher interest rate in an effort to compensate for loan defaults by riskier borrowers. This may in turn preclude relatively risk-averse borrowers who may not be willing to bear the risk premium, which represents the compensation for the default risk of riskier borrowers. The relatively more risky borrowers remain in the market, and consequently, the likelihood of loan default increases. In the extreme case, this can result in a totally nonexistent credit market. To complement prior research which focused on the supply side and market failures of India’s rural financial system, we focus on rural households’ and individuals’ financial decision making in this study. We argue that this perspective can contribute to the understanding of outcomes of rural households’ financial decisions. In this study, we first shed additional light on the borrower as an individual, the means available and the limits to an individual’s financial decision making. Second, we stress the decision-making process within a household. Several individuals may be involved in this process and may determine the outcomes of financial decisions at the household level. The first objective focuses on an individual’s financial literacy, as it is central to undertake informed financial decisions. However, in the context of poverty, taxes on mental capacity may disturb an individual’s decision making. Mental capacity, which is limited for each individual, can be demanded by pressing financial obligations (e.g., education, health and social events) to which individuals may be exposed simultaneously. In contrast, non-poor individuals may be relatively less exposed to this tax. They may be exposed to the same financial obligations, but are able to settle them more easily, as they are not poor. We explore whether such a tax negatively affects an individual’s level of financial literacy. Experimentally, we show that for individuals, considered to be poor, such a tax negatively affects their level of financial literacy. In contrast, individuals who are not considered poor are not negatively affected by the tax. Moreover, we find that a financial incentive can act as a counter-measure. It increases the level of financial literacy. We recommend that policymakers consider measures that assist individuals in financial decision making when they have a lower level of financial literacy and to consider incorporating financial incentives in measures intended to increase financial literacy, e.g., in financial literacy training. Our research is informative on the relevance of financial decision making for poverty in rural India. We find that a tax on mental capacity negatively influences financial literacy in the context of poverty. Thus, financial literacy, which is central for informed financial decisions, is negatively affected. When informed financial decision making is hampered, it may become more difficult to escape poverty. In essence, this suggests a vicious circle, whereby poverty promotes the likelihood of the tax on mental capacity and the tax leads to worse financial decisions due to lower financial literacy. In turn, the likelihood of escaping poverty diminishes. For the second research objective, we focus on loan control among women who are members of a Self-help group (SHG) and have access to loans through the SHG. We analyze the influence of loan control on the likelihood that the households invest into agriculture. Agricultural investments are important for potential poverty reduction due to their productive nature. Moreover, agriculture is a traditional male domain in India. In our econometric analysis, we show that the likelihood of investing into agriculture declines with increasing loan control by women. The implication of our findings is twofold. First, this inverse relationship shows that households in which women have less loan control invest in domains over which women have no say, agriculture in our study. Thus, the women bear the obligation to repay while having no control over the loan. This may make it more difficult for SHG member women to repay their loans and to develop the reputation of being a reliable borrower. Second, although this burden contradicts the goal of empower¬ing women through access to credit, the household as a whole may still benefit from the productive agricultural investment. This is the tradeoff found in our study in the case of SHG lending. We suggest measures intended to diminish that tradeoff. Measures to encourage women’s agricultural investments are discussed. First, we elaborate on women’s access to land and markets in India. Second, we discuss the potential for diminishing the tradeoff through measures to increase loan control for women. In particular, we argue that it is worth exploring having loans that are not distributed directly to the SHG member women but are instead transferred to an agricultural investment counterpart. The women can then obtain goods or services from the investment counterpart and do not face the risk of losing control over the money when bringing it home. This research is informative for rural development because it identifies two diametrically opposed outcomes that are both important for rural development, namely potential monetary benefits at the household level through productivity-increasing investments and women’s empowerment in the area of loan control. This dissertation relies on data collected through a survey of 658 households between February and May 2014 in India. To conduct the survey, we visited the households of SHG member women. During the survey, we conducted an experiment that yielded the data for the first research objective. The second research objective relies on cross-sectional data from the survey.
Keywords: financial literacy; household investment; SHG