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Paper 4: Political and Sociological aspects of Economics Essay Discuss why informal lending is so pervasive in developing countries. In this context, why do moneylenders charge such high rates of interest on their loans?
The financial market in developing countries shows some different characteristics compared to the markets in developed countries. One of the features is the high level of informal lending in developing economies, especially in rural areas, with interest rates much more variable and higher than in the formal sector. For example, informal lending stood at 90% in Thailand in 1975 and still 50% in the late 1980s. In the late 1980s in Nigeria, only 7.5% of all loans came from official sources such as banks, companies and projects, so the informal sector was substantial.In the early 1980s, interest rates in the formal sector in India were at 17%, whereas the informal sector had interest rates of 24%.2
One reason for the high level of informal lending is informational constraints. Lenders in the formal sector, such as registered banks or credit bureaus often do not have enough information regarding the characteristics and activities of their clientele.3 They can not monitor effectively how the loan is put in use and whether their clients are undertaking their best efforts to pay the loan back. Therefore, formal financiers are often not present in rural areas; so many individuals have no access to formal lending. The problem of lacking information can be overcome by informal lenders, who often limit their business to a small community such as a village. Informal lenders are much better informed about the borrowers in their local community. They can monitor the efforts of the clients better than formal banks and can assess their risk accordingly. Borrowers often see it in their interest to take higher risk than the lender would like to see. As the borrower has limited liability, the borrower would benefit from a positive outcome of a risky project, but is cushioned on the downside.Thus, the bank would like to see the money invested in a safe project, whereas the borrower maximises his expected outcome by investing in a risky project. However, if the borrower could be made to repay the loan at all events, the bank would be satisfied and indifferent between safe and risky projects. But only wealthy borrowers can assure the bank of their ability to repay the loan even in the case of failure, whereas the poor cannot. Hence, many banks do not lend to poor individuals in the
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