The Covid-19 crisis in developing countries put a pause to some poverty-reduction initiatives from international institutions, such as the World Bank and the UN. One of those policies was financial inclusion. This policy seeks to promote access to and usage of financial services by poor individuals, including through the use of mobile money.
In theory, financial inclusion would be beneficial to low-income households, as bank accounts could facilitate financial transactions and allow individuals a safe repository for their savings. In practice, however, poor individuals might not need formal financial services and financial inclusion might even lead to over-indebtedness due to the high interest rates on loans. The inherently high costs of financial services and the need for formal finance is, however, often overlooked by policymakers.
The cost of financial services
Developing countries have three key characteristics that contribute to the high cost of financial services. First, the informal labour market is extensive, reaching 80.8% of workers in urban Africa. Informal workers are considered risky clients by banks, as they do not have a regular income stream nor collateral, besides being more likely to default on their payments and make insurance claims. Thus, services to those workers are more expensive and contract terms tend to be shorter than in developed economies.
Second, developing countries are inserted in a hierarchical international monetary system. In it, core currencies such as the US dollar and the Euro are found at the top and the currencies of developing countries are at the bottom. Thus, to prevent capital flight, central banks must set higher interest rates than those seen in developed countries. Despite the all-time low interest rates in the Global North, countries such as Argentina and Ghana have base interest rates at 38% and 13.5%, respectively.
Third, there is often a lack of competition in the financial sector in developing countries. In the Gambia, for instance, bank concentration (assets of the largest three banks as a share of total banks) is 100%. This allows banks to set high prices for services and to add an oligopoly-like mark-up to the interest rate. Thus, loans and financial services to low-income individuals in developing countries are inherently costlier than in high-income countries.
These particularities of developing economies shape the local financial system. As the costs of financial services are high and the repayment schedules are strict, many poor individuals have issues in affording these costs on time. This may lead to high fees for late repayments, loan defaults and over-indebtedness, thus preventing financial inclusion from reducing poverty.
The need for formal finance
From the consumer side, the issue is much simpler. According to the World Bank, most individuals in developing countries did not have a bank account because they did not have enough money (either to afford fees or to make use of the account). Moreover, almost 30% of individuals said they have no need for a bank account. This suggests that, unlike existing mainstream approaches to “fix” the local financial system, such as boosting the fintech sector or simplifying the bureaucracy, there is actually a lack of demand for most formal financial services.
Reasons for not having a bank account (Findex World Bank), in %
Source: Balliester Reis (2020)
As most workers are informal, they earn a low income in irregular patterns and mostly in cash, so that there is little need for formal financial services. In fact, the most required service by the poor is credit – as they might need to it to compensate the lack of income. In general, credit is used for basic needs, such as food, school fees and medications. However, with excessively high interest rates, it is unlikely that credit will help those individuals to overcome poverty even if it increases their consumption in the short run.
As discussed by Tobias Franz, households in Latin America, for example, are highly indebted and have no savings. Thus, pushing further financial inclusion during Covid-19 will not be a salvation, but a means to deepen poverty in the long term. If unemployed or informal workers need to smooth their consumption over time with high-interest loans, financial inclusion can lead to the selling of assets, such as cattle, or even food insecurity. In 2018, a CGAP study showed that 20% of mobile money borrowers in Kenya had to cut food to repay their loans, shading light to the detrimental effects of fintech loans.
Instead of fostering financial inclusion as a tool to reduce poverty, international organisations could focus their resources on the formalisation of the labour market. This policy would create a minimum wage floor, a steady income and access to social security to the poor, thus providing consumption smoothing and promoting mass exit from poverty. Such an approach could ultimately lead to an increase in the use of financial services, if demanded by workers. In conclusion, financial inclusion should be seen as a result of structural transformation in these economies, not the driver of development.