Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor? Experimental Evidence from India

This paper presents the results of a field experiment conducted to compare the classic microfinance contract which requires that repayment begin immediately after loan disbursement to a contract that includes a two-month grace period. The study was conducted with Village Financial Services (VFS), an MFI that makes individual-liability loans to women in low-income neighborhoods of Kolkata, India. A study sample of 845 clients was taken into consideration with them being randomized into one of the two repayment schedules. The study makes the following observations:

• High returns to capital were identified for small entrepreneurs in a developing-country setting;
• Liquidity constraints limit small entrepreneurs from exploiting high returns;
• MFIs may not offer a higher interest rate grace period contract because of the associated adverse selection and moral hazard concerns;
• Carefully targeted subsidies may well allow microfinance to alleviate credit constraints among the poor in a manner that encourages profitable investments among the poor.

The paper concludes by suggesting that evaluating the economic impact of debt contract design can provide valuable insights on entrepreneurial behavior and help identify alternative methods of reducing liquidity constraints.