Does Microfinance Repayment Flexibility Affect Entrepreneurial Behavior and Loan Default?

This paper examines the trade-offs between the rigidity of a classic microcredit contract, default and investment in microenterprises. It analyzes whether the immediate repayment obligations of the classic microcredit contract inhibit investment in microenterprises as they tend to make illiquid entrepreneurial investments too risky for small business owners in the short run. The paper tests whether client investment behaviour is sensitive to introducing greater flexibility in loan contracts.

Using a field experiment, the paper evaluates the effect of relaxing liquidity demands on households early in the loan cycle by offering a random set of clients a two-month grace period before repayment begins. Study findings include:

• Client investment and repayment behavior are sensitive to when repayment obligations start;
• Likelihood of investing in existing businesses and starting new ventures is higher among clients who receive a two-month grace period;
• Clients receiving a two-month grace period are also likely to default on their loan, suggesting that illiquid investments imply greater risk in ability to repay;
• Effect of the grace period increases with clients level of risk aversion, suggesting that risk averse clients are most deterred by repayment obligations.