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A pawnbroker’s building in Detroit, Michigan.

Unit 9 Lenders and borrowers and differences in wealth

How borrowing and lending expand opportunities for mutual gain, and the factors that limit their capacity to accomplish this.

9.1 The importance of Chambar moneylenders

Before you start

To analyse borrowing and lending throughout this unit, we use the approach explained in Unit 3 for solving constrained choice problems using indifference curves and the feasible set. If you are not familiar with this method, you should read Sections 3.2 to 3.6 before beginning work on this unit.

The market town of Chambar in south-eastern Pakistan serves as the financial centre for 2,400 farmers in surrounding villages. At the beginning of the kharif planting season in April, when the farmers sow cotton and other cash crops, they buy fertilizer and other inputs necessary for production. Months have passed since they sold the last harvest, and so the only way they can buy inputs is to borrow money, promising to repay at the next harvest. Others borrow to pay for medicines or doctors.

But few farmers have ever walked through the shiny glass-and steel doors of the JS Bank on Hyderabad Road. Instead, they visit one of approximately 60 moneylenders.

If they are seeking a first-time loan, they will be questioned intensively by the moneylender, asked for references from other farmers known to the lender, and in most cases, will be given a small trial loan as a test of creditworthiness. The lender will probably visit to investigate the condition of a farmer’s land, animals, and equipment.1

The lenders are right to be wary. If the farmer’s crop fails due to drought or lack of attention, the lender will make a loss. Unlike many financial institutions, lenders do not usually require that the farmer set aside some property or belongings—for example, some gold jewellery—that would become the lender’s property if the farmer does not repay the loan.

If the would-be first-time borrower seems reliable or trustworthy enough, the farmer is offered a loan. In Chambar, this is at an average interest rate of 78% per annum. If the borrower pays the loan back in four months (the growing period of the crop prior to harvest), 100 rupees borrowed before planting is paid back as 126 rupees. But, knowing that more than half the loan applications are refused, the borrower would feel fortunate.

And indeed, the borrower in Chambar would be, at least compared to some people 12,000 km away in New York, who take out short-term loans to be repaid when their next pay cheque comes in. These payday loans bear interest rates ranging from 350% to 650% per annum, much higher than the legal maximum interest rate in New York (25%). In 2014, the ‘payday syndicate’ offering these loans was charged with ‘criminal usury’, meaning charging illegally high interest rates.2

Given the interest rates charged, is the business of lending in Chambar or of payday loans in New York likely to be exceptionally profitable? The evidence from Chambar suggests it is not. Some of the funds lent to farmers are borrowed from commercial banks, like the JS Bank, at interest rates averaging 32% per annum, representing a cost to the moneylenders. And the costs of the extensive screening of borrowers and collection of the debts further reduces the profits made by the moneylenders.

Partly as a result of the careful choices made by the moneylenders in Chambar, default is rare—fewer than 1 in 30 borrowers fail to repay. By contrast, default rates on loans made by commercial banks are much higher—one in three. The moneylenders’ success in avoiding default is based on their accurate assessment of the likely trustworthiness of their clients.

Not everyone passes the trustworthiness tests set by the moneylenders and the payday lenders—some would-be borrowers find it impossible to get a loan. And, in Chambar and New York, some of those who do, pay much higher interest rates than others.

Long before there were the employers, employees, and the unemployed that we study in Unit 6, there were lenders and borrowers. Some of the first written records of any kind were records of debts. Differences in income and wealth between those who borrow—like the farmers in Chambar and those seeking payday loans in New York—and those who lend—like the moneylenders in Chambar and the payday lenders in New York—remain an important source of economic inequality today.

  1. Irfan Aleem. 1990. ‘Imperfect information, screening, and the costs of informal lending: A study of a rural credit market in Pakistan’The World Bank Economic Review 4 (3): pp. 329–49.  

  2. Jessica Silver-Greenberg. 2014. ‘New York prosecutors charge payday loan firms with usury’. DealBook. Updated 11 August 2014.