Cheap Credit and International Political Relationships : The Case of Global Microfinance

The provision of subsidized credit to financial institutions is an important and frequentlyused policy tool of governments and central banks. To assess its effectiveness, we exploit changes in international bilateral political relationships that generate shocks to the cost of financing for microfinance institutions (MFIs). MFIs that experience politically-driven reductions in total borrowing costs hire more staff and increase administrative expenses. Cheap credit leads to greater profitability for MFIs and promotes a shift towards noncommercial loans but has no effect on total overall lending. Instead, the additional resources are either directed to promoting future growth or dissipated. We thank Damian von Stauffenberg and MicroRate for access to the data, and Viral Acharya, Ray Fisman, Matthias Kahl, Justin Murfin, and audiences at NYU Stern, UCLA Anderson, the NBER, Drexel, ISNIE, the Peruvian Banking Superintendency (SBS), the Peruvian Central Bank, and Universidad de Piura for useful comments. Natividad acknowledges the financial support of the Berkley Center at NYU Stern. The provision of credit to financial institutions at below-market interest rates is one of the primary tools used by governments and central banks to regulate and stimulate the broad economy. When cheap financing is provided, the benefits of injecting capital must be balanced against the costs of distorting market incentives for financial institutions to operate efficiently. Despite the widespread use of low-priced credit, however, empirically analyzing its consequences is difficult. The allocation of subsidized financing may be endogenously related to country-wide economic conditions or to unobserved characteristics of the financial institutions receiving the influx of capital. In this paper, we investigate the effects of below-market credit on the operations, lending activities and performance of microfinance institutions (MFIs) around the world. We employ an empirical strategy based on changing bilateral international political relations between the host country of an MFI and the nations of its lenders, as measured by the similarity of their U.N. voting patterns. Comparing MFIs in the same country, we show that those experiencing improved political relations with the states of their lenders receive politically-motivated subsidized financing (in many cases at rates below those of U.S. government bonds of equivalent maturity) that is plausibly unrelated to their characteristics. In this sense, shifting political relationships may be viewed as an exogenous source of variation in the provision of cheap credit. Given the international pervasiveness of below-market credit for financial institutions, which has been accentuated in the past few years, it is important to understand its effects. In particular, it is useful to know to what extent the subsidy generates additional lending and to what degree it is dissipated or captured by managers and employees at the financial institutions. Our study analyzes MFIs, small lending institutions that resemble banks except that they typically finance themselves with loans, not deposits. They are a rising form of financial intermediary in many developing markets. We use political shocks to the supply Low-priced credit may take the form of a reduced cost for government-guaranteed deposits (Gatev and Strahan (2006), Gatev, Schuermann and Strahan (2009)), central bank lending to financial institutions (Flannery (1996) and Artuç and Demiralp (2010)), direct support of government-owned banks (La Porta, Lopez-de-Silanes and Shleifer (2002) and Sapienza (2004)) or emergency assistance (Gorton and Huang (2004) and Duchin and Sosyura (2011)). 1 of credit to gauge the impact of subsidized financing by studying three basic issues. First, we consider the effect of cheap financing on the hiring and operations of MFIs. We show that MFIs receiving low-cost funds increase the number of credit officers and especially augment their non-credit staff. They also have higher administrative expenses. Second, we assess the impact of below-market financing on the quantity and composition of lending by financial institutions (Bernanke and Blinder (1988), Gertler and Gilchrist (1993), Kashyap and Stein (1995) and Den Haan et al. (2007)). We show that, similar to its effects on banks in developed markets, cheap credit has little impact on the total amount of lending, but does lead to a shift in favor of non-commercial loans. Third, we analyze the effect of the financial subsidy on the performance of lending institutions (Saunders, Strock and Travlos (1990), Hovakimian and Kane (2000) and Acharya and Yorulmazer (2008)). We find that subsidized MFIs enjoy higher gross margins, but exhibit no change in their propensity to make non-performing loans. We also find no evidence that the subsidy leads MFIs to charge lower rates to their customers. The influence of politics on global capital flows is an increasingly important question, but it has received relatively little attention in empirical work. It is clear that for developing countries this is a first-order question as the supply of critical loans from multilateral organizations is likely affected by international political connections. Even in developed economies political proximity can facilitate bailouts (Faccio, Masulis and McConnell, 2006) and political connections can be valuable to individual firms (Faccio 2006). Given the role of globalization in explaining financial institutions’ lending activities (e.g., Cetorelli and Goldberg (2011)), understanding the political economy of cross-country links is particularly important. Our results from our large sample of lenders from 47 countries and borrowers in 28 emerging markets allow us to quantify the significant impact of international political relationships on loan terms and to describe the eventual implications of this credit for the financial institutions that receive it.