How do we get more people in emerging markets into the formal economy? Simple, make money cheaper.
Written by Koen The on 22 July 2021
As an economics student you learn about the 'law of one price': the concept that the price of identical assets should be the same. Then after college, as a student of life, you quickly realize that what you learned as an economics student is simplistic and detached from reality. In other words, horse crap.
The price of employee stock
Allow me to use valuation of employee stock as an example. Employee stock is usually valued at the last known price at which an outside investor invested in a company (let's assume there are no specific restrictions to the employee stock). That's not the law of one price as dictated by nature or economic dynamics, but by grey people in grey suits somewhere in a grey building.
Look at this from an employee's point of view. She is all-in: if the company doesn't do well, she loses her job and ends up with shares that are worth, well, horse crap. The outside investor meanwhile is diversified and only has 1-5% of his funds invested in the company. He's not too worried, as the gains on other investments will more than compensate for any potential loss. If a stock price represents the discounted future cash flows of a company, then the employee should clearly (be allowed to) use a different discount factor than the investor. Same asset, different prices, very consistent.
The price of money
Now let's go to the incredibly interesting topic of interest rates. An interest rate can be seen as the price of money, and depends on what your bank thinks your capacity to repay is. The law of one price thus dictates that you pay the same interest rate as someone else with the same creditworthiness.
Imagine for a moment that we are in a rural area in India. People here live on a few Euros a day and quite a lot of them make a living as traders. They buy wholesale and sell at the local market. They make some money and can take care of their family. The next day it starts all over again. Some of them have the skills to grow their business. They take entrepreneurial risks, take out a loan, and basically leverage their business in the hopes of increasing their future earning potential.
This leverage comes at a cost of - hold tight - 30% per annum. Clearly there is no comparison in creditworthiness with someone in the Netherlands that takes out a mortgage. But still, the price of his money is 28.5% higher?
Explaining the difference
Research has shown that local financial institutions in emerging markets are not necessarily making outsized profits. The return on equity is decent, and obviously higher than in North America and Europe, but there is also more risk involved. The cost of funding can of course be quite high for a local financial institution. The Indian government is borrowing at 6%, and you can expect a local financial institution to pay more than that for their debt.
You can add a premium on top of that if borrowing happens in a different currency and the exposure needs to be hedged. Leverage ratios are nowhere near those of western banks and therefore margins need to be higher. Where the INGs and ABNs of this world leverage themselves 20 times, a local financial institution in an emerging market cannot do that. It would be too risky and no one would lend them the money. So where ING only needs to add a margin in basis points, the local financial institution has to add several percentage points.
Furthermore, the entrepreneur does not usually have valuable assets that can be used for collateral. The local financial institution has to deal with higher probabilities of default and a higher loss given default. Before you know it, all this adds up to an interest rate of 15% or so. That's high, but not even close to the 30% the Indian entrepreneur ultimately is charged. So what makes the difference?
It's the low operating leverage.
The current harsh reality of disbursing small loans
It's very costly to originate and service small loans. That's especially the case in cash-based markets with customers spread over a large area. Collections often happen by loan officers going into villages, and the paperwork in order to get the loan in the first place is also oftentimes very inefficient. It's a sad reality in that the price of money is for a large part determined by how expensive it is to process the loans.
We've said it before: it's expensive to be poor. Annual operational costs can add up to 15% of the portfolio, and sometimes even much higher than that.
Inspiration for the solution can be found in... Silicon Valley of all places
If operating leverage is low, leading to a relatively high price of money, the question is of course how to fix that. For that we go from rural India to the shiny buildings of Silicon Valley. Here you have companies that have high operating leverage. Think Slack or Zoom, selling another new subscription to a business account. A big chunk of their work is done upfront. They develop the software and then sell it as a service, over and over.
For local financial institutions in emerging markets, it's key that they make use of a modern tech stack to service the loans. There is so much low hanging fruit if they do! If loan officers have to go remote areas, let them do that using a tablet and QR codes. Heck, mobile phone penetration is surprisingly high in emerging markets, and there should be less of a need for a loan officer to visit customers.
Loan origination can be done by applying digital KYC methods (dare I say blockchain?) and data models to determine creditworthiness. A green light would mean money in the bank in the blink of an eye. And the bank obviously lives in an app, not a building. The combination of machine learning and human inference can lead to improved speed and lower default rates. Less non-performing loans means lower operational costs.
Especially in emerging markets, technology can drive down operational costs significantly. After a while this should translate into lower interest rates for borrowers. If the price of money becomes cheaper, it will become better available for more people who need it.
More businesses will flourish and more jobs will be created.
As long as some people pay an unfairly high price for money, poor people will stay poor. Traditional financial institutions are doing what they can, but if we want to accelerate change and truly make a difference in the fight against poverty, we need to stimulate the innovators.
There may not be a law of one price, but there is certainly a need for making financing a more equal level playing field.