The Hindu Business Line : Formal finance for informal sector

The informal sector plays a significant role in the economy in terms of employment opportunities and poverty alleviation. This sector generates income-earning opportunities for a large number of people. In India, a large section of the total workforce is still in the informal sector, which contributes a sizeable portion of the country's net domestic product.

The informal sector in India refers to productive institutional units characterised by a low level of organisation with no access to formal credit, little or no division between labour and capital, labour relations based on casual employment and/or social relationship, as opposed to formal contracts, labour-intensive technology, and low-skill labour. These units to a large extent belong to the household sector and cannot be associated with other organisations.

According to economists, the labour absorption capacity of the informal sector is much more than its formal counterpart. Thus, with passage of time and further liberalisation and globalisation of the economy, the informal sector is expected to absorb more labour than the formal sector.

Present Scenario

It is surprising to note that despite a decade and a half of economic reforms and rapid progress in the banking sector, India's informal sector, particularly the rural segment, still has very limited access to formal finance. As per a World Bank-NCAER survey on accessibility of finance in the rural sector, 70 per cent of the rural poor do not have a bank account and 87 per cent have no access to credit from a formal source.

Sources of Informal Finance

The informal financial sources generally include funds available from the family or moneylenders who operate outside the legal and policy framework of banks. Apart from this, the chit fund is another form of credit source operated by groups of people for mutual benefit; but this approach has its own limitations. Credit in the informal system is usually available on tap. The loans are granted mostly without collateral and lengthy documentation formalities as the lender depends mainly on the personal knowledge of, and contact with, the borrower. However, over the years, a few NGOs have engaged themselves in activities related to community mobilisation for savings and credit-related operations targeted at some groups in the rural sector.

It has been observed that with a few exceptions, most micro-finance institutions (MFIs) in India are small, region-specific and with a limited collective outreach. Except a few, most MFIs also offer a limited range of financial services beyond credit. This needs a serious policy attention in the light of the fact that in many places, especially in Indonesia and Bangladesh, MFIs operate on a larger space.

New Channels of Finance

Considering the problems faced by the rural people in getting adequate finance at a reasonable rate in a transparent manner there are two options.

Following the international experience, banks in India need to, one, develop more customised as well as flexible loan products specifically catering to the needs of this sector, and, two, develop new delivery channels for lending to the informal sector directly and indirectly. Banks can appoint some business correspondent agencies, such as NBFCs (non-banking finance companies), reputed NGOs, MFIs and cooperatives, for this.

These intermediaries can identify and disburse of small loans in the rural areas for farming or personal purposes. As these business correspondents are basically from the local areas, they can be expected to be more aware about the activities and have other relevant information of their borrowers than any bank officer. By this can be addressed the uncertainties about the quality of borrowers and of the assets. This will help banks in risk mitigation, as a bank's risk will be exposed to the business correspondents only. With proper selection of these business correspondents this risk can also be reduced significantly.

Without opening a full-fledged branch in the rural areas, banks can increase their business through this approach, which reduces the cost of operations. Simultaneously, considering the risk factors of lending to this sector, banks can charge comparatively higher interest rates and earn higher returns. Thus, bank finance to this informal sector through the above route is a win-win situation for both banks as well as the rural economy. Apart from steady flow of finance to Rural India, banks can increase their margins by higher return on assets and lower cost of operations.

Roping in Money Lenders

Considering the huge demand for funds in the informal sector, the business correspondents, in view of their existing spread, may not be sufficient to fill the gap of fund requirement in this sector. Banks cannot replace the moneylenders, who are present at every nook and corner of the rural sector. Though apparently the interest rates charged by them are comparatively high, taking into account the risk factors — such as poor quality of security, lack of proper records, incidence of high degree of crop failure — it can be said that from an economic point of view the moneylender still plays a vital role. They are aware not only of the quantum of finance required by the rural people but also the timing. Thus, considering their importance in the informal sector, moneylenders must be co-opted as a business correspondent to the banks.

The interest rate to be charged and the scope of finance are to be decided by the banks.

This mechanism will bring some degree of transparency to the operations of moneylenders and simultaneously larger flow of funds to be channelled to the informal sector at a reasonable rate. If the moneylenders can be brought into the formal financial system, this is likely to avoid a social tension as well.

Needed, a new mechanism

The lack of adequate finance in the informal sector is one of the important problems in a growing and developing economy such as India.

The success of graduating from a developing to a developed economy, to some extent, depends upon the degree of integration between informal and formal sectors. Considering this and taking into account the immense contribution of the informal sector to the country's growth process, there is an urgent need for policy-makers, financial institutions and banks to take the initiative to ensure that the informal sector gets adequate finance at reasonable rates.

Developing a new financing mechanism by bringing in the informal agents/intermediaries into the finance mainstream will help the informal sector and thereby the overall economy of India.

(The author is Assistant General Manager, Corporate Strategy and Planning Department, IDBI, Mumbai.)

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