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Corruption, Poverty Traps, and Credit Market Imperfection

by Indranil Dutta and Ajit Mishra

In many developing countries corruption is pervasive and is often cited in policy discussions as a major stumbling block for development. The local media in these countries frequently report serious cases of corruption, typically involving siphoning of money from government projects. For instance, roads built this year may be washed out by the next, village wells may only be built on drawing boards, and schools may only provide midday meals in official documents. This type of corruption has broad macroeconomic effects through poor infrastructure and reduced investment, leading to lower economic growth.

Corruption also affects day to day life in the developing world. Whether it is obtaining a driving license or receiving subsidized credit, there is a certain amount of corruption to contend with. Yet, to an extent, the effect of corruption is not classless; the rich are able to get away with more compared to the poor. An industrialist may be able to benefit from not adhering to the antipollution laws through bribing an inspector. A government contractor may supply shoddy goods at the full price by paying a consideration to officials. Through bribery and collusion the rich can clearly benefit from corruption.

When it comes to the poor, however, the story is different. The World Bank study ‘Voices of the Poor’ proclaims that ‘Poor people engaged in the study reported hundreds of incidents of corruption as they attempt to seek healthcare, educate their children, claim social assistance, get paid, attempt to access justice or police protection, and seek to enter the marketplace’. The poor are often harassed by public authorities and are seldom the beneficiaries of development projects. In a telling revelation in the same World Bank study, Vares from Bosnia-Herzegovina states that, ‘[previously] everyone could get healthcare, but now everyone just prays to God that they don’t get sick because everywhere they just ask for money’. The implications of this are quite clear. When the poor cannot get medical care, when they are excluded from potential jobs, when they are not paid their due social assistance, simply because being poor they cannot afford to pay the bribes then they would remain poor. In other words, corruption becomes a crucial factor in reinforcing the poverty trap. By keeping the poor in their place and providing the rich with greater benefits, corruption can and does, in effect, exacerbate inequality.

There are various questions one can raise about exactly how corruption is able to exclude the poor. First, why don’t corrupt officials actually reduce their cut and charge the poor the maximum possible bribe that they can pay? Although there may be several reasons why officials do not reduce their bribes, one obvious reason among them is that when officials engage in corruption there is certain probability (however small or large) that they would get caught and be punished. It is this expected punishment that acts as a cost for engaging in corrupt activities, thus prompting officials to charge some positive amount of bribe. Other reasons could include that the corrupt officials may not be able to distinguish between those who can pay the bribes and those who cannot, thus asking the same bribe from all. Further, it may also be the case that there is more than enough demand by people who can afford to pay a higher bribe for the limited number of say, jobs or other resources, that the official can dispense.

Note that because of moral hazard problems bribes must be paid upfront. Hence it is usually not the case that the poor receives the benefit and then pays the bribe. Had such been the case, corruption would not give rise to poverty traps. To illustrate this point consider a poor person with health problems who cannot obtain medical care because they cannot afford the bribes. This implies that the person continues to suffer from ill health and is unable to earn a higher income, thus remaining poor. On the other hand, if the poor person could get medical care on a promise of paying the bribe later, and then fund the requisite amount from the extra income made after getting well, they would not be trapped in poverty. The issue, however, is that once the person gets well, what is there to stop them from reneging on their promise to pay the bribe since, given its illegal nature, they cannot be enforced in a court of law. Thus the upfront payment of the bribe is crucial in maintaining the poverty traps.​​

The other important question one can raise is why don’t the poor borrow the required amount of bribes from the credit market and thus avoid the poverty trap? The obvious explanation is that banks would not lend to the poor; but why? It is assumed that since the poor do not have collateral, banks would not risk a loan because in the event of reneging they do not have many options to recover the loans. The reason, therefore, is that given the lender’s inability to monitor the loan once it has been issued, the lender does not want to take the risk of lending the money. The underlying assumption here is that poor people would cheat in such circumstance simply because they could get away with it.

This assumption, however, may not reflect reality satisfactorily. Many of the poor are hardworking and honest people, who would fulfil their commitments like others. If, suppose, the banks were to receive a guarantee that the poor would not renege, would they then lend to the poor? The answer to this is not apparent. There can still be a case where the poor are excluded from the credit market. If the borrowers have heterogeneous abilities in terms of their performance with the loans and the lenders cannot differentiate between the borrowers, then situations may arise where some of the high ability poor borrowers are pushed out of the market because they cannot be distinguished from the low ability borrowers, thus increasing their cost of borrowing and making it unsustainable for them to remain in business. The high ability rich borrowers, however, can be easily differentiated from the rest because being rich they can afford to put up collateral, and in turn enjoy a lower rate of interest.

An argument along similar lines has been explored in our paper (‘Inequality, Corruption and Competition in the Presence of Market Imperfections’, WIDER Research Paper 2005/46), which discusses the interlinkages between corruption and inequality in the presence of incomplete information in the credit market. In fact we demonstrate that corruption, by allowing low ability agents to collude with government inspectors, plays an intrinsic role in the exit of the high ability poor borrowers. The tragedy of the situation is that the more hardworking and better able of the poor are excluded from the market and thus are unable to move out of the poverty trap. This is quite contrary to our expectations where we hope that through hard work and ability one can build a better life for themselves, free from poverty. Thus in the presence of corruption and credit market imperfection, even if the poor do not renege on their repayment, they still may be excluded from the credit market.

What we have tried to highlight is the role of corruption in reinforcing poverty traps. Hence, if we aim to reduce poverty, fighting corruption should be an important priority. Typically this is achieved by focusing on stricter laws, better monitoring, and greater enforcement; the idea being that it will deter officials from engaging in corrupt activities. But given the vast scale of corruption in many countries, it becomes clear that monitoring and enforcement may be extremely costly. As such, a better route of reducing poverty may then be to focus on credit market imperfections. In this way at least the poor would not be cash constrained to pay the bribes. But as we show, it is possible that a better functioning credit market may also help in reducing corruption.

Indranil Dutta is a Research Fellow at UNU-WIDER, Helsinki, Finland. He returns to the Department of Economics, University of Sheffield in January 2007.

Ajit Mishra is a Senior Lecturer with the Department of Economic Studies, University of Dundee, UK.