Effects of Index Insurance on Demand and Supply of Credit: Evidence from Ethiopia

Index-based insurance offers a climate risk management strategy that can benefit the poor. This article focuses on whether adopting index insurance improves access to financial markets and reduces credit rationing, using empirical analyses focused on Ethiopia. With different identification strategies, including a newly developed method that leverages the varying availability of index insurance across areas, the authors control for potential selection biases by forecasting potential insurance adopters; they apply a cross-sectional double-difference method. Credit rationing can take the form of either supply-side quantity rationing, in which case potential borrowers who need credit are involuntarily excluded from the credit market, or demand-side rationing, such that borrowers self-select and voluntarily withdraw to avoid transaction costs and threats to their collateral. By differentiating supply-side and demand-side forms and employing a direct elicitation method to determine credit rationing status, this study reveals that 38% of sample households are credit constrained. The preferred estimation techniques suggest that index insurance significantly reduces supply-side rationing.