The Debt Trap Paradox: How Financial Inclusion Exacerbates Poverty in Developing Economies

Abstract

Prevailing development orthodoxy holds that expanding financial inclusion is a reliable pathway to poverty reduction. This paper challenges that assumption. Analyzing panel data from 38 developing countries over 2015–2024, we find that a 10% increase in formal financial inclusion is associated with a 1.8% increase in household debt distress and no statistically significant reduction in extreme poverty once we control for digital infrastructure quality, labor market conditions, and pre-existing informal financial networks. Our instrumental variable estimates suggest that the causal effect of financial inclusion on poverty is near zero and, in the poorest quartile of countries, marginally positive (i.e., poverty-increasing). We identify three mechanisms driving this paradox: consumer debt traps from unregulated digital lending, displacement of effective informal risk-sharing networks, and extraction of savings through high-fee formal financial products. These findings directly contradict the optimistic consensus-exemplified by studies reporting that financial inclusion reduces extreme poverty by over 2%-and call for a fundamental reorientation of development policy away from inclusion-first strategies toward regulation-first and capability-first frameworks.