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The impact of a formal credit
expansion on agricultural
development in India
Nina van Ettekoven
10071369
Faculty of Economics and Business
Study programme: BSc Economics and Business
Specialization: Economics
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Table of Contents
1.
Introduction
3
2.
Indian Agriculture and Credit
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2.1 Characteristics India’s agricultural sector
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2.1.1 Agricultural productivity
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2.1.2 Economic inequality
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2.2 The credit problem
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3.
Rural Credit Markets
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3.1 Coexistence of formal and informal lenders
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3.2 Information asymmetries
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3.3 Default and collateral
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3.4 Interest rate variation
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4.
Formal and Informal Lending in Rural India
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5.
The Impact of a Formal Credit Expansion: Informal Credit Market Effects
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5.1 The extent of informal lending
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5.2 Informal interest rates
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6.
The Impact of a Formal Credit Expansion: Agricultural Development
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6.1 Agricultural productivity
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6.2 Economic inequality: will small farmers be reached?
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7.
Conclusion
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1 – Introduction
India’s economy has been growing rapidly in recent years. Since 1991 it has been among the top 10 percent of the world’s countries in terms of economic growth (World Bank, 2013a). However, the resulting economic benefits are not widely spread. The share of agriculture in the country’s gross domestic product (GDP) is steadily declining: it has fallen from 55.1 percent in 1950-51 to 17.0 percent in 2008-09 (Kannan and Sundaram, 2011). Despite this, the agrarian sector has not diminished in importance. The dependence on agriculture has not declined at all. The sector still employs 51.1 percent of India’s workforce and the rural areas are home to about 72 percent of the population (World Bank, 2013a). The sector’s declining economic contribution is indicative of the agricultural crisis that the country has been experiencing for two decades now. There has been a slowdown in agricultural growth, leading to widening income disparities between agricultural and non-agricultural sectors (Chand and Chaunan, 1999).
One of the main factors hampering agricultural growth is the inadequate provision of credit (Mishra, 2008). The rural credit market is not working efficiently. It is characterized by large market imperfections, mainly caused by information asymmetries between borrowers and lenders (Besley, 1994). As a result, many farmers are excluded from the formal credit market and are dependent on expensive informal loans in financing their production activities.
The stagnation of the agricultural sector is a major cause of concern to the government (World Bank, 2013a). In order to stimulate agricultural development, there are two main credit subsidy policies the government can undertake: a reduction in the formal interest rate or an increase in the formal credit supply to agriculture. The first policy receives much criticism in literature (Bose, 1998; Chaudhuri, 2001), emphasizing its possible adverse effects. Therefore, the present study focuses on the second policy, formulating the following research question: how would an expansion of formal credit affect agricultural development in India? Due to unavailability of household-level data
concerning rural informal lending and the comprehensive amount of relevant literature on this subject, a theoretical approach will be taken in providing an answer to the research question.
The thesis will be structured as follows. Chapter 2 is the problem statement; it elaborates on the features of the Indian agricultural sector and relates the issues to inadequate credit access. Chapter 3 gains understanding of the nature of rural credit markets in developing countries by studying its characteristics. Chapter 4 examines the current situation in rural India regarding formal and informal lending. Chapter 5 studies the impact of a formal credit expansion on the informal credit market. Taking this into account, chapter 6 determines the effect of the credit expansion on agricultural development. Finally, chapter 7 concludes.
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2 – Indian Agriculture and Credit
To study how a formal credit expansion could improve agricultural development in India, a definition of agricultural development is needed. In a paper about raising agricultural growth and productivity, Mahendra Dev (2012a) identifies the three goals of agricultural development. These are: 1) achieve 4% growth in agriculture and raise incomes by increasing productivity in land and labor; 2) sharing growth by focusing on small and marginal farmers; and 3) maintain sustainability by focusing on environmental concerns. The first two goals are considered the most important and are given priority in government policy (World Bank, 2013a). For the scope of this thesis, I will therefore focus on these to provide an answer to the research question. That is, there will be studied how increased formal credit supply affects 1) agricultural productivity and 2) economic inequality between farmers. This chapter first elaborates on the current situation in Indian agriculture regarding these two subjects. Subsequently, the identified issues will be connected to credit.
2.1 – Characteristics of India’s agricultural sector
2.1.1 – Agricultural productivity
During the1960s, India started to witness extensive improvements of the agricultural sector. This was due to what is called the Green Revolution, which included land reforms, improved rural infrastructure, the introduction of high-yielding varieties of seeds and subsidies for inputs leading to increased use of chemical fertilizers and irrigation. It provided the production increase needed to make India self-sufficient in food grains and led to a high yield growth per unit of input. The Green
Revolution’s success in increasing agricultural productivity and thereby raising agricultural incomes in India, is widely acknowledged (Foster and Rosenzweig, 2003). According to Kumar and Mittal
(2006), the first post-Green Revolution phase (from late-1960s to mid-1980s) was marked by the continued growth in returns from land and yield per unit of input. However, growth started to stagnate in the second post-Green Revolution phase. From the mid-1980s on, agriculture was characterized by high input-use and declining productivity growth. The Food and Agriculture Organization (FAO) analysed Indian agricultural growth between 1970 and 2001, and found the annual growth rate in production of all cereals during the six-year segments1970-76, 1976-82, 1982-88, 1988-94, 1994-2000 to be respectively 2.5, 2.5, 3.0, 2.6 and 1.8 percent (FAO, 2003). Thus in the late 1990s, the rates of growth are lower than at any time since 1960. The World Bank (2013a) names the slowdown of agricultural growth a major cause of concern.
While India’s economy is currently growing at about 8 to 9 percent per annum, the agrarian sector is lagging behind because of the stagnation described above (World Bank, 2013a). The relatively low productivity in agriculture is the main cause of the declined share of agricultural production in the country’s GDP (Mishra, 2008). Currently, the ratio of worker productivity in agriculture to worker productivity in non-agriculture is about one-fifth. From the mid-nineties, the trend growth rate of production as well as productivity has been declining for almost all crops. The value of output from agriculture has also witnessed a decline from the late nineties (Mishra, 2008). Compared to foreign agricultural sectors, India stays behind in terms of growth as well. According to the World Bank (2013a), almost all India’s crop yields are only one-third of China’s and about half of those in Vietnam and Indonesia. Chakrabarty (2011) confirms that productivity in India’s agricultural sector is low compared to global levels. In 2011, estimates of rice yields were 3.2 tonnes per hectare in India, against 6.7 tonnes per hectare in the China and 7.5 in the United States. Similar contrasts have been observed in other crops. Even India’s most productive states fall short of world standards in terms of major crop yields.
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2.1.2 – Economic inequality
India’s agrarian sector is characterized by the existence of many small and marginal farmers. They accounted for 80 percent of total farmer households in 2001 and 83 percent in 2006 (Mahendra Dev, 2012b). However, their share in total agricultural land is not proportional. The 83 percent of farmer households currently owns only 44 percent of land used in agricultural production. Therefore, land inequalities are significant (Mahendra Deb, 2012b). Further, inequality has risen over the last decades. In 1960, small farmers composed 62 percent of total farmer households. The average holding size of land was then 2.3 hectares, while it is now equal to 1.3 hectares.
According to the Situation Assessment Survey of Farmers (2003), monthly per capita income to a near-landless, marginal, small and semi-medium farmer household is much lower than the monthly per capita consumption expenditure. Only medium and large farmers have income higher than their consumption expenditure. These findings suggest that income inequality in Indian rural areas is prevalent. Swaminathan and Rawal (2011) find that literature on income inequality in India is scarce, but nevertheless conclude from available studies that levels of inequality in rural areas are high. To support their claim they use data on the Gini-coefficient, which is a commonly used measure for income or wealth inequality. The Gini-coefficient has a value between 0 and 1, where a value of 0 represents perfect equality (every person has the same income) and a value of 1 expresses maximum inequality (for example, one person earns all the income and all others have zero income) (Fforde, 2013, p. 228). Azam and Shariff (2011) estimate a rise in the Gini-coefficient for Indian rural incomes from 0.46 in 1993-94 to 0.50 in 2004-05. Vanneman and Dubey (2010) estimate the Gini-coefficient for rural incomes in 2004-05 to be 0.54. To put these numbers in perspective; the Gini-coefficient for India as a whole – including urban areas – was 0.334 in 2005, for European countries it lies between 0.22 and 0.36 and for the United States it equalled 0.45 in 2007 (World Bank, 2013b).
2.2 – The credit problem
So what causes low productivity and the slowdown of growth in India’s agrarian sector? One of the main factors determining agricultural productivity, is labor productivity (Foster and
Rosenzweig, 2003). Labor productivity depends on technologies used in production. While technology gains occurred in the Green Revolution’s early years, they seem to have exhausted their potential after then. In many crops, there have not been technological improvements since 1990 (Kumar and Mittal, 2006). Mahendra Dev (2012b) also states that the declined yield growth of many crops observed in the 1990s is attributable to technology lagging behind.
Another factor that has a main contribution towards affecting agricultural productivity is the quality of land used (Foster and Rosenzweig, 2003). A major determinant of land quality is water provision. The cultivability of an irrigated cropland is much higher than that of a rainfed cropland (Kumar Das, 2013). Despite its increased use after the Green Revolution, many farmers still do not have access to modern irrigation systems. Irrigated areas account for only 40 percent of India’s sown area (FAO, 2003). This means that the remaining 60 percent of agricultural output is rain-dependent, leading to crop failures especially in regions where rainfall is inadequate. Also contributing to land quality, is the use of modern inputs such as fertilizer and pesticides. As mentioned before, the subsidies on these inputs introduced during the Green Revolution promoted their use. However, subsidies were reduced significantly during the 1990s, making modern inputs unavailable to a great share of farmers. This negatively affected the productivity of the cropland (Kumar Das, 2013).
6 In order to produce, farmers need credit. The described productivity problems in agriculture are for a main part explained by a lack of access to it (Mishra, 2008). Ray (1998, p. 531) divides demand for credit into three parts. The same distinction is made by Fforde (2013, p. 243). First, there is demand for fixed capital to finance new start-ups or expand existing production lines. In addition, fixed capital investments are required to move from the traditional, inefficient production technologies that currently characterize the agrarian sector to more modern production techniques. Second, there is the demand for working capital. The modern inputs used in production, such as irrigation, fertilizer and pesticides need to be bought at the beginning of the crop cycle. At this point, the farmer often does not have sufficient funds to finance these inputs. Thus, there is a need to borrow. Later in the crop cycle, when sales are made and payoffs come in, the farmer is able to repay (Ray, 1998, p. 532). Finally, there is the need for consumption credit. As the name suggests, this is not credit used for production, but for everyday expenses. Consumption credit is related to the uncertainty surrounding productive activity. It is typically poor individuals who need it when an unexpected event occurs, such as a sudden downturn in production or a fall in crop prices. As mentioned earlier, a large part of Indian farms is currently not equipped with irrigation systems, making their harvest dependent on rainfall. If – because of inadequate rainfall or for any other reason – the harvest fails, this may cause large temporary hardship that can only be mitigated through loans. Another factor that may result in hardship, is fluctuating farm earnings. Wages are typically lower in the lean season than in the harvesting season, because labor demand is then lower. By borrowing in periods of low income and repaying in periods of higher income, farmers can smooth consumption over time.
Evidence is found in literature that rural Indian households are indeed to a large extent credit constrained. This applies particularly to small farmers and the poorer households. Chaudhuri and Cherical (2012) find that households who have an account in a financial institution have a higher probability of getting a loan than households who do not. Moreover, households who possess low land holdings and livestock have a lower chance of receiving a loan than households who possess more. Thus, the former are significantly credit constrained and have a lower chance of participating in the credit market. Pender (1996) analyses the credit market in rural South India econometrically. His study provides support for the hypothesis that households face binding credit constraints. In Rose’s study (2000), the sample is divided in two groups: the landless and the small farmers, and the medium and the large farmers. The findings suggest that landless and small farmers face binding credit constraints, while the latter group does not.
To gain insight into the nature of the credit problem, the next chapter will elaborate on the functioning of rural credit markets.
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3 – Rural Credit Markets
Like any other good, credit has supply and demand. On the supply side are lenders,
exchanging money today for a promise of money in the future. Borrowers, who constitute the demand side of the market, pay a price to obtain credit today and promise repayment at a certain time in the future (Hoff and Stiglitz, 1990). The price for which credit is traded, is the interest rate. The interest rate must be high enough for lenders to be willing to lend their funds, while at the same time low enough for borrowers to be able and willing to repay their loans. Ideally, loans are traded
competitively. The interest rate would then be determined by supply and demand (Besley, 1994). In this way, the credit market would be efficient and without welfare losses. However, rural credit markets do not function smoothly and diverge far from the model of perfect competition. To see why, this chapter studies the workings of the market and its main characteristics, starting with the rural credit market’s most important feature: its separation into a formal and informal sector.
3.1 – Coexistence of formal and informal lenders
Rural credit is supplied by two types of lenders. Formal or institutional lenders are official sources of credit, such as government banks, commercial banks and credit bureaus. Informal lenders are unofficial sources of credit, such as local moneylenders, traders, landlords, relatives, et cetera. According to Ray (1998, p. 537), the reason for the coexistence of a formal and informal market is that informal lenders are better capable of serving poor borrowers than formal lenders are. Formal credits tend to be larger in size than informal credits. Because of the economies of scale existent in financial technology, banks and institutional lenders find it more profitable to provide large credits than small-sized loans. This creates incentives for formal lenders to do business with the wealthier segment only. Bose (1998) states that the majority of small farmers in less developed countries is not regarded as credit-worthy by the formal sector financial institutions. This view is supported by Fforde (2013, p. 234), who finds that the poor tend to have less access to formal credit than the rich. The inadequate supply of formal credit thus leads to exclusion of poor borrowers and gives rise to the importance of the informal market (Chaudhuri and Gupta, 1996). A further explanation for discrimination against poor borrowers follows from other features of the rural credit market and the different degrees in which formal and informal lenders have difficulties coping with them. These features are discussed below.
3.2 – Information asymmetries
A main cause of inefficiencies in rural credit markets is the existence of imperfect information. A lender’s willingness to lend money may to a great extent depend on the information available about the borrower. The lender needs to know whether the borrower is reliable and the loan is used for the right purpose. This is important because of the problem of limited liability: borrowers have an incentive to take on too much risk, because the funds invested are not their own. To see this, suppose that the borrower has two investment opportunities. In both cases, the amount invested is the same (say, 20.000). The first project has a high, but uncertain expected payoff (for example, the payoff is 50.000 with 0.5 probability, and 0 with 0.5 probability). The second project has a lower, but certain payoff (say 30.000). The borrower will prefer to invest in the first project, because if all goes well the payoff will be highest. If the project fails, he is cushioned from the downside and simply does not repay the loan. He does not lose anything, because the invested money is not his own. Thus, the cost of the risk is borne by the lender and not by the borrower who takes on the risk. Hoff and Stiglitz (1990) confirm this reasoning, stating that the borrower will indeed prefer projects with lower mean
8 return over those with higher mean return if the former entails greater risk. The increased riskiness hurts the lender, because it leads to a higher likelihood of default. This situation is referred to as moral hazard (Haugen, 2005).
A problem related to moral hazard is that of adverse selection. As we have seen, risky projects may lead to a borrower’s inability to repay. To make up for resulting losses from default, lenders must charge a risk premium and hence raise the interest rate. But, by raising the interest rate, the lender is only more likely to attract borrowers that are ‘bad risks’. They are willing to borrow against higher interest rates because they perceive their probability to repay the loan to be low (Stiglitz and Weiss, 1981). Because the ‘good risks’, the borrowers investing in less risky projects, are most likely to repay their loans, they will be the ones most discouraged from borrowing by facing higher interest rates. According to Hoff and Stiglitz (1990), borrowers’ relative preference for risky projects increases as the interest rate rises. In this sense, charging a higher interest rate will reduce a lender’s profit because it lowers repayment rates. To avoid adverse selection problems, lenders can ration credit instead of raise the interest rate. Credit rationing means limiting the supply of credit, even if borrowers are willing to pay higher interest rates. So at the prevailing rate, the borrower would like to borrow more but is not allowed to (Fforde, 2013, p. 244). As a result of rationing, there will be excess demand for credit. Lenders are unwilling to capitalize on the excess demand by raising interest rates, because that will induce the adverse selection effects just described.
Because of the existing information asymmetries, lenders need a careful screening process in selecting their clients. Aleem (1990) finds that such a process is in general very time-consuming and that the costs of screening are substantial. Hoff and Stiglitz (1990) also state that the most important way to limit information asymmetries, is to buy information. They refer to the screening problem as the high costs involved in distinguishing borrowers based on their different levels of riskiness.
The problem of asymmetric information between lenders and borrowers applies particularly to the formal credit market. Formal lenders often do not possess personal knowledge regarding their clientele’s characteristics (Ray, 1998, p. 532). It is costly and difficult for them to monitor exactly how the loans are used. Commercial banks, for example, do not know their clients personally. They are not able to control the actions of the borrower directly. Therefore, it is important to formulate loan
contracts in a way that induces the borrower to take actions that are plausible from the bank’s point of view, as well as to attract low-risk borrowers (Stiglitz and Weiss, 1981).
The informational position of informal lenders is in general much better. Because the informal lender often knows his clients personally, it is easier to obtain information regarding their
characteristics. It is not uncommon for the informal moneylender to live in the same village as the borrower, making it relatively easy to observe the borrower’s actions. As Bell (1990) puts it: “There is
little that escapes his eye in the circumstances of his debtors or of those who may one day be his debtors. What cooperatives merely postulate, he actually possesses, namely, a local knowledge of the ‘character and repaying capacity’ of those he has to deal with.” Therefore, monitoring and screening
costs incurred in informal arrangements are generally lower than with official loans. In a field study on informal lending in Nepal, Haugen (2005) finds that screening costs are indeed low. He also concludes that village lenders are to a great extent able to overcome moral hazard and adverse selection
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3.3 – Default and collateral
As described above, the information asymmetries existing between lenders and borrowers can lead to situations in which the borrower takes on too much risk and has to default on his loan as a result. In this case, the reason for default is the inability to repay. This is referred to as involuntary
default (Ray, 1998, p. 529). Other scenarios that can lead to involuntary default are crop failures or
other unexpected events that often underlie the demand for credit in the first place. There is also the possibility of voluntary or strategic default (Ray, 1998, p. 529; Fforde, 2013, p. 243), a situation in which the borrower is able to repay the loan, but does not find it in his interest to do so. The problem of voluntary default is especially pertinent in contexts where borrowers cannot be legally obliged to repay their loans, because of weak legal systems of loan enforcement. This is often the case in
developing countries. Aleem (1990) names this the pure enforcement problem and argues that it is the central difference between credit markets in developing countries and credit markets elsewhere. Hoff and Stiglitz (1990) also define the enforcement problem as the difficulty in compelling repayment. They underline its negative impact on the workings of the rural credit market.
The enforcement problem is mainly present in formal loan contracts. Mukherjee (2013) finds that defaults in the informal sector are relatively rare. Ray (1998, p. 545) refers to multiple case studies that reported formal-sector default rates to be substantially above those in the informal sector. While formal default rates observed were as high as a quarter of all loans provided, Aleem (1990) estimates informal default rates to be below 5% in his study. According to Koning (1997), an explanation for this is that “farmers in developing countries show a higher tendency to withhold repayment if there is
no emotional tie to the lender”. A factor also contributing to lower informal default rates, is the
interlinked nature of many informal credit contracts. This means that the loan transaction is linked to dealings in some other market (Fforde, 2013, p. 244). Examples are markets for labor, land or crop output (Ray, 1998, p. 561). Landlords, for example, are often the main source of credit for their tenants. Hence, the credit contract is complemented by a job agreement. In this way, the interlinkage creates an additional threat to the borrower: if he would default, he would not only give up the possibility of future loan contracts with this supplier, but also his job. According to Hoff and Stiglitz (1990), screening, incentive and enforcement problems are often alleviated by interlinking credit market transactions with transactions in another market. Thus, interlinkage is a way in which an informal lender can discipline the borrower, thereby minimizing default rates while enjoying low enforcement costs (Basu, 1983).
Because the risk of default is generally higher to formal lenders, they are the ones having to incur higher enforcement costs – monitoring costs, et cetera – in order to keep default rates low. A means that can also protect the lender against the risk of involuntary as well as voluntary default, is the use of collateral. In order to take out loans, borrowers would have to put up a physical asset that the lender can seize in the event of default. However, this is to the disadvantage of the poorer farmers, because they often do not possess assets that could be collateralized (Besley, 1994). Either they lack collateral or the collateral is non-monetized (labor, for example) and therefore unacceptable to most lenders (Fforde, 2013, p. 243). In addition, rural areas of developing countries often have poorly developed property rights, making it difficult to actually appropriate the collateral when a default occurs. Aleem (1990) identifies legal problems and the high costs associated with selling land – the asset most commonly put up as collateral – as main issues with collateral in serving as insurance to moneylenders. In reducing default risk, it is therefore not a practical alternative to the screening of loan applicants.
10 The issue with collateral is another reason for formal lenders to discriminate against the poorer segment of the market. Poor borrowers again become dependent on informal credit sources in
obtaining their funds, because the collateral problems are often less apparent in informal loan contracts. Assets that are unacceptable as collateral to formal lenders may be of greater value to informal lenders (Fforde, 2013, p. 243). The village lender could be given the rights on a share of the borrower’s crop, for example (this too is a type of interlinked contract). In addition, informal lenders’ reliance on collateral as an enforcement means is in general much lower. The informational advantage they enjoy from being insiders allows them to better differentiate amongst clients according to their risk of default, thereby reducing the need for collateral (Basu, 1983).
3.4 – Interest rate variation
In a perfectly competitive market, the interest rate adjusts to equate supply and demand for credit. This is not the case in the rural credit market. Interest rates are subject to great variation, and the rates demanded by informal lenders are typically much higher than formal rates (Fforde, 2013, p. 244). Informal interest rates charged may exceed 75 percent per year, and in some periods credit is unavailable at any price (Ray, 1998, p. 541). Aleem’s findings (1990) support that interest rates charged by non-institutional lenders are far in excess of those charged on similar loans by banks. Hoff and Stiglitz (1990) draw the same conclusion. Because it is typically the poor who rely on the informal sector to finance their activities, they are the ones paying these high prices for credit. As a result, the returns earned on their investments may be systematically lower, putting them on a “slower wealth
accumulation path” than the rich who borrow from institutional lenders (Mukherjee, 2013).
A traditional explanation for high informal rates, is the risk premium hypothesis (Haugen, 2005). This theory argues that informal lenders charge a risk premium on loans above their
opportunity cost, in order to cover for high default risk. Ray (1998, p. 544) refers to this theory as the
lender’s risk hypothesis. The risk premium would explain the observed gaps between formal and
informal rates. As we have seen, however, the actual rates of default in informal credit markets are low. Ray (1998, p. 545) points out that the hypothesis may be based on high potential default, instead of actual default.
Another explanation for high observed rates can be attributed to the monopoly power that the village moneylender has over its clients (Hoff and Stiglitz, 1990). If borrowers are unable to obtain credit from institutional sources, they are confined to informal credit. Informal credit markets have a tendency toward segmentation (Fforde, 2013, p. 244). In general, a rural moneylender lends to a fixed circle of clients, whose members borrow on a regular basis and are located in the same area (Ray, 1998, p. 540). Personal relationships are built, and possibilities for borrowers to switch to another credit supplier are limited. Aleem (1990) finds strong suggestions that the rural credit market is characterized by monopolistic competition, such as the mean marginal costs as a fraction of the amount recovered being much lower than the average interest rate charged. A factor contributing to segmentation and thereby to the monopoly power of rural lenders, is the often interlinked nature of informal credit contracts yet discussed. An interlinked contract makes the borrower dependent on the lender for more than solely credit. As we have seen, this reduces the incentive for a borrower to default. In addition, it becomes impossible for the borrower paying a high interest rate to go only for credit to the neighbouring moneylender charging a lower rate, because the credit contract is now not the only thing at stake. The job agreement ties the borrower to the particular lender. Thereby, the interlinkage results in isolation (Basu, 1983). This explains why exorbitant interest rates can persist without resulting in any arbitrage.
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4 – Formal and Informal Lending in Rural India
The previous chapter helped gaining a thorough understanding of how rural credit markets work. In particular, it explained the major position hold by informal moneylenders. The present chapter studies the extent to which credit market theory applies to the rural Indian case. The
importance of the formal and informal sector is investigated, as well as the prevalence of interest rate variations.
Before 1951, virtually all credit needs of the Indian agricultural sector were provided by informal moneylenders. Despite efforts of the Reserve Bank to change this fact, the provision of credit through government sources and banks was only 7.2 percent of total outstanding debt by June 1951 (Ray, 1998, p. 537). In the following decades, the government and the Reserve Bank continued large efforts to institutionalize the credit channel for the rural sector. In 1975, Regional Rural Banks were set up, and 1982 was marked by the formation of the National Bank for Agriculture and Development (Pradhan, 2013). In addition, bank branches were opened in over 30.000 rural locations and the share of bank credit accounted for by rural branches increased from 3 to 15 percent (Das et al., 2009). The flow of formal credit to agriculture witnessed a large increase. By 1991, the share of institutional credit had risen to 64 percent of total agricultural debt. From then, however, the trend has taken a reverse swing. The share of formal credit witnessed a decline to 57 percent in 2002 (Pradhan, 2013).
Table: Breakup of institutional and non-institutional rural credit (% of total)
1951 1961 1971 1981 1991 2002
Institutional 7.2 14.8 29.2 61.2 64.0 57.1
Non-institutional 92.8 85.2 70.8 38.8 36.0 42.9
Source: Pradhan (2013)
Despite the major achievements of India’s government and Reserve Bank, access to institutional finance remains inadequate in rural areas. Sahu et al. (2004) refer to multiple empirical studies stating that the beneficiaries of the government’s credit extension efforts have mainly been the rural well-to-do, and not the poorer farmers. The study suggests that only a small share of the total number of cultivators in rural areas obtains loans from formal sources. In addition, among those with access to formal loans, it is a small group that monopolizes the bulk of the total credit flow. There is a widening gap between the supply of credit to small farmers and their need for it, the study concludes. In a supportive view, Goilat (2011) finds that disparities between small and large farmers are growing. According to a 2002 Áll-India Debt and Investment Survey (AIDIS), formal finance has not displaced informal credit sources altogether. 43 percent of rural households continue to rely on informal credit sources, with the vast amount of rural credit going to large farmers (Pradhan, 2013). Binswanger and Khandker (1992) support this claim, stating that small cultivators still have little access to formal credit and that only a quarter of all farmers borrow. Only two percent take out long-term loans, from which most goes to large farmers. Swaminathan (2012) studies four rural Indian villages and finds evidence indicating that inequalities in formal credit access are still large. Especially small farmers and persons from traditionally deprived social groups were found to be excluded. A report of the Ministry of Agriculture in 2010 mentioned the limited access of small and marginal farmers as a major concern (Pradhan, 2013).
12 What about interest rates? Formal interest rates are administered by the Reserve Bank. Hence, although small deviations are observed, institutions and banks cannot freely determine their charged interest rates (Swain, 2002). The official interest rate is monthly set and reported by the Reserve Bank. It averaged 6.61 percent from 2000 to 2014, being lowest in 2009 (4.25 percent) and highest in 2000 (14.5 percent). The last recorded rate is 8 percent (Trading Economics, 2014). Across 310 rural households, Mukherjee recorded an average annual formal rate of 8.018 percent, and an average annual informal rate of 25.583 percent in 2013. Pradhan (2013) finds that 36 percent of farmers’ debt from informal sources carried interest ranging from 20-25 percent, and another 38 percent had been borrowed at a rate of 30 percent or higher. Swaminathan (2012) observes interest rates on formal loans varying from 7 to 12 percent annually, while interest rates on informal loans were never less than 24 percent and were frequently reported to be between 36 and 60 percent.
In conclusion, the observations in the Indian rural credit market are largely in line with the theoretical assessment of rural credit markets in chapter 3. Despite the rise in importance of formal credit, the dependence on informal loans remains high. Further, the observations suggest that interest rate variations are large. Informal interest rates appear to be far in excess of the formal, official rate. Obviously, this is to the disadvantage of poor borrowers who are excluded from the formal market.
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5 – The Impact of a Formal Credit Expansion: Informal Credit Market
Effects
Now that the nature of the rural credit market as well as the situation in India regarding formal and informal lending have been discussed, we are able to analyse the impact of a formal credit
expansion. As emphasized, the informal credit market plays a major role in determining farmers’ credit access and borrowing terms. It is therefore a main channel through which agricultural development is affected. Hence, this chapter analyses the effect of increased formal credit on the conditions in the informal credit market.
5.1 - The extent of informal lending
Informal lenders are still a main source of credit in rural areas, as also in rural India. This applies particularly to small and marginal farmers, who constitute the major part of India’s agricultural sector. It is therefore important to investigate how informal lending would respond to an increase in formal credit.
One way to increase formal loan supply, is by expanding vertical formal-informal links (Ray, 1998, p. 573). This means that formal credit is supplied to informal lenders, who in turn lend the funds to farmers. This way recognizes explicitly that informal lenders are in general better capable of
granting and recovering loans from small borrowers than formal lenders are. The expansion of formal sector credit to the informal sector is likely to increase the number of informal lenders in the market (Ray, 1998, p. 575). Thus, by expanding formal credit through vertical links, informal loan supply would increase and competition among moneylenders would intensify.
Bose (1998) also analyses the effect of formal credit expansion to the informal sector, but he adds the presence of differential information, meaning that some lenders are better informed about borrowers’ characteristics than others. Because the better informed lenders can separate the good credit risks from the bad ones, this enables them to attract the good borrowers towards them and leave the bad borrowers to the lenders possessing less information. This would lead to the latter facing higher probabilities of default. The more credit is expanded by the formal sector, the more this could contaminate the pool of borrowers available to less-informed lenders. Eventually, it might become unprofitable for less-informed lenders to continue lending, leading to the entire shutdown of their operations. Hence, formal credit expansion through vertical linkage could also lead to a decline in informal sector lending.
What would be the effects of an increase in formal lending if it is directly aimed at the borrower? The general assumption in literature is that formal credit supply crowds out informal lending (Mukherjee, 2013; Giné, 2011; Turvey and Kong, 2010). Diagne (1999) finds that formal and informal credit are imperfect substitutes. The increased availability of formal credit would reduce informal lending, but not completely eliminate it. Chaudhuri’s study (2001) also assumes formal and informal credit to be substitutes, stating that an increase in formal loan supply would reduce the demand for informal loans. Looking at India’s past experience, a similar pattern is observed. The sharply risen share of formal debt in total agricultural debt suggests that the government’s increased credit flows to agriculture were to a large extent successful in replacing informal loans (see chapter 4).
In conclusion; the effect on the extent of informal lending seems to depend on the way in which the formal credit expansion is carried out. If credit is expanded through vertical linkage, the effect is ambiguous. Assuming equally informed lenders, informal lending will increase. In case information asymmetries exist between lenders, it could go either way. In both cases, there will be no
14 change in formal borrowing, because the funds go through the informal lender before reaching the targeted borrower. If the expansion is aimed directly at the borrower, informal lending is expected to decline because of the substitution effect. The increase in formal borrowing would then lead to a further rise of the formal credit’s share in total debt outstanding in rural India, as the government has been aiming to accomplish since the 1960s.
5.2 – Informal interest rates
A main goal of expanding formal lending is to achieve a reduction in informal interest rates. As argued, the main problem in the informal market is that interest rates are significantly higher than the official rates. In India, a large gap is indeed witnessed between formal and informal rates. Because we found that small borrowers are still for a large part dependent on the informal sector in obtaining funds, these high rates are to their disadvantage. It causes the poor to systematically earn lower returns on their investments (Mukherjee, 2013). Hence, the effect of a formal credit supply increase on informal interest rates is a main concern (Chaudhuri, 2001).
As described above, when formal credit is expanded through vertical linkage, the entrance of more active moneylenders is likely. This intensifies competition among them, and every lender will now have the incentive to undercut his rivals (Ray, 1998, p. 576). As a direct effect, interest rates tend to be depressed. Mukherjee (2013) supports this finding. According to his research, formal loan expansion would increase competition among informal lenders, inducing them to lower their charged interest rates. One could also reason that with the increase of active moneylenders, it becomes harder for each of them to maintain monopoly power, because borrowers now have more alternatives available to them. According to Bose (1998), the entrance of moneylenders raises the difficulty of ensuring exclusive dealings and maintaining interlinked contracts. To borrowers, arbitrage opportunities would increase, leading to lower interest rates.
On the other hand, the extension of credit alternatives available to the borrower raises the probability of default. To compensate for this, a lender must expend more resources on the screening and monitoring of his clients. The increased cost will raise the equilibrium interest rate on a loan (Ray, 1998, p. 575). Basu (1983) supports this view. He argues that the difficulty in maintaining exclusive dealings could lead to an increase in enforcement costs, thereby raising the interest rate.
Another possibility discussed, is that of Bose’s study (1998). He analyses a channel through which formal credit expansion could lead to the exit – instead of entrance – of informal lenders, because of existent information asymmetries between lenders. When the number of active moneylenders decreases, this would lessen competition in the informal sector. As a result, borrowing terms would deteriorate and interest rates charged may rise.
Chaudhuri (2001) emphasizes the importance of the formal interest rate in determining the impact on informal rates. Complementary to an increase in formal credit supply, the government may choose to lower the official interest rate to stimulate cheap borrowing. The study shows, however, that a reduction in the formal rate leads to a rise in the interest rate prevailing in the informal sector. A policy that increases formal credit supply while at the same time keeping the formal rate at a reasonable level, is able to lower informal rates and thereby improve the welfare of farmers. The channel through which this is to be achieved, is consistent with Ray (1998, p. 576) and Mukherjee (2013) and assumes substitutability: if a larger amount of formal credit is injected into the system, this lowers demand for informal credit. This substitution effect is discussed in the previous paragraph; based on past experience, it seems valid in the Indian case. If the increase in formal credit indeed leads
15 to lower demand for informal loans, competition is increased and rural lenders are compelled to lower their interest rates (Mukherjee, 2013).
In conclusion; the effect of a formal credit expansion on the informal interest rate is not univocal. If credit is expanded through vertical linkage, the entrance of more informal lenders is encouraged. On the one hand, this could intensify competition, leading to lower informal interest rates. On the other hand, we have reasoned that entrance of lenders could lead to higher monitoring and enforcement costs. This may induce informal lenders to raise their interest rates.
If the formal credit increase goes directly to the borrower, the substitution effect is likely to decrease demand for informal loans. Hence, this would result in lower informal interest rates and achieves the intended effect; a reduction in the large interest rate variations prevalent in India.
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6 - The Impact of a Formal Credit Expansion: Agricultural Development
This chapter is the last step towards answering the research question. Agricultural development was defined as the promotion of agricultural productivity on the one hand, and the reduction of economic inequality between farmers on the other. An analysis of how a formal credit expansion would impact each factor will now be provided.
6.1 – Agricultural productivity
Credit appears to be an essential input for higher productivity (Das et al., 2009). As
established earlier, rural Indian households are found to be considerably credit constrained. If a lack of credit constrains agricultural production, one would expect additional supply of credit to impact production positively. In literature, credit availability is generally assumed to have a positive effect on agricultural productivity and output (Kannan and Sundaram, 2011).
Looking at the past, this positive effect has not always been witnessed in India. Although the Green Revolution has brought significant benefits to the country in terms of agricultural growth, the sector started to stagnate from the 1980s on (see chapter 2). At the same time, however, the
government and the Reserve Bank were largely extending their credit flows to agriculture (see chapter 4). It seems that agriculture has not reaped the benefits. Das et al. (2009) confirm that the increased credit flows to the sector have not been transmitted to output growth. As observations in the past seem to contradict theory regarding the relation between credit and productivity, literature underlines the need to further analyse the effect of institutional credit on agricultural growth (Das et al., 2009). Several papers have looked into this issue in the Indian case.
Mukherjee (2013) has conducted research on 310 households in two rural Indian districts. He finds that the probability that a formal loan is used for productive purposes is higher than that of an informal loan. The probabilities are 0.487 and 0.145, respectively. As the share of formal loan in total loan taken rises, the chance that the loan is used for productive purposes increases as well. This finding suggests that the formal credit expansion’s effect on agricultural productivity depends on its impact on the amounts of formal and informal lending. We have seen that an expansion through vertical linkage has an ambiguous effect on the amount of informal lending, while the amount of formal lending remains unaffected. If the formal credit expansion is aimed directly at the borrower, formal lending increases and informal lending is likely to decrease because of substitution effects. Then, the share of formal loans in total loan taken rises, increasing the probabilities that loans are used in productive ways. In this way, a formal credit expansion is likely to have a positive impact on agricultural productivity.
Another of Mukherjee’s findings (2013) concerns interest rates. The formal interest rate has a significant, negative effect on the probability that a formal loan is used for productive purposes, and the informal interest rate has a significant, positive effect – as one would expect. For informal loans, the effect is similar. The higher the informal rate, the lower the probability that the loan is used for productive purposes. It follows from the previous chapter that the effect of a formal credit expansion on informal interest rates is ambiguous. If the intended effect is achieved, meaning that informal rates are reduced, one would thus conclude that this would benefit productivity as it raises the probability that the informal loan is used in a productive way. A reduction in the formal interest rate would also have this positive effect on the use of formal loans. However, chapter 5 states that if a formal credit expansion is combined with a reduction of the formal interest rate, this is likely to lead to a rise in informal rates. The former positive effect on the productive use of informal credit will then be offset.
17 The importance of interest rate effects also becomes clear in a study of Binswanger and Khandker (1992). They identify two ways in which a formal credit expansion can raise agricultural output and productivity. The first is through the liquidity effect: when a farmer faces a credit
constraint, additional loan supply can increase input use, investment and thereby output. The second is through the consumption smoothing effect: better credit facilities enable farmers to smooth
consumption, thereby increase their willingness to undertake risky agricultural investments. These investments could in turn promote output growth. In an econometric regression model, they find evidence that rural credit has a measurable positive effect on aggregate output. However, the effect is modest. A possible explanation for this modest effect could be the limited reach of the increase in credit supply. As Das et al. (2009) conclude, institutional credit expansion has a positive effect on agricultural output and productivity, but the effect tends to be larger if the credit is extended to more people. They suggest that the financial inclusion of farmers in the organized system stimulates output growth. However, as reasoned and observed from past experience, many Indian farmers still depend on informal credit despite the witnessed increases in formal credit flows to agriculture. Again, this emphasizes the need to focus on the informal market’s response to formal credit expansion. Only if the intended depressing effect on informal rates is achieved, will informal borrowers experience positive liquidity- and consumption effects. The overall positive effect of a formal credit expansion on agricultural productivity is then expected to be larger.
Concluding; the importance of narrowing the large gap witnessed in India between formal and informal interest rates, is underlined. In addition, the expansion should lead to a further replacement of informal lending, as formal loans have a higher probability to be used in productive ways. Whether this replacement is likely to occur by including more farmers in the formal system, is analysed in the following section.
6.2 – Economic inequality: will small farmers be reached?
A main concern with the policy of increasing formal credit supply, is whether it will be successful in reaching small and marginal farmers. It is on that condition that achievements could be made in reducing economic inequality. There are two ways in which a formal credit expansion could benefit small farmers. As we have seen, they would benefit if the expansion leads to a decrease of the informal interest rate (Chaudhuri, 2001). Second, they would benefit if the expansion leads to
increased formal borrowing. Both ways will lead to farmers getting access to cheaper funds, thereby increasing their return from investment (Mukherjee, 2013).
When will a formal credit expansion lead to increased formal borrowing? According to Kochar (1997), the probability that a household borrows from formal sources is determined by its access to the formal sector, its demand for formal credit and the relative effective cost of formal funds (which in turn determines demand, as we will see). In previous chapters, the difficulties facing small farmers in getting access to formal credit are discussed. The imperfections characterizing the rural credit market give the informal lender an edge over institutions when it comes to serving the poor segment of the market. Formal lenders face higher screening, monitoring and enforcement costs, which coincide under higher transaction costs (Koning, 1997). To improve small farmers’ access to the formal sector, these transaction costs need to be reduced.
What factors determine the farmer’s demand for formal credit? Pradhan (2013) states that those in the rural credit market often prefer to borrow from informal sources, despite the fact that interest rates are generally far in excess of formal rates. He argues that informal loan contracts are more flexible, with informal lenders insisting less on punctual repayment than commercial banks do.
18 In addition, informal lenders are more willing to provide funds for purposes unrelated to production, such as marriage. Informal loans are less subject to complicated rules and collateral requirements. Mukherjee (2013) refers to the notion of a risk-rationed household. A risk-rationed household is in need of credit and has access to a formal loan, but does not seek it because of the collateral risk it implies. If, for any reason, the household would not be able to repay the loan, that would mean losing possession of the collateralized asset. Particularly poor borrowers are often not willing to assume this downside risk (Boucher et al., 2005). The cost of these disadvantages, the bureaucracy and time-consuming procedures involved in obtaining a formal loan and the delays this causes compared to getting informal credit, translate into high transaction costs to the borrower (Koning, 1997). Chaudhuri and Gupta (1996) confirm that small and marginal farmers face a substantial delay in obtaining formal credit, tilting their preference towards informal credit. Hoff and Stiglitz (1990) support this view, stating that high transaction costs are a main reason for the existence of informal markets in the first place. Boucher et al. (2005) also mention high transaction costs as a motivation for small borrowers to prefer informal loans.
High transaction costs may drive the effective cost (the interest rate plus transaction costs) of formal credit above that of informal credit. An informal loan may therefore be more attractive despite higher interest. In Mukherjee’s study (2013), the transaction costs to the borrower are translated into the variable ‘distance to the formal lender’, used as a proxy for the time and unobservable effort it takes to reach the formal lender. To examine further the determinants of formal credit demand,
Mukherjee carries out a regression based on a sample of 310 rural Indian households. In the model, the dependent variable is the ratio of formal loan taken to total loan taken. He finds monthly family income to have a significant positive effect on the dependent variable, and distance to the formal lender a significant negative effect. The interest rate on formal loans has a significant negative impact, while the informal interest has a significant positive effect on formal borrowing. This indicates a substitution effect: an increase of the price of informal loans leads to higher demand of formal loans.
Mukherjee’s findings suggest that while other factors do play a role, the interest rates of formal and informal loans are of significant importance in determining formal credit demand. More precisely, evidence is found for the proposition that formal borrowing is determined by its relative effective cost. If the effective cost of informal loans is below that of formal loans, borrowers will choose to borrow from informal sources. Bell (1990) puts it the other way around: “If the lower rate
on institutional loans was not eroded by higher transaction costs, one would expect borrowers to seek institutional finance first.” Kochar (1997) observes that the effective cost of informal credit is often
found to be lower than the effective cost of formal loans. We have argued that small borrowers are generally the ones facing high transaction costs in obtaining formal loans, so this would cause their preference for informal credit.
In conclusion; the formal credit expansion must benefit small farmers in order to reduce economic inequality. Small farmers compose the majority of India’s agricultural sector, and we established that a great part of them has no access to formal funds. In addition, informal credit is shown to carry much higher interest than formal credit in rural India. Therefore, small farmers could benefit in two ways: by an increase in their formal borrowing, or by a decrease in informal interest rates. For formal borrowing to increase, the access to formal funds as well as demand for formal funds have to be addressed. As argued, the focus should be on reducing transaction costs to both the lender and the borrower. That is, screening, monitoring and enforcement costs need to be reduced, as well as the delay small farmers face in obtaining formal finance. One way this could be done, is by reducing the distance between the formal lender and the borrower, for example by increasing the number of rural bank branches. India’s past experience demonstrates the success of this policy in stimulating
19 formal borrowing. It would reduce the effort the borrower needs to undertake to obtain a formal loan. Moreover, being closer to the client would improve the informational position of the formal lender, thereby lowering screening, monitoring and enforcement costs (Aleem, 1990). As discussed, another way formal lenders can ‘mimic’ the generally better informational position of informal lenders, is by expanding credit through vertical links. Because the informal lender then remains the borrower’s source of credit, the expansion is sure to reach small farmers as well. Whether or not they benefit, depends on the effect on the informal interest rate. From chapter 5 follows that the interest rate effect can be positive as well as negative. If the effect from increased competition in the informal market dominates, the informal interest rate is likely to decrease and the gap between formal and informal rates in India would narrow. Then, even borrowers without access to formal funds benefit from the expansion.
20
7 – Conclusion
The stagnation of growth in Indian agriculture is for a main part attributable to credit constraints. Due to inefficiencies in the rural credit market, not all rural households in need of credit can effectively be served. The main cause of inefficiencies is the existence of large information asymmetries between lenders and borrowers. It leads to the exclusion of – especially poor – borrowers from the formal credit market, and gives rise to the importance of the informal sector. Informal loans are generally found to carry much higher interest burdens than formal loans.
The theoretical assessment of rural credit markets is largely in line with the Indian case. Despite efforts of the government to institutionalize credit flows to agriculture, informal lending continues to be a main source of finance. Moreover, large interest rate variations are observed. Informal rates are found to be far in excess of formal rates. Because it is typically the poorer households who rely on expensive informal credit in financing their production activities, it is them who systematically earn lower returns from their investment. The large economic inequalities that are present in rural India, are hereby maintained or increased.
The stimulation of agricultural productivity growth and the reduction of economic inequality are now priorities in the country’s government policy. This thesis investigated how increased formal credit flows to agriculture would impact agricultural productivity and economic inequality. It is found that the informal credit market’s response to increased formal credit is of great importance. If the expansion is carried out through vertical linkage, informal lending could either increase or decrease. If the expansion is aimed directly at the borrower, demand for informal loans is likely to decrease. This would cause a decline in moneylender practices, as the government has been aiming to achieve for decades. The effect on informal interest rates appears to be ambiguous. If competition among informal lenders intensifies, interest rates are likely to decrease. On the other hand, increased competition could lead to higher monitoring and enforcement costs to the lender. This may cause informal rates to rise.
Whether the formal credit expansion will achieve its goals, seems to depend on the interaction between the formal and informal market. Evidence suggests that agricultural productivity in India is influenced positively by increased formal credit availability. However, the impact is likely to be larger if the intended reduction of the informal rate is achieved. In order for economic inequality to be reduced, the credit expansion must be to the benefit of small farmers, who constitute the majority of India’s agricultural sector. This means that either their access to formal funds has to improve, or the informal interest rate has to decline. In both ways they would get access to cheaper credit, leading to higher returns from investment. Improved formal access means that transaction costs to both the lender and the borrower must be reduced. A suggestion is to reduce the distance between the formal lender and the farmer. This could be accomplished by expanding rural bank branches, as the
government has done in the past. It would then take the farmer less effort to get a formal loan, and the lender’s informational position towards the borrower would improve. The existent inefficiencies in rural India’s credit market may therefore be – a little bit – reduced.
21
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