Developing Countries the Record on Directed and Subsidized Credit to Farmers Has Been Poor

Improving Rural Finance in Developing Countries The record on directed and subsidized credit to farmers has been poor. Sound policy reforms, therefore, need to tackle the defects of the institutional structure of the particular rural economy Avishay Braverman and Monika Huppi

O "ver the last three decades, governments tively supported these interventions. For ex- ket failures. Under certain circumstances, in- in many developing countries have inter- ample, about one fourth of all World Bank terventions in the rural financial markets of vened heavily in rural financial markets. lending to agriculture during the 1980s, or developing countries may still be warranted, Their intervention has been motivated by the $9.7 billion, went to agricultural credit. provided acceptable institutional structures belief that a shortage of affordable credit con- The performance of most credit programs exist to administer such programs. strained agricultural growth and develop- has, however, fallen short of expectations. Reasons for intervention ment and prevented the integration of small Although various factors account for the lim- farmers into the market economy. The most ited success of subsidized credit programs, The main justification for intervention in frequent forms of intervention have been ad- the failure of these programs can at least par- rural credit markets has been a perceived ministrative allocation of funds, interest rate tially be attributed to defects within the insti- shortage of affordable credit, which has gen- ceilings, and establishment of specialized ru- tutions designated to carry them out and, in erally been attributed to imperfections in rural finance institutions. Many donors have ac- part, to the assumptions underlying past poli- ral financial markets, and the discrepancy be- cies. As a result, a growing literature is devel- tween private and social rates of return. oping that seeks alternative forms in manag- Because of the seasonal nature of agricul- ing and channeling credit to rural markets, tural operations, cash flows and cash needs of This article draws heavily on the work carried out that could eradicate or at least significantly rural producers are not synchronized. In addi- by the Agricultural Policies Division, as well as work reduce the problems previously encountered. tion, the income of agricultural producers is by researchers outside the Bank. For example, see It is questionable whether abolishing credit highly influenced by climatic conditions. "Rural Credit in Developing Countries" by Avishay subsidies alone would eliminate the major in- Hence, lending to agriculture is more difficult Braverman andj. Luis Guasch, Policy, Planning, than regular commercial lending. Lending in and Research Working Paper No. 219, The World efficiencies that currently afflict rural credit Bank, and "The Role of Groups and Credit systems in developing countries. It is also rural areas often implies servicing a geo- Cooperatives in Rural Lending," by Monika Huppi doubtful that a simple laissez-faire policy graphically dispersed clientele, which in- and Gershon Feder, The World Bank Research would effectively reach small farmers with increases transaction costs. Administratively Observer, July 1990. stitutional rural credit and counter other mar- imposed ceilings on interest rates have often

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©International Monetary Fund. Not for Redistribution prevented commercial lenders from passing funds, they have often had to follow adminis- about 15 percent in Asia and Latin America, on fully these costs to borrowers. Together trative guidelines, rather than creditworthi- have had access to formal credit, with five with the frequent absence of collateral and dif- ness criteria, in allocating their credit. To percent of borrowers often receiving as much ficulties in enforcing contractual obligations, guarantee availability of cheap funds, govern- as 80 percent of the credit. Thus, instead of all the preceding factors tend to discourage ments have often imposed low interest rate narrowing income inequalities, low interest commercial banks from engaging in rural ceilings on all formal lenders. But such ceil- credit programs have often increased them. lending. ings have had adverse effects, preventing Since large farmers generally borrow larger Where commercial lending institutions are these lenders from covering their operating amounts than small producers, the former active in rural areas, they almost exclusively expenses and loan losses. As a result, govern- benefit more from credit subsidies than the cater to large farmers. Lending to small farm- ments have had to intervene to cover such latter. When interest rates do not reflect the ers is a problem because of the substantial bills. In some cases, governments have even true cost of capital, the distribution of benefits unit costs in processing and administering covered part of interest payments for certain from official loans is generally even more re- small loans, lack of collateral and the often un- categories of borrowers from these lending in- gressive. Cheap funds lead to excess demand justified belief that small agents are bigger stitutions (for example, small-scale farmers or of capital, so that subsidized loans must be ra- risks than large farmers. producers of a specific crop). High rediscount tioned. Because rural lenders prefer large bor- The absence of strong formal credit mar- margins have allowed rural financial interme- rowers (especially when low interest rate ceil- kets has given rise to informal financial mar- diaries to only finance a small part of the ings do not allow them to cover the higher kets in rural areas of many developing coun- granted subloans themselves, while the rest transaction costs involved in lending to small tries. Most of these markets are characterized has been financed by the central bank at sub- farmers), small farmers tend to be rationed by relatively quick disbursement of funds and sidized rates. Nonrural financial inter- first. low transaction costs. But they have high in- mediaries have frequently been obliged to buy The continuous availability of cheap funds terest rates due to such factors as high risk, obligatory bonds yielding below-market rates. and ceilings on interest rates have prevented limited diversification of the loan portfolio, The proceeds of these transactions have then specialized agricultural credit institutions and and, sometimes, monopoly rents. While it is been made available to rural financial inter- other formal lenders from mobilizing rural not uncommon for friends and relatives to mediaries. savings and thus building up their own lend at zero interest (or even negative rates in Effects of rural credit programs sources of funds. Specialized agricultural real terms), money lenders have been found to lending institutions have, therefore, never de- charge 200 percent or more. A study among The effects of three decades of intervention veloped into true and viable financial interme- rice farmers in the Philippines, for example, in rural financial markets have, unfortunately, diaries between net savers and net borrowers. found that 15 percent of the producers paid been dismal. A number of case studies have Studies in rural areas of various developing more than 200 percent in interest on their shown that the availability of subsidized countries have, however, shown that even loans from the informal market, while 20 per- credit has had little, if any, effect on agricul- small producers in poor areas can and do save cent of them had loans at zero interest rates. tural productivity. Unless lenders employ significant amounts, if given the opportunity In Chile, studies show that relatives, friends, strict (and often costly) supervision, the fungi- to do so. The problem, therefore, is not so and patrons lent to farmers at zero or even bility of money makes it difficult to guarantee much a shortage of funds in a particular area, negative interest rates, while stores, traders, that borrowers use funds to finance agricul- but rather a lack of possibilities to manage li- and moneylenders lent at rates as high as 360 tural investments. Further, it is impossible to quidity over time. Credit unions and other percent. ensure that borrowed funds are used to fi- credit cooperatives in Cameroon, Guatemala, Private banks' reluctance to lend to agricul- nance higher investment than would have Rwanda, South Korea, Taiwan Province of ture in general, and to small farmers in particr taken place without subsidized credit. Credit China, and Togo, for example, have been very ular, and the uncertainty regarding the avail- project evaluations in countries as diverse as successful in mobilizing savings in rural ar- ability of high interest credit in the informal Kenya, Mexico, and the Philippines, for exam- eas. Extensive saving mobilization campaigns market, have been the main reasons for gov- ple, have found that the use of funds for pur- and innovative offers for deposits adapted to ernment intervention in rural financial mar- poses other than the ones stated at the time of local rural conditions have helped many of kets. It has also been argued that the limited borrowing was a major factor that severely these credit cooperatives to increase their own availability of affordable capital delays, if not limited the programs' effects on productivity funds and attain near self-sufficiency in terms prevents, the adoption of new production increases. One argument often used in favor of funding. In Rwanda, where credit unions technologies and the use of nonlabor inputs of credit subsidies is that they compensate were created for the specific purpose of mobi- such as fertilizer. This, in turn, slows down farmers for the adverse effects of other poli- lizing rural savings, membership grew by 47 output growth and the development of the cies. This is, however, doubtful as subsidized percent between 1977-86, with real savings agricultural sector. Finally, governments of- credit does not make investments in agricul- growing at an average annual rate of 35 per- ten intervene and attempt to compensate ture more profitable, and such funds could cent. Similarly, in Togo and Cameroon, real fanners for the adverse effects of "urban bi- well be diverted to other, more lucrative, un- savings mobilized by credit unions grew at an ased" pricing (i.e., government policies that fa- dertakings. But even to the extent that subsi- average annual rate of 25 percent and 14.5 vor residents of the urban sector over rural in- dized credit does compensate producers for percent, respectively, during the same time habitants), taxes, and exchange rate policies. urban biased policies, it only benefits the few period. To overcome the paucity in formal rural who actually have access to such funds. Government-supported rural credit institu- lending, governments, often supported by in- Despite the remarkable expansion of credit tions with limited accountability have also ternational donors, have frequently estab- in rural areas of most developing countries, lacked the incentives to effectively monitor in- lished specialized agricultural credit institu- the distribution of official credit has remained vestment and repayment behaviors of their tions. While these institutions have been skewed in favor of large farmers. An esti- borrowers. The performance of such credit in- provided with cheap government or donor mated five percent of farms in Africa, and stitutions have often been based on quick loan

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©International Monetary Fund. Not for Redistribution approval and growth of the lending volume, and profit constraints. Governments and prevent them from borrowing the desired rather than on financial performance. This donors must thus stop financing recurrent amount, so that intervention in their favor has facilitated willful loan defaults. For in- deficits incurred by these institutions and ru- may be called for. stance, default rates as high as 50 percent ral financial intermediaries must be allowed to Alternative institutional arrangements, were observed in India, 71 percent in cover their costs with higher interest rates. such as lending groups and credit coopera- Bangladesh, and 40 percent in Malaysia and Managers, supervisors, and loan officers of tives, have the potential to reduce transaction Nepal. And in Thailand, over 50 percent of the rural finance institutions must be provided costs, because they allow for the processing of loans made through the cooperative system with the incentives to screen loan applica- one large loan rather than numerous small were in arrears in the 1980s. Inefficiencies and tions, monitor investment and repayment per- loans. Administrative responsibilities such as incompetent management in rural finance in- formance, and enforce loan contracts. Strict loan allocation within the group, record keep- stitutions have further encouraged high de- accounting and auditing procedures, rewards ing, and loan collection may then be taken fault rates. Deficient accounting practices and according to performance (including loan col- over by the group. Familiarity among group inadequate record keeping, for example, can lection), and rotation of key employees can members or between the cooperative manage- make it difficult to determine when payments help make a financial institution more effi- ment and its members also allows the reduc- are overdue and loan agreements must be en- cient, while lowering the possible losses tion of informational costs linked to the reduc- forced. Default rates in most subsidized rural through misallocation and patronage. tion of adverse selection and moral hazard credit systems have, therefore, been exces- While external funds may be necessary to behavior. sively high and cannot be merely attributed to help restructure institutions and help them Experience with organized credit groups or higher risks associated with agricultural pro- get off the ground, donor and government cooperatives has been mixed to date, but their duction. Recovery rates of 50 percent and funds should primarily be used for institution limited success appears to be due to shortcom- lower have frequently plagued agricultural building purposes. This includes proper train- ings in their implementation and general defi- credit systems in developing countries. ing of managers, supervisors, and loan offi- ciencies, such as low interest rates, rather The incentives to actively enforce loan cers, and the introduction of adequate ac- than inadequacy of the approaches them- agreements and collect repayments have counting, auditing, and management informa- selves. Successful group lending programs sometimes further been weakened by govern- tion systems. have shown that factors such as homoge- ment-backed crop insurance schemes, which Borrowers must face an incentive structure neous borrowing groups that are jointly liable have shifted part of the recovery risk to other that induces them to repay their loans. Certain and assume themselves some managerial and agencies. successful group lending and credit coopera- supervisory responsibilities, a common bond Reforming rural finance tive arrangements have shown that some other than credit, and denying access to future form of joint responsibility or liability by credit to the whole group in case of default by Purely supply driven credit schemes must small groups of farmers can also enhance re- any member, are crucial elements. Important be transformed into self-sustainable systems payment. factors for successful outcomes of credit coop- and rural financial intermediaries must be- Given the overall adverse effects of subsi- eratives include institutional development, ex- come viable and self-carrying agents. While dized credit programs, the general continua- tensive training at all levels, savings mobiliza- market failures in rural financial markets may tion of credit subsidies has to be seriously tion, slow expansion of cooperative activities, call for active government and donor involve- questioned. Liberalization of interest rates for and strict monitoring and auditing. ment, it must be realized that any form of in- lending to agriculture would allow rural finan- tervention can only effectively counter these cial intermediaries to cover their operational deficiencies if adequate institutional struc- costs. They could then be required to operate tures exist. Intervention in rural financial as financial entities which face bona fide markets of developing countries should thus, profit constraints. Market interest rates may Avishay Braverman above all, focus on restructuring and strength- also encourage financial intermediaries to ef- Israeli, was Chief of the ening rural financial institutions and remov- fectively mobilize rural savings. This would Bank's Agricultural Policies Division. He is ing obstacles to the efficient functioning of ru- make them more independent from external now President of Ben ral credit markets. This includes elimination financial sources, while making them respon- Gurion University in Israel. of monopolistic practices regarding access to sible for managing their own funds. Market government rediscounting facilities, tighter rates decrease the incentives for patronage targeting of small farmers along with gradual and arbitrary decisions, and can thus help im- removal of subsidies, and deregulation of in- prove the regressive character of subsidized terest rates, to allow for full cost recovery. credit programs. Experience has shown that Existing rural financial institutions must the price of loans is a relatively unimportant be restructured in a way that they can eventu- factor in inducing farmers to borrow. Much Monika Huppi a Swiss national, is in the ally function in a competitive environment. more important are timely services and simple Young Professionals pro- They must be encouraged to spread their application and disbursement procedures. gram of the Bank. She risks through portfolio diversification and The question remains, however, whether holds degrees from Zurich thus start lending to rural enterprises other freeing up interest rates will give small fann- College of Education, The than agriculture. To the extent possible, they ers enough access to formal credit Liberalized Graduate Institute of must be induced to mobilize their own re- interest rates can be expected to decrease International Studies in sources through the provision of savings facil- overall demand of credit, so that small farm- Geneva, and Tufts ities. ers' access to funds should to a certain extent University. Further, these institutions must be stream- be improved. High transaction costs and lack lined and required to face strict accountability of significant collateral, however, may still

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