Improving Rural Finance in Developing Countries

International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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over the last three decades, governments in many developing countries have intervened heavily in rural financial markets. Their intervention has been motivated by the belief that a shortage of affordable credit constrained agricultural growth and development and prevented the integration of small farmers into the market economy. The most frequent forms of intervention have been administrative allocation of funds, interest rate ceilings, and establishment of specialized rural finance institutions. Many donors have actively supported these interventions. For example, about one fourth of all World Bank lending to agriculture during the 1980s, or $9.7 billion, went to agricultural credit.

This article draws heavily on the work carried out by the Agricultural Policies Division, as well as work by researchers outside the Bank. For example, see “Rural Credit in Developing Countries” by Avishay Braverman and J. Luis Guasch, Policy, Planning, and Research Working Paper No. 219, The World Bank, and “The Role of Groups and Credit Cooperatives in Rural Lending,” by Monika Huppi and Gershon Feder, The World Bank Research Observer, July 1990.

The performance of most credit programs has, however, fallen short of expectations. Although various factors account for the limited success of subsidized credit programs, the failure of these programs can at least partially be attributed to defects within the institutions designated to carry them out and, in part, to the assumptions underlying past policies. As a result, a growing literature is developing that seeks alternative forms in managing and channeling credit to rural markets, that could eradicate or at least significantly reduce the problems previously encountered.

It is questionable whether abolishing credit subsidies alone would eliminate the major inefficiencies that currently afflict rural credit systems in developing countries. It is also doubtful that a simple laissez-faire policy would effectively reach small farmers with institutional rural credit and counter other market failures. Under certain circumstances, interventions in the rural financial markets of developing countries may still be warranted, provided acceptable institutional structures exist to administer such programs.

Reasons for intervention

The main justification for intervention in rural credit markets has been a perceived shortage of affordable credit, which has generally been attributed to imperfections in rural financial markets, and the discrepancy between private and social rates of return.

Because of the seasonal nature of agricultural operations, cash flows and cash needs of rural producers are not synchronized. In addition, the income of agricultural producers is highly influenced by climatic conditions. Hence, lending to agriculture is more difficult than regular commercial lending. Lending in rural areas often implies servicing a geo-graphically dispersed clientele, which increases transaction costs. Administratively imposed ceilings on interest rates have often prevented commercial lenders from passing on fully these costs to borrowers. Together with the frequent absence of collateral and difficulties in enforcing contractual obligations, all the preceding factors tend to discourage commercial banks from engaging in rural lending.

Where commercial lending institutions are active in rural areas, they almost exclusively cater to large farmers. Lending to small farmers is a problem because of the substantial unit costs in processing and administering small loans, lack of collateral and the often un-justified belief that small agents are bigger risks than large farmers.

The absence of strong formal credit markets has given rise to informal financial markets in rural areas of many developing countries. Most of these markets are characterized by relatively quick disbursement of funds and low transaction costs. But they have high interest rates due to such factors as high risk, limited diversification of the loan portfolio, and, sometimes, monopoly rents. While it is not uncommon for friends and relatives to lend at zero interest (or even negative rates in real terms), money lenders have been found to charge 200 percent or more. A study among rice farmers in the Philippines, for example, found that 15 percent of the producers paid more than 200 percent in interest on their loans from the informal market, while 20 percent of them had loans at zero interest rates. In Chile, studies show that relatives, friends, and patrons lent to farmers at zero or even negative interest rates, while stores, traders, and moneylenders lent at rates as high as 360 percent.

Private banks’ reluctance to lend to agriculture in general, and to small farmers in particular, and the uncertainty regarding the availability of high interest credit in the informal market, have been the main reasons for government intervention in rural financial markets. It has also been argued that the limited availability of affordable capital delays, if not prevents, the adoption of new production technologies and the use of nonlabor inputs such as fertilizer. This, in turn, slows down output growth and the development of the agricultural sector. Finally, governments often intervene and attempt to compensate farmers for the adverse effects of “urban bi-ased” pricing (i.e., government policies that favor residents of the urban sector over rural inhabitants), taxes, and exchange rate policies.

To overcome the paucity in formal rural lending, governments, often supported by international donors, have frequently established specialized agricultural credit institutions. While these institutions have been provided with cheap government or donor funds, they have often had to follow administrative guidelines, rather than creditworthiness criteria, in allocating their credit. To guarantee availability of cheap funds, governments have often imposed low interest rate ceilings on all formal lenders. But such ceilings have had adverse effects, preventing these lenders from covering their operating expenses and loan losses. As a result, governments have had to intervene to cover such bills. In some cases, governments have even covered part of interest payments for certain categories of borrowers from these lending institutions (for example, small-scale farmers or producers of a specific crop). High rediscount margins have allowed rural financial intermediaries to only finance a small part of the granted subloans themselves, while the rest has been financed by the central bank at subsidized rates. Nonrural financial intermediaries have frequently been obliged to buy obligatory bonds yielding below-market rates. The proceeds of these transactions have then been made available to rural financial intermediaries.

Effects of rural credit programs

The effects of three decades of intervention in rural financial markets have, unfortunately, been dismal. A number of case studies have shown that the availability of subsidized credit has had little, if any, effect on agricultural productivity. Unless lenders employ strict (and often costly) supervision, the fungi-bility of money makes it difficult to guarantee that borrowers use funds to finance agricultural investments. Further, it is impossible to ensure that borrowed funds are used to finance higher investment than would have taken place without subsidized credit. Credit project evaluations in countries as diverse as Kenya, Mexico, and the Philippines, for example, have found that the use of funds for purposes other than the ones stated at the time of borrowing was a major factor that severely limited the programs’ effects on productivity increases. One argument often used in favor of credit subsidies is that they compensate farmers for the adverse effects of other policies. This is, however, doubtful as subsidized credit does not make investments in agriculture more profitable, and such funds could well be diverted to other, more lucrative, undertakings. But even to the extent that subsidized credit does compensate producers for urban biased policies, it only benefits the few who actually have access to such funds.

Despite the remarkable expansion of credit in rural areas of most developing countries, the distribution of official credit has remained skewed in favor of large farmers. An estimated five percent of farms in Africa, and about 15 percent in Asia and Latin America, have had access to formal credit, with five percent of borrowers often receiving as much as 80 percent of the credit. Thus, instead of narrowing income inequalities, low interest credit programs have often increased them. Since large farmers generally borrow larger amounts than small producers, the former benefit more from credit subsidies than the latter. When interest rates do not reflect the true cost of capital, the distribution of benefits from official loans is generally even more regressive. Cheap funds lead to excess demand of capital, so that subsidized loans must be rationed. Because rural lenders prefer large borrowers (especially when low interest rate ceilings do not allow them to cover the higher transaction costs involved in lending to small farmers), small farmers tend to be rationed first.

The continuous availability of cheap funds and ceilings on interest rates have prevented specialized agricultural credit institutions and other formal lenders from mobilizing rural savings and thus building up their own sources of funds. Specialized agricultural lending institutions have, therefore, never developed into true and viable financial intermediaries between net savers and net borrowers. Studies in rural areas of various developing countries have, however, shown that even small producers in poor areas can and do save significant amounts, if given the opportunity to do so. The problem, therefore, is not so much a shortage of funds in a particular area, but rather a lack of possibilities to manage liquidity over time. Credit unions and other credit cooperatives in Cameroon, Guatemala, Rwanda, South Korea, Taiwan Province of China, and Togo, for example, have been very successful in mobilizing savings in rural areas. Extensive saving mobilization campaigns and innovative offers for deposits adapted to local rural conditions have helped many of these credit cooperatives to increase their own funds and attain near self-sufficiency in terms of funding. In Rwanda, where credit unions were created for the specific purpose of mobilizing rural savings, membership grew by 47 percent between 1977-86, with real savings growing at an average annual rate of 35 percent. Similarly, in Togo and Cameroon, real savings mobilized by credit unions grew at an average annual rate of 25 percent and 14.5 percent, respectively, during the same time period.

Government-supported rural credit institutions with limited accountability have also lacked the incentives to effectively monitor investment and repayment behaviors of their borrowers. The performance of such credit institutions have often been based on quick loan approval and growth of the lending volume, rather than on financial performance. This has facilitated willful loan defaults. For instance, default rates as high as 50 percent were observed in India, 71 percent in Bangladesh, and 40 percent in Malaysia and Nepal. And in Thailand, over 50 percent of the loans made through the cooperative system were in arrears in the 1980s. Inefficiencies and incompetent management in rural finance institutions have further encouraged high default rates. Deficient accounting practices and inadequate record keeping, for example, can make it difficult to determine when payments are overdue and loan agreements must be enforced. Default rates in most subsidized rural credit systems have, therefore, been excessively high and cannot be merely attributed to higher risks associated with agricultural production. Recovery rates of 50 percent and lower have frequently plagued agricultural credit systems in developing countries.

The incentives to actively enforce loan agreements and collect repayments have sometimes further been weakened by government-backed crop insurance schemes, which have shifted part of the recovery risk to other agencies.

Reforming rural finance

Purely supply driven credit schemes must be transformed into self-sustainable systems and rural financial intermediaries must become viable and self-carrying agents. While market failures in rural financial markets may call for active government and donor involvement, it must be realized that any form of intervention can only effectively counter these deficiencies if adequate institutional structures exist. Intervention in rural financial markets of developing countries should thus, above all, focus on restructuring and strengthening rural financial institutions and removing obstacles to the efficient functioning of rural credit markets. This includes elimination of monopolistic practices regarding access to government rediscounting facilities, tighter targeting of small farmers along with gradual removal of subsidies, and deregulation of interest rates, to allow for full cost recovery.

Existing rural financial institutions must be restructured in a way that they can eventually function in a competitive environment. They must be encouraged to spread their risks through portfolio diversification and thus start lending to rural enterprises other than agriculture. To the extent possible, they must be induced to mobilize their own resources through the provision of savings facilities.

Further, these institutions must be streamlined and required to face strict accountability and profit constraints. Governments and donors must thus stop financing recurrent deficits incurred by these institutions and rural financial intermediaries must be allowed to cover their costs with higher interest rates. Managers, supervisors, and loan officers of rural finance institutions must be provided with the incentives to screen loan applications, monitor investment and repayment performance, and enforce loan contracts. Strict accounting and auditing procedures, rewards according to performance (including loan collection), and rotation of key employees can help make a financial institution more efficient, while lowering the possible losses through misallocation and patronage.

While external funds may be necessary to help restructure institutions and help them get off the ground, donor and government funds should primarily be used for institution building purposes. This includes proper training of managers, supervisors, and loan officers, and the introduction of adequate accounting, auditing, and management information systems.

Borrowers must face an incentive structure that induces them to repay their loans. Certain successful group lending and credit cooperative arrangements have shown that some form of joint responsibility or liability by small groups of farmers can also enhance re-payment.

Given the overall adverse effects of subsidized credit programs, the general continuation of credit subsidies has to be seriously questioned. Liberalization of interest rates for lending to agriculture would allow rural financial intermediaries to cover their operational costs. They could then be required to operate as financial entities which face bona fide profit constraints. Market interest rates may also encourage financial intermediaries to effectively mobilize rural savings. This would make them more independent from external financial sources, while making them responsible for managing their own funds. Market rates decrease the incentives for patronage and arbitrary decisions, and can thus help improve the regressive character of subsidized credit programs. Experience has shown that the price of loans is a relatively unimportant factor in inducing farmers to borrow. Much more important are timely services and simple application and disbursement procedures.

The question remains, however, whether freeing up interest rates will give small farmers enough access to formal credit. Liberalized interest rates can be expected to decrease overall demand of credit, so that small farmers’ access to funds should to a certain extent be improved. High transaction costs and lack of significant collateral, however, may still prevent them from borrowing the desired amount, so that intervention in their favor may be called for.

Alternative institutional arrangements, such as lending groups and credit cooperatives, have the potential to reduce transaction costs, because they allow for the processing of one large loan rather than numerous small loans. Administrative responsibilities such as loan allocation within the group, record keeping, and loan collection may then be taken over by the group. Familiarity among group members or between the cooperative management and its members also allows the reduction of informational costs linked to the reduction of adverse selection and moral hazard behavior.

Experience with organized credit groups or cooperatives has been mixed to date, but their limited success appears to be due to shortcomings in their implementation and general deficiencies, such as low interest rates, rather than inadequacy of the approaches themselves. Successful group lending programs have shown that factors such as homogeneous borrowing groups that are jointly liable and assume themselves some managerial and supervisory responsibilities, a common bond other than credit, and denying access to future credit to the whole group in case of default by any member, are crucial elements. Important factors for successful outcomes of credit cooperatives include institutional development, extensive training at all levels, savings mobilization, slow expansion of cooperative activities, and strict monitoring and auditing.

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