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The case against cheap credit

by Dale Adams

Until recently most policymakers agreed that a majority of farmers in low-income countries needed cheap loans. Large amounts of money went to farmers through special rediscount windows in central banks, regulations were issued to force lenders to make cheap loans to farmers, and loans and grants for agricultural credit became a large part of rural development. In the early 1970s a few people became uneasy about the results, arguing that the outcome of many credit projects was less desirable than had been expected. An evaluation of small farmer credit programmes by the Agency for International Development in 1972-73, an agricultural credit policy paper by the World Bank in 1975, and a credit conference in Rome sponsored by FAO in 1975 demonstrated this concern.

Various combinations of at least 10 rural financial market problems have been identified. These include:

- lending procedures that create high costs for bath lenders and borrowers;
- serious loan repayment problems;
- financial intermediaries whose revenues are less than their costs;
- badly fragmented rural financial markets;
- intermediaries who evade or ignore the intent of government regulations;
- strong patronal relationships;
- a general lack of savings deposit services;
- the common practice of intermediaries who do mobilize savings to transfer a significant part of the money mobilized out of rural areas;
- heavy dependence of many segments of rural financial markets on outside money, which makes substantial political intrusions in these markets common;
- worst of all, the fact that a large part of the cheap credit ends up in the hands of the well-to-do.

These problems have led policymakers to expect that rural credit programmes will be mediocre. While the criticism of credit programmes has mounted, increasing attention has turned to clarifying the reasons for these problems. This article is intended to summarize the main causes of these difficulties and briefly outline ways to improve the performance of rural financial markets.

Problem diagnosis. Over two decades of study I have been impressed by the similarity of financial market problems in several dozen low-income countries. Traditional credit activities are doing a poor job of supporting efficient and equitable development. Five factors often lie behind these difficulties:

- agricultural credit efforts are based on faulty assumptions;
- agricultural credit policies and overall use of rural financial markets are incorrect;
- many bad loans stem from public policies that result in low economic return to farming;
- weak and incorrect research and evaluation have helped to support faulty policies;
- donor assistance has often reinforced damaging policies.

Traditional assumptions have a powerful influence on agricultural credit policies. It is regularly assumed, for example, that most farmers are too poor to save, especially in financial form, that most farmers need cheap credit before they will adept new technology, and that most farmers need supervision. These assumptions have the same ring to them as those challenged by T.W. Schultz in the early 1960s in his bock Transforming Traditional Agriculture. While Schultz's argument is now generally accepted, many people continue to stereotype rural people as irrational when it comes to financial markets.

I am convinced that most rural people in low-income countries do not regularly need formal loans, that many formal borrowers Bet few benefits from loan supervision, that most rural people will save more if given the opportunity and incentive to do so, and that low interest rates are not necessary to stimulate high-return investments.

Widespread suspicion surrounds informal financial intermediaries, and 6 horror stories are repeated to sustain these biases. Despite an increasing number of studies that show these horror stories are not typical, they continue to colour agricultural credit policies. Suspicions about informal lenders are based on religious dogmas or on racial and ethnic biases. Further, since any price is higher than a consumer wants to pay for a good, and producers always want to have a higher price for their products, both groups feel cheated by most market transactions, even though they participate volontarily. Seldom does the consumer or the producer understand how prices are determined, and the marketing intermediary is often a scapegoat. Further ill feelings about financial intermediaries come from those who are forced to borrow by economic stress. It is easy for the borrower to see the loan as part of the problem rather than as a solution.

Other damaging assumptions are made about finance in general. Credit is often viewed as an input rather than as a claim on resources and services. Fungibility of financial instruments is normally ignored by policymakers. This leads them to think that these claims can be targeted to specific uses. If a country wants more rice output, targeted loans for rice production are a common reaction. Cheap credit appeals to politicians who want to help the rural poor. Central credit planning and requests for credit impact studies result from these views.

The financial system is a supple political instrument. In some cases governments use nationalization of banks to try to force financial intermediaries to comply with government decrees. It is widely thought that a government-owned bank can defy the laws of financial gravity. The landscape of low-income countries is littered with the wreckage of rural financial institutions, ruined by such misjudgements. I conclude that most traditional assumptions about borrowers, savers, lenders, finance, and rural financial marketings in low-income countries are weak or false.

Faulty policies. Credit programmes have been accompanied by several damaging policies. Foremost among these have been the low and inflexible interest rates applied to most agricultural loans and to savings deposits. These low rates are justified as offsetting other price distortions, to transfer income to the rural poor, and to induce farmers to adopt new technologies. With substantial inflation in most low-income countries during the past ten years, many interest rates charged and paid in rural areas on formal financial instruments have been negative in real terms. As a result, borrowers repay lenders less in purchasing power than they borrow and savers are returned less in purchasing power than they deposit.

Low interest rates have powerful effects on rural financial markets. They make it especially difficult for financial intermediaries to mobilize voluntary private savings. This forces the intermediaries to rely on government and donors for funds and to become very susceptible to political intrusion. The low rates also make it difficult for lenders to cover their operating costs. This, in turn, forces the lender to continually seek subsidies to cover operating expenses, to gradually decapitalize, to shift a substantial part of his loan transaction costs to the borrower, or to reduce the costs of lending by making large loans. This forces lenders to depend on external funding, to exclude many potential borrowers from formal loans, to concentrate concessionary priced loans, and to lose money on lending.

Regardless of the policymaker's intent, a weak or bankrupt lender provides unsatisfactory financial services, and employees of the intermediary become demoralized. Accusations of fraud, mismanagement, and incompetence surround the decline of these financial agencies, and personalities, rather than policies, are blamed for the problem. The solution is seen as tightening up the administration, appointing new leadership, combining the weak organization with another, better-managed agency, or cresting still another institution that must face the same hostile environment.

One might accept the undermining of financial intermediaries as a worthwhile cost, as long as the objectives of equity and efficient resource allocation were met. But, as suggested earlier, low interest rates force lenders to concentrate loans. Three types of benefits accrue to those lucky enough to get these loans. The first is the normal net benefits one gets from profitable use of borrowed resources. The second is the income transfer associated with negative real rates of interest. And the third is the income transfer that accrues to loan defaulters. All three of these benefits are proportional to loan access; large borrowers get large benefits, small borrowers get small benefits, and non-borrowers get no benefit. All savers and potential savers in financial form, of course, lose because of the even lower interest rates paid on deposits.

Cheap credit also fails to correct for the misallocation of resources resulting from government policies that depress agricultural incentives, yields, and in comes. A simple example may clarify why low interest rates do not induce farmers to allocate resources in a manner contrary to that signalled by product prices and yields. Let us assume that a farmer has a few dairy cows and also grows marijuana. Let's assume further that the government sets a very low price on milk because of urban pressures, and that this causes farmers to shift resources away from milk production to more profitable activities. To discourage this, the government announces a special credit programme for dairy producers that provides loans at negative real rates of interest to compensate farmers for low milk prices.

Let us ignore the effect these low interest rates have on the behaviour of the lender and savers and assume that all dairy producers get a cheap loan. The additional liquidity provided by the loan can be used by the borrower to buy more consumption goods, to expand production of marijuana, to enter into new economic activities, or to sustain milk production. But there is no logical reason why the farmer would sustain milk production, with or without a cheap loan, since the economic returns from that activity are made unattractive by price control. House hold consumption, marijuana production, and new economic activities would logically absorb most additional liquidity provided by cheap loans.

Cheap credit does not make an unprofitable activity profitable. Further, the fact that low interest rates force lenders to concentrate loans in the hands of relatively few people means that the credit subsidy is not equitably distributed. Using cheap credit to offset the misallocation caused by other price and yield distortions is like trying to sweep water uphill.

Low agricultural returns. In part, the problems encountered in the rural financial markets in low-income countries are beyond the control of participants in these markets. Low product prices, low and unstable yields, the lack of new technology, and natural disasters make farming a low-return activity in many countries. At the same time, political instability, wars,
cumbersome judicial procedures, and vague or uncertain land titles increase lending risks. Low returns to agriculture reduce savings capacities. These conditions restrict the scope for efficient financial intermediation and make it difficult for intermediaries to realize economies of scale. Cleady, higher agricultural prices and yields would allow rural financial markets in low-income countries to perform better.

It should come as no surprise that much of the research done on these markets in the past 30 years has been closely tied to the policies, strategies, and assumptions already discussed. Until recently, research seldom tested traditional assumptions. In many low income countries, most research has attempted to measure the impact of credit use at the farm level, and also to estimate credit needs. Very little time has been spent in diagnosing the problems of rural financial markets. The small amounts of research done on savers' behaviour, the behaviour of financial intermediaries, and work on the overall performance of these markets reflects the effects of strongly held traditional assumptions.

Much less research on impact at farm level is needed; more research ought to be directed at testing assumptions and policies that are closely associated with rural financial markets. This type of research would shed more light on why things do not work well in these markets.

Donor assistance. Most people look at donor assistance as an important way of solving problems of rural financial systems. In a number of low income countries donor loans and grants have made up a large part of the total agricultural loan portfolio. An agricultural credit project is highly desirable for both the donor and the local government. Credit projects are easy ways for donors to lend large amounts of money, and agricultural credit can be disbursed rapidly. For the local government, these projects are easy to arrange and give the country large amounts of foreign exchange. Donors and governments generally ignore that the country does not need foreign exchange to expand the amount of local currency used for agricultural loans. Printing presses in the central bank can easily do this. External loans have three primary effects: they provide the government with more foreign exchange, they orient rural financial markets toward external sources for their funding, and they reinforce important policies that damage the performance of rural financial markets.

External funds reinforce the dependency mentioned earlier, make it easier to sustain low interest rate policies, and discourage intermediaries from mobilizing savings. Concessionary rediscount facilities used to move donor funds from the central banks to rural intermediaries are particularly damaging. Managers of agricultural credit agencies conclude that it is cheaper to get money from the central bank than it is to mobilize saving. All of the potential savings in rural areas that do not take place because many people are offered low returns to savings, or in fact lack any acceptable places to hold additional savings, are major costs of these concessionary rediscount facilities.

Until recently, researchers have done a poor job of clearing away the misconceptions and erroneaus assumptions that clouded what happens in rural financial systems. I know of no other area in development where there is a wider gap between policymakers' notions and actual events.

An efficient, effectively functioning financial market should provide loans to most of those who have economic opportunities that exceed the capacity of their own resources. An effective formal rural financial market is doing well if it provides loans to 20 to 25 per cent of the farmers in a country. If roughly half of the rural firms and households in the country also have regular access to either formal or informal loans, I think the financial market is doing a remarkably good job. Providing loans, however, is less then half of financial intermediation. A much larger number of rural people could benefit from convenient, safe, and high-return savings accounts. At present, most people in rural areas do not have access to deposit facilities, and only a few receive cheap loans.

Policymakers must realize that it is impossible to use rural financial markets to make income distribution more equal. Under the best of circumstances, financial intermediation will have a slightly negative effect on income distribution. (This would be a large improvement over what is currently happening, however.) Furthermore, it is becoming increasingly clear that cheap credit is an ineffective instrument to compensate farmers for low product prices and yields. Cheap credit fails on both equity and efficiency, grounds.

Despite the confusion that surrounds rural financial markets, the treatments for its problems are relatively simple. First and foremost, much more emphasis must be place on encouraging rural financial markets to mobilize savings. Doing so would provide this valuable service to a large number of rural poor who have few savings opportunities. It would also reorient managers of financial intermediaries away from toadying to government and donor officials and toward doing a better job of serving rural clients. This would cause financial intermediaries to be less susceptible to political intrusions, and also would encourage social sanctions on loan defaulters.

It will also be necessary to revise interest rate policy. Savers will not hold substantial amounts of financial assets if the expected real rates of inflation are vital for mobilization of savings. Higher rates on loans would reduce the demand among those who use large amounts of cheap credit, allow more lenders to cover their costs, and encourage lenders to reduce the costs of transacting loans for both borrowers and themselves.

Policymakers should not try to accomplish too much with credit projects. Product prices, crop yields, and the costs of production are much more powerful determinants of farmers' decisions than are credit availability or interest rates. Same of the money and energy currently being wasted in cheap credit programmes would be better directed at making product prices more attractive and in developing new technologies that boost yields.