|Rural Finance and Poverty Alleviation - Food Policy Report (IFPRI, 1998, 32 p.)|
In most developing countries, it is the private, informal markets that the rural poor turn to for their financial needs. Why have these institutions succeeded in providing services to the poor when formal institutions have not? What are their basic limitations? The answers may indicate important directions that public policy should take in encouraging institutional innovations.25
Typically, informal institutions can be categorized as follows:
· Lending and borrowing among relatives, friends, and neighbors. Borrowing from socially close lenders is often the first recourse of poor households in financing expenses, especially essential consumption expenditures. Transactions are collateral-free and, as the IFPRI country studies show, interest is usually not charged.26 These are essentially informal social insurance schemes that have the principle of reciprocity at the core of the transactions.27 Hence, both the lender and the borrower gain from the transaction, and the process is self-sustaining. The borrower is able to finance urgently needed expenditures quickly and with few transaction costs; there is no lengthy appraisal process, little or no paper work or travel time, and the terms of transactions are easy to understand. The lender gains a right to reciprocity that he can lay claim to in the future. Further, risk of a loan not being recovered is minimal because the lender only lends to persons who are part of his or her social network, within which contracts can be enforced. For each partner, therefore, the long-term gains associated with maintaining borrowing privileges is greater than the short-term gain from reneging on the payback.
· Rotating savings and credit associations (ROSCAs), found in many countries, are also network-based but address different needs of their members. The rules of conduct are more formalized. These associations, which may even operate under a designated manager, pool savings from members each period, and rotate the resulting pot among them, according to various rules including random drawing. The process is repeated each period until the last member receives the pot. Unlike demand deposits, once the saving is committed, it usually cannot be withdrawn before the members scheduled turn, although some groups do allow for an early draw of the pot in an emergency situation.
· Informal moneylenders. Typically, informal moneylenders are approached when the amount of credit required is larger or is needed quicker than can be obtained from friends and neighbors. Moneylenders lend for profit and often charge high interest rates. Rates in the range of 5 to 7 percent per month are not uncommon.28 Typically, moneylenders lend only to households about whom they possess adequate information. However, they may make an exception if punitive actions against defaulters are feasible - if there is physical collateral that can be seized or social collateral in the form of community pressure that can be exerted when contracts are breached. The informal nature of these transactions must be emphasized: more often than not, these sanctions are not enforced by any legal authority but by the commonly understood rules of the communities themselves.
· Tied credit. Credit transactions are frequently tied to transactions in land and labor markets to circumvent problems of inadequate information and lack of assets suitable for collateral. Traders, for example, disburse credit to farmers in exchange for the right to market the growing crop; shopkeepers increase sales by providing credit for food, farm inputs, and household necessities; large landholders secure access to labor in the peak season in return for earlier loan advances to laborers. In these types of transactions, the lender also deals with the borrower in a nonlending capacity and is able to use this relationship to screen applicants and enforce contracts. The grain buyer or the local sugar mill that advances credit to the farmer, for example, is reasonably assured of repayment because the loan can simply be deducted from future sales of the farmers harvest.
· Household savings, until recently, were perhaps the most overlooked component of rural finance. Savings provide for the accumulation of capital, which, in turn, can generate future income and enable future consumption. However, there is now ample evidence that poor rural farmers save to build a precautionary buffer to be used during lean seasons or to finance unexpected expenditures.29 For example, in Cameroon, 59 percent of households reported saving for health care or to meet family obligations, roughly 30 percent for education and house construction, and less than 10 percent for agricultural production.30
In general, the ingenuity of informal lenders and self-help organizations in tailoring savings, loan, and insurance products to the requirements of their clients or members makes them indispensable in both the urban and rural financial landscape of developing countries.
Informal Systems Face Disadvantages as Well
Innovative and useful as the informal sector may be, it also frequently runs up against severe constraints.31 Informal credit markets, by their very nature, are segmented. A market typically consists of a single village community or a socioeconomic group within a village. And informal lenders seldom manage savings deposits. Hence, financial intermediation in the sense of providing a common clearinghouse for borrowers and lenders does not take place to the fullest extent possible. As a result, the supply of credit is limited, resulting in either severe credit rationing or extremely high interest rates for some borrowers.
It is not surprising, therefore, that in all the studies conducted by IFPRI, informal sector transactions were small, short-term loans taken in order to purchase urgently needed goods for household consumption-especially food-or, to a lesser extent, inputs such as seeds and fertilizer. The IFPRI study in Bangladesh, for example, found that in 1994 the average size of a loan in the informal sector was about US$15 taken for about three months. Invariably, when larger projects need to be financed, such as a new enterprise, an irrigation pump, or the lease or purchase of agricultural land, people often turn to formal lenders. Also, especially in agricultural regions, droughts or floods affect both informal lenders and borrowers simultaneously, so a credit supply crunch is likely to take place just when the demand for credit peaks. Formal institutions such as banks usually have a network of branches across different regions of a country and are therefore in a better position to diversify risks. And when they are allowed to collect savings deposits, they serve the needs of savers as well as borrowers. Formal institutions can also leverage funds in other financial markets such as the bond market.
Lessons from Informal Systems
A number of lessons can be derived from the workings of the informal system:
· Credible long-term partnership. That the accumulated benefits associated with continued long-term transactions are larger than the short-term gains associated with delinquent behavior is what makes informal loan contracts enforceable. Formal institutions, similarly, must successfully demonstrate to clients that they expect to be in business for a long time. This demonstration of stability is essential for maintaining high repayment rates. Clients are usually astute in making inferences about the permanence of new projects. Short-term and sporadically implemented credit projects generally encounter higher rates of loan delinquency precisely because the short-run gains from defaulting outweigh uncertain future gains.
· Tailoring financial services to specific demand patterns. As with the marketing of any product, financial services must be sculpted to fit the specific demands of the borrowers or savers. For the poor, the privilege of borrowing from various informal institutions is worth preserving precisely because their services are responsive to the households needs. Emergency loans, for example, can be obtained immediately on demand; the repayment structure is closely linked to local production cycles associated with the borrowers occupation; and loans can be renegotiated, taking into account both the lenders and the borrowers specific circumstances. These attributes greatly increase the value of loans to borrowers and provide further incentive for them to retain borrowing privileges.
On the other hand, when terms of loans are incompatible with local production patterns or when loans are tied to activities that, given the structure of local resources, yield poor returns, little is gained by retaining borrowing privileges. Benefits from defaulting may outweigh the retention of borrowing privileges. For example, agricultural credit programs frequently provide credit for specific farm enterprises, usually export crops or main food staples. The loan, most often for seeds and fertilizer, is frequently provided in-kind, and the amount loaned is closely tied to the area devoted to the crop. Thus, improving the credit line or using the loan to finance other remunerative activities is not possible. This reduces the flexibility of the farm household in making the best use of the loan. Under these conditions, the farmer may be better off defaulting and investing the loan amount elsewhere.
· Knowledge of the local economy is important; therefore, decisionmaking should also be made at the local level. The ways in which informal agents successfully interlink financial transactions with transactions in the markets for land, produce, and labor provides yet another example of how financial products can be tailored to clients requirements. To do this requires intimate knowledge of the structure of the local economy as well as knowledge of existing institutional arrangements that can potentially be used to strengthen contract enforcement. Generally this is not possible within a top-down organizational framework. Frontline managers must be actively involved in adapting financial products to local institutional arrangements.
· Most financial contracts are not self-enforcing, and adequate steps must be taken to enforce contract compliance. Whereas the majority of informal financial contracts between friends and relatives are self-enforcing, socially distant lenders depend on explicit (though not necessarily legally codified) mechanisms to enforce repayment. Just as moneylenders must obtain a mandate from small communities to take punitive actions against defaulters, it is also important for formal institutions to have clear, implementable, and well understood plans for contract enforcement and loan recovery before lending begins. Lack of a credible plan only invites default.
· Group-based transactions hold promise. The existence of ROSCAS and networks of friends and relatives indicate the possibility of using groups in formal lending and saving activities. If groups can be made responsible for some of the screening, monitoring, and enforcement functions, the risks would be reduced for formal outsider institutions. Furthermore, group loans would be larger in size and less costly to administer. Although the group-based concept has been widely applied in formal rural financial systems in Asia, Africa, and Latin America, little is known about the efficiency and outreach of groups, compared with other member-based institutions such as credit unions or village banks. Future research in this area is urgently needed.
· Provision of savings services. The poor place a high value on savings services, especially when the options provided combine security of deposit, value retention, and flexibility in making savings deposits and withdrawals. For the banks, rural savings mobilization can provide relatively inexpensive funds for on-lending. The particular form in which household savings are kept is influenced by return, liquidity, and risk. When investigating the savings behavior of the food-insecure and poor, the standard definition of household savings and investment, which focuses on money and physical assets, is too narrow.32 It neglects the potential for savings to increase human capital through investment in education and improved nutritional and health status of family members. Such expenditures may not only increase the ability of people to earn a living now, but they are likely to have a beneficial effect well into the future.
· A question of incentives. Borrowers and lenders in the informal market directly interact with each other. This is not necessarily so in formal systems, where loan managers may not have the same incentive to make good loans as owners or trustees of the bank might have. For example, in most government-run institutions, loan managers are not rewarded for making good loans. Therefore, they are less likely to take sufficient care in screening clients or in taking steps to recover loans swiftly. Formal lending systems should therefore establish incentives that build on the loan managers knowledge of clients in order to minimize fraud and other problems of contract compliance.