2 impmved financal market would lower the risk of lending to smalUholders and improve their access to new inputs, and would therefore contnbute to productivity growth. 2 The rural financial system in Pakistan, furthermore, has to address the special needs of the disproportionately large number of poor households located in rural areas. Policy-directed lending to the poor is justified because of the market's failure to correctly assess the risk in lending to the poor and to manage that risk. The poor may not be able to satisfy the collateral requirements grounded in individual property rights. On the other hand, policy-directed credit based on group lending spreads risk and appeals to social responsibility for contract enforcement. This results in better management of risk and renders the poor more creditworthy. Furthermore, lending to the poor is also an important equity objective both because reduction in income inequality per se is often a social goal and because poverty reduction contributes to political stability and thus facilitates growth.

According to the 1987-88 household income and expenditure survey, 85.8 percent of the country's total population in poverty live in rural areas. This is consistent with a more recent finding that household income in rural areas is 35 percent lower than income in urban areas. The poor are found among small cultivators (ownercultivators on marginal lands and tenants), landless agricultural workers, small livestock owners, and nonfarm workers. Rural finance directed at these households must be affordable and sustainable and, more importantly, must reach the truly needy. However, the development of rural credit market in Pakistan has been "considerably distorted" (Mellor, 1995). The result is a fragmented credit market that varies in development and density by region, as examined by Malik (Credit Use. Poverty and Role of Institutional Rural Credit: the Case of Pakistan. 3iPRI, 1993.) In addition to farmers and the rural poor, there is a large community of non-farm rural households engaged in microenterprises. Their credit needs for income generating activities are substantial and are currently not being met satisfactorily. Given this sector's contribution to overall economic growth and employment generation, it is important that credit be made available.

This paper argues that a properly designed rural finance system in Pakistan must have the following objectives: 2 It has been argued that when market imperfections exist, lenders face the problem of managing the risk of loan default (J.D. Von Pischke, Finance at the Frontier Debt Canacity and the Role of Credit in the Private Economy. The World Bank, 1992). Some view credit as a process of intermediation rather than as a production input and argue for improving this process through the market mechanism (Dale Adams, D. Graham and J.D. Von Pischke, Undermining Rural Devedopment with Cheap Credit. Westview, 1984). However, neither financial intermediation nor higher interest rates will resolve the problems of asymmetric information and imperfect enforcemen **t** hat prevail in developing countries (Karla Hoff and J. Stiglitz, "Introduction: Imperfect Information and Rural Credit Market - Puzzles and Policy Perspectives". The World Bank Economic Review: 4(3) 1990.