metadata: authors: 0: author: Yaron,Jacob
docna: 0: docna: Rural finance in developing countries
docty: Policy Research Working Paper
subtopic: Rural Settlements,Agricultural Economics,Rural Finance,Food Security,Agricultural Growth and Rural Development,Financial Sector Policy
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The establishment of formal agricultural
            credit systems in most developing countries in recent
            decades has been motivated by the belief that widespread
            shortages of short- and long-term finance have arrested
            agricultural growth and development.  The lack of affordable
            formal credit has been blamed for delaying, if not
            preventing, the timely adoption of new production technology
            and intensive nonlabor inputs.  Commercial lending
            institutions generally focus on large-scale farmers and
            ignore small-scale farmers because of the significant cost
            of processing and servicing unsecured small loans and the
            prevalent belief that small entrepreneurs represent a
            greater risk than large ones.  The shortage of strong formal
            credit markets has caused informal credit institutions to
            flourish in many developing countries.  These informal
            institutions disburse funds rapidly, and the transaction
            costs for borrowers are low.  Many specialized agricultural
            credit institutions have suffered from design deficiencies.
            They often were not expected to function as true financial
            intermediaries that mobilize deposits to make loans.
            Arrangements such as lending groups and credit cooperatives
            could reduce both transaction costs and the risks involved
            in lending to small farmers.  For a rural financial
            institution to become viable, state or donor support should
            focus on institution-building and development.
repnme: repnme: Rural finance in developing countries
display_title: Rural finance in developing countries
listing_relative_url: /research/1992/03/699741/rural-finance-developing-countries
topicv3: Agriculture and Food Security m1326205 435,Rural Finance m1326285 191,Agricultural Credit m1327605 1962,Financial Sector Development m1327681 1920,Rural Development m1504505 2667
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Rural Development Department (RDV)
no_of_pages: 30
author_keys: 0: author_key: 90419
model_extractions: **Policy Research**

## **Agricultural Policies**

# WPS 875

- This paper a product of the Agricultural Policies Division, Agriculture and Rural Development - Department is part of a larger eftbrt in the department to define appropriate modes of Bank ac0ivities in the areaof rural finance. Copies of the paperare available free from the World Bank, 1818 H Street NW, Washington, DC 20433. PIlease contact Cicely Spooner, room N8-037, extension 30464, or through electronic mail (March 1992, 25 pages).

The establishment of fonnal agricultural credit systems in most developing countries in recent decades has been motivated by the belief that widespread shortages of short- and long-terrn finance have arrested agricultural growth and development. The lack of affordable formal credit has been blamed for delaying, if not preventing, the timely adoption of new production technology and intensive nonlabor inputs.

Commercial lending institutions generally focus on large-scale farmers and ignore smallscale farners because of the significant cost of processing and servicing unsecured small loans and the prevalent belief that small entrepreneurs represent a greater risk than large ones. The shortage of strong formal credit markets has caused informal credit institutions to flourish in many developing countries. These infonnal institutions disburse funds rapidly, and the transaction costs for borrowers are low.

Many specialized agricultural credit institutions have suffered from design deficiencies. They often were not expected to function as true financial intenmediaries that mobilize deposits to make loans. Instead, they have merely channeled government-supplied funds to rural borrowers. Making external funds continuously available at below-market interest rates has not obliged rural financial institutions to operate under constraints of financial viability. That -ogether with the lack of competition and limited accountabilityhas led to bad loans, inefficient operations, patronage, and irregularities.

Arrangements such as lending groups and credit cooperatives could rcducc both transaction costs and the risks involved in lending to small farners. Successful group lending programs have shown the importance of such factors as homogeneous borrowing groups that are jointly liable and themselves assume some of the managerial and supervisory responsibilities. Fact,,s attributed to the success of credit cooperatives include bottom-up institutional development, extensive training at all levels, reliance on mobilized savings and equity contributions rather than extemal funds, prudent expansion of cooperative activities, strict monitoring and auditing, and adequate incentives to staff and clients.

For a rural financial institution to become viable, state or donor support should focus on institution-building and development. Targeted credit without institution-building is almost always a recipe for prolonged dependenec on donor or state funds and bailouts. Attention to institution-building often makes the difference between a rural financial institution that can be self-sustaining after a few years of support during its startup period and one that continues to depend on public support.

ThePolicy RescarchWorking PaperScriesdisseniinatcs the findingsof work undcr way in the Bank. Anobjectivcof thcscries is to get thcsc findings out quickly, cven if prcsentations are Icss than fully polished. The findings, interpretations, and conclusiorns in thesc papers do not necessarily reprc.;cnt ofrficial Bank policy.

Produced by thc Policy Research Dissemination Ccnter
# Rural Finance in Developing Countries

# by Jacob Yaron

# Table of Contents

# Chapter 1: t3ackground

|Chapter 1:t3ackground|1|
|---|---|
|The "second best" argument<br>Performance|I<br>4|
|Chapter 2: Issues Related to Supply-led Credit Approach|5|
|Perceivea shortage of credit<br>|5<br>|
|Fungibility of money|7|
|Chapter 3: Issues Related to Credit Delivery System|8|
|Lack of savings mobilization and misguided performance criteria<br>|8<br>|
|High lending and borrowing costs<br>|10<br>|
|Theeffect of controls on interest rates<br>|11<br>|
|Loan collection performance<br>|12<br>|
|Successful credit programs|14|
|Chapter 4: The Impact of the Bank's Recent Policy Paper on Financial<br>Sector Operations on Future Agricultural Credit Lending|17|
|Chapter 5: Implications for Future Agricultural Credit Lending|19|
|Preferred Mode of Assistance to the RFI<br>|23<br>|
|Institution Building|24|
# RURAL FINANCE IN DEVELOPING COUNTRIES

# Chapter 1: Backoround

1. The establishment of formal agricultural credit systems In most developIng countries over the recent decades was motivated by the belief that widespread shortages o short and long terms finance constituted a constralnt which arrested agricultural growth and development. The absonce of what was perceived as affordable formal credit was also blamed for delaying, If not preventing, a tknely adoptlon of now productlon tochnologls and the disseminatlo' of non-labor Intensive Inputs such as fertilizer, thereby slowing down the growth and development of the agricultural sector. The "Infant Industry" argument was frequently raised to support Interventlon In financial markets In favor of the sector as a whole or In support of specific seagmnts of It (small-scale farmers, promotion of new technologies such as line of credit to finance shallow tubowells, etc.).

2. The "second best" argument. The emergence and proliferation of distorted sconomic policies affecting the agriculture and rural sectors providad pro-interventlonists wlth additlonal arguments favoring Interventions by states In financlal markets so as to compensate the agricultural sector for the distorted, urban-biased macro-policles (over-valued rate of exchange, price control on agricultural products, and overprotection of domestic Industrial Inputs which were used as agricultural Inputs). Many donors Initiated and supported channeling
2 concessional credit to agricultural credit programs,<sup>based on the "second best" argument, i.e.</sup> mitigating the Impact of "urban -biased" pollcies.<sup>Governments In developing countrias have</sup> Intervened heavlly In rural financlal markets, alming<sup>at supplying affordable credit to small-scale</sup> farmers and rural entrepreneurs, who were percelved<sup>as a clientele with no alternative access to</sup> formal credit markets. A perceived Imperfectlon<sup>In rural financlal markets that generated a</sup> discrepancy between social and private costs and<sup>benefits has provided a Justification for</sup> Intervention In rural credit markets. As private returns<sup>were estimated to be below the social</sup> ones, the Intervention was Intended to overcome tiils<sup>failure and to spur Investments that would</sup> not have materialized otherwise.

3. The perceived imperfectlons In rural credit markets stem<sup>from the characterlstics of</sup> agricultural production systems. Agricultural Income<sup>Is Influenced markedly by climatic conditlons,</sup> which expose the rural population to h!gher risks than those<sup>provailing In other sectors. In</sup> addition, crops may often be subject to drastic price<sup>changes, causing further variability In</sup> farmers' Income and the relat, r'.payment capacity. These risks are typically hlghly<sup>correlated</sup> across wide segmients of the i. ming community. Lending<sup>In rural areas often Implies servicing a</sup> geographically dispersed clientele, which entails<sup>hlgh transaction costs. In many developing</sup> countrlos, the weak legal system and the Ineffective<sup>reinforcement arrangements have</sup> contributed to the reluctance of commerclal banks<sup>to engage In lending to the rural population.</sup> Related to this Issue Is the frequent lack of secure<sup>land tenure, leading to the absence of</sup> collateral or reduced foreclosure capability.
3 4. When commercia **l** ending institutions have been active In rural areas, they, In most Instances, have focused on large-scale farmers while small-scale farmers have been Ignored, due to the significant lending cost Ir. processing and servicing unsecured small loans. The prevalent, though often unjustifled, belief that small entreprenevlrs constitute a hlgher risk than large ones has encouraged caterlng to large borrowers. In the absence oY strong formal credit markets, Informal credit markets have flourlshed In many develoDing countrle-s. These Informal markets are characterized by low transaction costs for the borrower and rapid disbursement of funds. These features can be attributed to close familiarity with the borrower's creditworthiness that, combined with efficlent loan collection mechanisms, made the Informal credit market, often either the exc asive or the preferred source of credit In rural areas In spite of high Interest charges. Most of the Informal lenders, however, were limited In the term diversification of the loan portfolio, and operated within limited geographical areas.

> h. The Intervention was vlewed as justified also on equity grounds - moneylenders' short term, high cost financkltg was considered an Impediment to growth and equity objectives. The social cost of Intervening In financial markets was perceived to be minor. Three basic forms of Intervention In the rural credit market have prevailed: (I) the administrative allocatlon of 'Ands to agricultural activitlis and rural areas, (11) an Imposed Interest rate ceiling, and (111) the estabilshment of and regular support for speclalized agricultural credit institutlons (SACI) so as to cover their regular deficits. These Interventlons attempted to Influence the amount lent In rural areas and the price of loanable funds as well as to control the Institutlonal development and mode of operatlons of the SACIs Involved.
4 C. Performance. By and large, past performance of the state- and donor-supported agricultural credit operations has been below expectatlons. Most of the programs reached only a minority o? the faming population, while benefits were frequently concentrated among wealthIer farmers. Many of the irstitutlons established or supported for dolivering credit programs have not developed Into self-sustalning credit faciltles. Furthermore, In many Instances, the subsidy dependence of these institutlons has become significant and has been rilsing. This, In turn, made credit programs an extremely costly affair for their sponsorlng governments. For example, the agricultural credit systems of the World Bank's three most knportant agricultural credit borrowers In the eighties, Brazil, Mexico, and India, have all suffered from severe equlty erosion. In Brazil and Mexico, highly negative Interest rates In an Inflationary environment generated the erosion, whilo In India the equity erosion resulted from dlsnal loan collectlon.<sup>1</sup> In the agracultura! credit systems of Brazil, Mexico, and India, administrative interventions retarded the development of efficient financial markets and had negative knplicatlons for other sectors In the economy by depriving them of loanable funds and Increasing thelr borrowing costs.

7. As an OED study of agricultural credit projects In 24 countries points out, these projects have often failed to become vehicles to upgrade farm technology.<sup>2</sup> The programs reached a minority of the farming population and benefits were frequently concentrated among wealthier farmers. For example, a study In Ccsta Rlca has shown that Income distrlbutlon could be J. **Yaron** and P. **_iegel,_** Sank *Lnding for Agricull Credlt FYM2M88 Agrulfture and Ruwa Developmt Departrert, Decembe 1968. 2 Documnt JAC 8845 of th Jont Audit Caommitt"e. **Aproach Far:** A Review of Bank Lendhg for Agricultural Credit (1961-1987) dated October S. 196P - 3. pam 6. The edy oovered Oh period beor 1976.
6 significantly Improved If credit subsld;es wore ollminated.<sup>3</sup> Many of the institutions established or supported for dol earing credit programs did not develop Into self-sustalned credit facliitles 4 8. The disappoInting performance of the credit supply-led approach can be attributed to two sets of Issues: (1) some of the underlying premises of this approach were frequently not valid, and (11) the Institutlons and arrangements established or utilized for kmplementing the policy were often dosigned and operated In an Inviable manner, or within a policy and social environment hindering thelr effectiveness.

Chapter 2: Issues Related to Supply-led Credit Approach 9. Perceived zhortage of credit In many Instances, It Is not clear that rural areas are slgnificantly constralned by a shortage of funds. Furthermore, In areas where effective Interest rates are kept low through subsidles or celilngs, demand tends to exceed supply and an artificlal sense of shortage of credit prevalils. Recent surveys In China and Thalland Indicated that both among borrowing and non-borrowing farmers (mostly smaliholders), only a minority had an unsatisfled dermaand for formal liquidity.6 Most farmers have access to the more flexible services provided by Informal lenders. It Is commonly claimed that Informal lenders charge very high Interest rates due to their monopoly position, and are therefore not socially desirable. This view 3~~~~~~~~~~~~~~~~~~~~~~~~~~~

> 3 R. Vog 'The Effct of Subsidizd Agrcutr Credit on ncome Diibution in Costs Rica', In Adans et al. Underminina Rural DevCoomwd _wHh_ Ch.aa Credit, Welw Prm, 1984.

4 Document JAC 88-35 of toe Joint Audit CommMit, October 5, 1988.

5 Feder at al. 'Agricultural Credit and Farm Peformance In Chins', J. of Comaarative Economics, December 1989 and unpubsd data from Woird Bank sty RPO 8733 'Land Title Security and Farm Producivity tn Thaiand'.
# B

Is not necessarily warranted. For example, studles In India, Malayela, and the PhIlippines show that there Is a significant lev'il of competition In Informal markets and relatively llttle monopoly. In the PhilIppInes, monopoly profits amounted to loss than 4 percent of the total sum lont.<sup>6</sup> In many Instances, the hlgh rates of Interest charged by Informal lnders reflect primarily the hlgh costs and risks Involved In lending to small farmers, although cases of exploitation exist.

10. The general validity of the promiso that credit shortages Inhib5t adoption of new technology Is questionable because many Inputs and tochnologles are divisiblo and can be adopted In a gradual manner, so little capital Is needed Initlally. Poor marketing networks, Input supplies and distorted product prices are often more crucial constralnts on technology adoption than lack of credit. Unless the new technology reQuires substantlal up-front outlays, wlth returns spread over tknu, It Is not obvious that credit Is the best mechanism to encourage adoptlon of now technoblos. Studles indicate that even small farmers have a signlficant savings potential, and are capable of mobilizing resources when profitable opportunitles for Investment exist.<sup>7</sup> This potential justifles institutlon building to facilitate Intermediatlon, but not necessarily Infusion of external funds. Rather, a large Inflow of external funds, especially when made avallable at subsidized rates, suppresses both savings and the growth of viable commercial 6 lHarrf, 'Monmy and Commodie: Their InteractioI **n** a Rural Indian Setng', In von Plschk **e** t al., Rural Financial Market In DevOlno Countre. Johns Hopkins Uniesit Pre", 1963.

K Slnh, *Strc ot Intr Ras on Consumpdon Loans In an Indian Vllage' In von Plshke et al., cited above, 1983. R.J.G. Web, _-An_ Input Credit Progrm for Small Famer In Wet Mla^y' In von Piechke et at. dt above, 1983. Technical Board of Agricultural Credit 'A Study on te Informal Rural FInnci Markts', Manila, 1981.

7See for example, 'Review of Rural Fian Seices in Sub-aharan Africa', Agriculture Division of Africa Technical Cepartment, 1889 or A. Wgue, Mobiliation of rura savings in developing countris: the case of Mai', Ph.D. Dissertaton, Univery of Cincimati. 1988; or C. _Cuvas._ 'Saving and Loan Cooperative InRural Areas of Developing Counties, Roent Peifomance and Potential', in &avinas and Deoent No. 1.188.
7 Inst!tutions. The perceived failure of credit markets to urovide funding for worthy agricultural activitles can often be traced to Inadequate public Investment In legal and phy8lcal lrarastructure, enforcement mechanisms, and commodity risk mitlgating arrangemente which would make lending to agriculture a more profitable undertaking.

11. Fungibility of money The effectiveness of attempts to address 'he Inadequacy of market-Induced Institutional credit to agriculture through governme-At Intervention Is often hindered by the fungiblilty of money. In many Instances, unless costly supervislon Is undertaken, borrowers can use funds for purposes preferable to them, regardless of the cbJectlves promoted by policy makers. Furthermore, It Is Impossible to ensure that borrowed funds are used to finance more Investment than would have taken place otherwise, with funding from other sources. Additional loan funds may thus generate otGy a partial iri:rc ie In Investment, especlally If the profitabillIty of agriculture Is low and farmers have other, more attractive Investment or consumption opportunities. Two OED studies on the offect of agricultural credit found tlhat substitutlon of funds was a major factor responsible for the limited success of credit In enhancing productivity.<sup>8</sup> For example, of the funds provided through Bank-supcorted credit projects In Mexico, Pakistan, and the Phillppines, only 25-50 percent were estimated to have added to agricultural Investment. The common argument that subsidized credit should compensate farmers for other policlis which penalize agriculture (e.g., price controls, overvalued exchange rates and commodity export taxes) Is frequently not valid, because the subsidy does 8 OED, 'Kenya, Impact Evaluafon Report First SmalJholder Agriculural Credit ProJect", Report No. 2968, May 5, 1980; OED, *Agrkulural Credit _Progmams,_ Report No. 1357,1976 (A otudy of 24 **cowntries).**
not change the profitability of the agricultural activities adversely affected and Invariably accrues largely as a windfall to the loss needy beneflcarles. Even If divei'sion of funds Is effe&tively controlled, the reciplents of the funds are, In most Instances, only a small proportion of the farming populatlon, and thu2 the distortion In resource allocation Is not slgnlifcantly rectifled.

Chapter 3: Issues Related t'i Crodlt Delivery System 12. Lack of savincs mobilizatlon and miisguided performance criteria. Many specialized agricultural credit institutions have suffered from deficiancies Inherent In their design. They frequently were not expected to function as true financial intermedlarles which mobiilzo deposits to make loans. Instead, these Institutions have merely channeled government supplied funds to rural borrowers. The continuous avallability of external funds at below-market Interest rates has not obilged rural financial Institutions to operate under financlal viability constralnts. Together with the lack of competitlon and limited accountability, this has led to bad loans, extremely Inefficient operations, patronage and Irreguluritles. A report prepared for the World Bank by local experts In India states that "During the election years there Is considerable propaganda from polltlcal platforms for postponement of Ioan recovery or prossure on the credit Institutions to grant extest jns to avold or delay the onforcement process of recovery. The willful defaulters are In general socially and politically Inportant people whose example others are likely to follow." It Is therefore not surprlsing that arrears of about 50 percent have plagued
this system. F thermore, the above cited report observes that "the<sup>general climate in rural</sup> areas Is becoming Increasingly hostile to rocoverles." 13. Because their operations were not driven by commercial financial<sup>performance criterla,</sup> lending institutions have lacked the inceintives to make strong<sup>collection efforts.</sup> Rather, the performance Incentives of specialized agricultural credit Institutions<sup>have often been based on</sup> quick loan approval and disbursement and rapid growth In<sup>the lending volume, facilitated by</sup> rapidly expanding ext(o al funding from donors. Doeticlent fInancial<sup>reporting practices have made</sup> It difficult to determine when and which payments are overdue. Typically, data<sup>presented on</sup> arrears (when they are available at all) only allow for a partlal analysis<sup>of the loan portfolio.</sup> This underestimates the severity of the arrears problem when the portfollo<sup>grows rapidly In</sup> nominal terms (high Inflationary economies) and the loan portfolio consists<sup>of substantlal long-</sup> term loans or grace periods are granted. Among important Bank<sup>cllents, Bra1ll, Mexico, and</sup> Yugoslavia all used stock measures of loan arrears, despite<sup>the fact that they were all plagued</sup> by hlgh InflaIon. This resulted In a misleading picture of the quallty<sup>of the loan portfolio. 9</sup> Proper provisions for bad debts were not made and an adequate<sup>assessment of the institutlon's</sup> viability was often impossible. Thl deficiency has been widespread,<sup>as reflected by the fact that</sup> only one-third of 24 Bank appraisal reports for agricultural<sup>credit projects which were reviewed</sup> by AGR for the period 1982-88 reported on annual collection<sup>ratlos and six provided no</sup> nformation on arrears.

9 _j._ Yaron and P. SIO, Sank Landing f6r AgrCultura Credit FYS2-88, Agricultu and Rural ODelopnDepamet Deoembr 1988.
10 14. As a result, financlal data often present rosy scenarios wnieo In absence of adequate provisions for loan losses, the SACIs' financial statements are likely to mislead the analyst. The overall cost of maintalning the SACI afloat Is almost never presented. Many of the subsidies Involved In SACIs' operations, such as concessional financial resources that were made available by the Central Bank, or state repayment of forolgn exchange losses on strong currency denominated loans, are not adequately captured In the SACIs' fInancial statements when the Issue Is the overall financial cost of malntaining the SACI afloat. Deficlent fInancial reporting has contrlbuted to lack of clarity on the SACls cost side. In many Instances, the subsidles that benefitted the SACis were not transparent, not funded from the budget, so as to allow a public debate on their costs, benefits and social desirability.

15. Specialized Agricultural Credit Institutions which depend almost exclusively on external funds have to follow goverrdnent directives when allocating thelr funds. As these directives frequently Include administrative allocation of funds to certain target groups And exclusive lending for agriculture, the financial Intermediarles have limited ability to diverslfy their loan portfolio, to use creditworthinoss criteria, and to Implement adequate risk management policy.

18. High lending and borrowing costs. In their attempt to ensur ellgibillty and avold diverslon of funds, specialized formal Institutions Incur high costs and also kmpose high transactlon costs on borrowers. Typically, farmers are obliged to spend slgnificant amounts of both money and tkne to obtain loans *ron specialized Institutions. In fact, small borrowers' transactlon costs are often so hlgh tnat the effective cost of a loan (including transaction costs and Interest
11 payments) obtained In the formal market exceeds<sup>that of a loan from the Informral market. A</sup> study in Bangladesh, for example, has shown<sup>that the average effective cost of a loan smaller</sup> than 1000 Takas varied between 146 percent and<sup>169 percent In the formal market, while It</sup> varled from 57 percent to 86 percent In the Infomal<sup>market.10Only for loans above this</sup> amount were effective loan costs cheaper for<sup>credit from formal markets. Another study In</sup> Bolivla showed that transaction costs which borrowers<sup>had to Incur before they even knew</sup> whether their loan would ever be approved amounted<sup>to over 18 percent of the amount applied</sup> for.<sup>11</sup> The same costs amounted to slightly over<sup>8 percent In the Informal market. A cross-</sup> sectlonal study found that transaction costs as<sup>a percentage of officlal Interest rates could be</sup> as high as 245 percent (Bangladesh) II r small loans,<sup>while It was between 3 percent and 56</sup> percent for large loans.<sup>12</sup> The hlgh borrower transactlon<sup>costs for small loans obtalned from</sup> official lenders explain why small farmers who<sup>require modest loans may avold using the formal</sup> market.

17. The effect of controls on Interest rates.<sup>Officlal ceilings on onlnding Interest rates</sup> have frequently forced lending at rates which<sup>do not cover transactlon and risk costs. For</sup> example, the typical spreads of 3 to 6 percent<sup>do not provlde for full cost recovery when</sup> lenders' administrative costs for small or medlum<sup>sized loans can reach up to 20 percent of the</sup> sum lent. Even specialized rural financlal<sup>Institutions with a good loan portfolio and excellent</sup>

> 10 **Z** Ahmed, **'Efhfeove** coot of rural loan In Bangladsh', World Development, 17.3, 1989. 1 **J.** Ladman, 'Loan **Transactions** Costs, Credi Ratoning and Market Structure: The Case<sup>of Bc'ivia', in 0. Adams et al.</sup> Underminina Rural Development wth Cheap Credit, Westview Press, 1984. 12 C. Cuevas, 'Transaction Costs of Borrowing and Credit Rationing in Developing Countries, ESOP No. 1470, The Ohio State UniversIty, 1988.
LI ' CollectIOD rates cannot cover thelr oporating expenses wlth suchi a _low_ spread, as shown by the example of the Malawi Development Flnance company, which collects over 97 percent of loans made, but can only cover 17 to 20 percent of operating costs.<sup>1 3</sup> Further, It has often not been taken fully Into account that high rediscount margins (whereby the central bank refinances most of the volume of subloans) allow financial Intermediaries to overcome their liquldity problem while being left with the full credit risk. In the face of restricted onlending Interest rates, financlal Intermedlaries resorted to credit ratloning. Hence, fewer but larger loans were made to save on administrative costs and minimize rlsk. This caused concentration of benefits among larger farmers In spite of the programs' equity objective.<sup>14</sup> Administratively fixed or Improperly Indexed Interest rates caused massive eroslon of rural financial Institutlons' equity In several highly Inflationary economles, which In some cases was temporarily masked by the Inflow of external funds. In Mexico, for example, loans were deficiently Indexed, so thelr nominal value Increased by only silghtly more than half the enormous Inflatlon rate between 1980-87. In Brazil, Improper Indexatlon resulted In a subsidy of US $5 billion within a six-month period In 1986.15 18. Loan collectlon performance. Borrowers' Incentives to repay loans are llmited If it is known that no serious efforts will be made to collect the dues and that default will not affect access to future loans. Government leniency on delinquencies has frequently encouraged new defaults. These factors, when combined with officlal lenders' Inadequate Incentives to collect 13 Revlew of Rural Finances Services In Sub-Saharan Africa', Agriculture Division of AfIdca Technical Department, 1989.

> 14 A. Braverman and J,L. Guasch, 'Rural Credit Reforms In LDCs: Issues and Evidence-, in Joumal of Economic Development, June 1989, and PPR Working Paper 219.

15 OED, Audit Report on Agricutural Credit and Export Development Project Report 7922, June 1989.
loarn repayiments, leci to low recovery ra{-l..i In mtlany ( Icial c >. u ;A ii -,u, [, i ates have usually varied between 50 and 6 percent, but sometimes have even fallen below 20 percent. In Bolivla, for example, delinquencles were around 47 percent In the 1970s. Over 50 percent of the loans made through the cooperative system in Thailand were In arrears In the 1980s. Delinquency rates of 50 percent were observed In Indla, 40 percent In Malaysia and Nepal, and about 80 percent In Bangladesh.1 6 19. Because of ineffIcient operations and low collection rates of many government supported lending Institutlons, officlal agricultural credit programs have often been extremely costly to governments and remained without adequate developmental Impact. For example, the official rural financial system of Mexico has cost the government over an extended Inflationary perlod more than one dollar for each dollar lent. It Is not a coincidence that the rural credit systems of the World Bank's three most importani agricultural credit borrowers, Brazil, Mexico, and India, have all experlenced severe problems and placed enormous burdens both directly on governmernt budgets and less directly on the external debt position. The government of Brazil has at times allocated about one-fourth of Its total agricultural expenditure to maintain the agricultural credit system. A major lesson cited by an OED report of a credit project In Brazil Is "the Inappropriateness of subsidized credit as a tool for agrlcultural development."17 A Bank-sponsored study of credit

> 16 Aslan Productivity Organization, Farm Credit Situathon in Asia, 1984, p. 47, and Asian Productivity Orgarizab'on, Farm Finance and Agricultural Development, 1988, p. 250.

> 17 OED Audit Report on Agricultwral Credit and Export Development Project, Report 7992, June 1989.
14 Inpact Indlcates that the main effect was a substitutlon of purchased Inputs and machinery for labor, with a very modest change In output.<sup>1 8</sup> 20. Successful credit programs. Notable exceptions are the agricultural credit systems In South Korea and Taiwan, where collection exceeds 90 percent. These systems' high recovery rates have frequently been ascribed to strong village cooperative systems and social cohesiveness which have provided repayment Incentives and enforcement mechanisms. Together with a small number of successful projects In other parts of the world, these systems have shown that although agriculture Is subjected to hlgher rlsks than other sectors, satisfactory repayment rates can be achleved If the rlght Incentive and enforcement structure exists.

2. Arrangements such as lending groups or credit cooperatives have the potentlal to reduce both the transaction costs of lending to small farmers and the risks Involved. Successful group lending programs have shown the Importance of factors such as homogeneous borrowing groups which are jointly liable and assums themselves some of the managarlal and supervisory responsibilitles, a common bond other than credit, and denying access to future credit to the whole group In case of default by any member. important factors for success of credit cooperatives Include bottom-up Institutional development, extensive tralning at all levels, reliance on savings mobilization and equity contribution rather than external funds, slow expansion of cooperative activities and strict monitoring and auditing. The limited success observed vIth such 18 H. Bnswanger et al., Thw Impact of Infrastructure and Financial InstituUons on Agricultural Output and Investment inIndia', PPR Working Paper no. 163, March 1989.
16 arrangements to date Is mostly due to shortcomings In their hmplementation and general deficiencies such as low Interest rates rather than factors Inherent In their desIgn.19 22. In recent years, other models of successful rural finance Institutions have emerged. Their success may assist us In better understanding the pollcies, mode of operatlons, and Incentives that generated significant outreach and financial viability. The Indoneslan general rural credit program was Introduced In early 1984 by Bank Rakyat Indonesia - Unit Desa (BUD) as a suppiyled institution. Over a relatively short perlod of time, from 1984 to 1989, It has become extremely successful In mobilizing and servicing deposits and savings and emerged as a wellbalanced financial institution. BUD has provided depositing and saving services to a large number of cilents and Its saving volume currently signilicantly exceeds Its outstanding loan portfolo. Effective policies and management practices stand behind BUD's success. The major polclies have been (I) applying high market on-lending Interest rates that cover the overall cost of operations, (ii) paying hlgh positive Interest rates on savings, (111) applying mobile banking technlques that contributed to maintaWng administrative costs In check, (lv) applying significant Incentives to borrowers for timely repayment In the form of Interest rebates, (v) promoting and paying bonuses to staff based on branch financial performance, (vi) applying simple, clear and efficient methods of loan approval, disbursements, loan repayments and saving mobilization. Clearly, applying these policies In a stable economy, whereln inflation was controlled below 10% P.A., has contributed significantly to the program's success. Over a period of a few years, and despite the high annual growth rate In outstanding lan portfollo, BUD became subsidy Independent, and 19 M. Huppl and G. Feder, The Role of Groups and Credit Cooperaftves In Rural Lending', PPR Working Paper no. 284, Agrtulture and Rural Development Deparfnmntm The World Bank, 1989.
16 bImuitaneously obtained high return on Its equity over the recent years. The role of subsidized financlal resources In the Initial stage of the BUD's operations was nelther cruclal nor necessary. In retrospect, one may argue that BUD actually needed non-subsidized financial resources to resolve a negative cash-flow problem In the first years of operatlons, rather than concessional fInancial resources.21 23. The Bank for Agriculture and Agriculture Cooperatives (BAAC) In Thailand was estabilshed In 1966 as a Government owned bank to provide financlal assistance to agricultural producers. Currently, It provides credit and other financial services to more than half of the rural populatlon. It gradually has made progress towards subsidy independence by using efficlent modes of operations that resulted In very low transactlon costs. Its overall administrative cost, measured against Its total assets. Is about 4 percent due to group londing and the use of mobile banking. It has achieved a hlgh loan recovery In lending to Individual famers and promoted an advanced financial reporting system. Recently, the highost growing source of finance has been voluntary savings, thereby shifting Its initlal characteristic from supply-led liistitutlon to a more universal, well-balanced financial institution, as well as reducing Its already modest subsidy dependence.

24. These two institutions differ In many ways In their mode of operations, yet they both have progressed significantly In the right directlon by (I) applying market oriented onlnding and deposit Interest rates, (ni) emphasizing saving mobilization, (111) providing staff and clients with 20 J. Yaron, *8ucossfA Rurai Fnanc Inution', Word Bank Dicussaon Pger, folhcominlg, 1992.
17 slgnificant Incentive and bonus schemes, (iv) applying efficient mobile banking systems, (v) achleving high ian recovery, and (vi) making use of some sort of social mechanism In officlont, rapld screening and approving of loans. It should be underscored that beside stable economles, economic policies enhancing more 1iberailzed financlal markets In the two countries contributed to the two schemes kinproved performance.

Chapter 4: The knpact of the Bank's Recent Pollcy Paper on Financial Sector Operations on Future Agricultural Credit Lending 25. The Bank's recent policy paper on financial sector operations considers directed credit to be a potentially useful tool for opening credit access to activities or groups whose access was impeded by Inadequate Information or other market Imperfections. Although there were exceptlons, It Is generally recognized that directed credit programs have often been misused with negative consequence for resource allocation, Income distributlon, and macroeconomic management. Therefore, It Is recommended that financlal sector strategias as well as Bank lending operatlons that Involve directed credit be carefully analyzed and well justified to ensure that objectives are adequately focused and achievable and that the programs would not outlive their usefulness. Past experience has led the Bank to look at the matter more cautiously and to require an explicit justlifcation before embarking on directed credit schemes or lending through specialized sector credit institutions. The conditions for ensuring that they would be engines of growth and consistent wlth officlent financial sector development had to be very carefully
18 defined and established. The cholce, however, of whether the Bank supports sectoral Institutions or universal commercial banks should be ultimately determined by the market; there Is nothing Inherently wrong with a speclallzed institutlon If It Is competitive and could survive In a competitive framework. The criteria bolng proposed for evaluating the financial Intermediaries therefore be uniformly applied across all Institutions. This inpiies pursuing pe-Picipatlon from many financial Intermediaries In agricultural credit project Implementation, rath, .nan malntenance of the position of a natlonal agricultural Bank as an exclusive Intermediary.

26. The last two years have witnessed a major re-evaluatlon of the Bank's approach, wlth much tighter standards on financial sector operations, as well as lending through financial intermedlares. This more restrictive approach has already generated a decline In Bank Agricultural credit lending through financlal Intermediaries over the last three years. In sum, the current Bank pollcy does not exclude directed credit programs per se from Bank support. It sImply subjects them to a more restrictive burden of proof test. The extont to which the current, more restrictive requirements differ from past performance Is highiighted by the ellgibillty criteria for financial Intermediaries' participatlon Is project Implementatlon. The Bank's recent draft on Operational Directives cn Fhancial Sector Operations reads: "Participating Fis should, at a minmum, demonstrate a collectlon rate, which, given Its lending margin and applicable tax rate, and taking Into account a reallstic estImate of possible portfolho losses, Inflation, and the opportunity cost of capital, avoids the eroslon of Its capital."<sup>21</sup> 21 Page 20. pam 65(c)
19

# CHAPTER 5: LJPLICATIONS FOR FUTUR AGRICTULRAL CREDrT LENDING

27. Targetting lending for Agricultural Credit<sup>projects may become warranted when It follows</sup> significant changes that have occurred<sup>In the economy and which are expected to have substantlal</sup> Impact on the rural sector. The recent<sup>Bank Policy paper on financlal sector operations reads:22</sup> "in many developing countries, poor informatlon,<sup>unfamillarity with modern financial</sup> Instruments and Institutions, lack of lender<sup>experlence and expertise In evaluating certaln</sup> activitles or new technologies, absence of<sup>confidence between borrowers and lenders,</sup> uncertalntles regarding the permanence of<sup>economic reforms, or simply traditlon may limit</sup> market response to the opportunitles opened<sup>and demands made by financial sector reform</sup> and broader economic adjustment. Properly<sup>designed and complemented by necessary pollcy</sup> reforms, targeted credit can act as a catelyst<sup>to overcomo such obstacles, opening market</sup> access to previously excluded groups and<sup>sectors, such as microenterprises and small</sup> farmers, thereby promoting the development of<sup>credit markets."</sup> It has to be, however, substantiated that full<sup>reliance on market forces Is not preferable, and that,</sup> In the absence of the proposed Intervention<sup>In the financlal market, the supply response or the</sup> adoptlon of now technologies vWouId be unacceptably slow. In the circumstances<sup>outilned above,</sup> agricultural credit projects serving as a<sup>catalyst In growth should be accompanied by the removal</sup> of distorted policies that inhlbit demand<sup>for agriculture Investments,</sup> Introducing a specific targetted line of credit aimed at speeding<sup>up supply response can be a complementary measure to</sup> the removal of price controls on agricultural<sup>products which hindered market-Induced lending to the</sup> rural sector. Slmilarly, directed credit<sup>can be useful when the banking system Is considered to be</sup> responding too slowly to other significant<sup>reforms such as changes In the terms of trade of the</sup> agricultural sector due to trade llberalizatlon,<sup>a sharp correctlon of an overstated rate of exchange</sup> World Bnk Polce Guidb Finania Seco Ope0ton,<sup>**Apri 1991,**page9,paagrah 10.</sup>
20 or removal of other "urban bias" policios. Under such circumstances, Inadequate Information on the creditworthiness of potentlal borrowers, lack of confidence in the sustalnability of the changes Introduced, and excessive rlsk aversion by lenders and borrowers can be mitigated by a directed line of credit.

28. There may be a Justificatlon for an agricultural credit line aimed at speeding up growth when refoms are Introduced to remove bottlenecks resulting from Inadequate land tenure system and deficlent contract enforcement arrangements. Likowls, the Introduction of now and unfamillar technologles characterizod by capital Intensity, may benefit from a directed credit at the initil stage. It must be established however, that an a priori Justificatlon for Intervention In the credit market, rather than alternative ones exists. Possible direct and Indirect negative impilcations of the Interventlons ought to be fully considered. The evaluation of the proposed Interventions should verify that other problem* afflicting agricuWture are not assessed to signifIcantly diminish the desired effect of the Interventlon In the credit market. When subsidy Is granted, the overall subsidy cost In operatnig a program of rural finance should be made transparent to ensure adequate assessment of the desirability of the Intervention In the financlal market as well as the use of quantified milestones In progress to be made towards subsidy Lndependence. The methodology of computing the Subsldy Dependence Index (SDI)23 of a rural finance institutlon Is Instrumental In (I) placing the total amount of subsudles recolved by an institution In the context of Its activity level--the Interest eamed on Its loan portfollo (similar to calculations such as offective protectlon or job J. Yamn, Subidzd Deveopme Fina k*hIr_: Is ounent s asament of hIr financW perbfrme adequa?' AGR Draft pae, Dem,ber, 1991.
21 creatlon cost) and (ii) tracking progress made by an Institution In reducing Its subsidy dependence overtime.

29. When such an Interventlon In the fInancial market Is considered warranted, It Is essentlal to ensure that the "Infant Industry" Is supported on a transitory bails. This would avoid unwarranted prolonging of the Intervention given that market forces are assumed to catch-up and resolve the transitory Issue of Inadequate allocatlon of funds to priority sectors/activities. The "Infant Industry" approach, by definition, conveys the message that an Intervention should eventually be phased out.

30. Given the poor state of affairs In the agricultural credit systems of many cilent countrlos, many rural credit operatlons will need to be conditloned on, and some may Include as a component, a significant financial sector reform.<sup>24</sup> The reform may be speciflc to agricultural credit, or deal more generally with the financlal system, depending on the nature of problems faced. The aim of the reform would be to ellminate obstacles to the officlent functloning of the rural credit market In the broadest sense under compotitive conditions such as removal of monopoly positlons In access to government rediscount facilitles, olimination or tighter targeting of subsidies, and deregulatlon of Interest rates.

2 4 This appills to credt programs in all rgiom, m fr exampl, 'Review of FNances Services in Sub-Saharan Africa', Agricultr Dihbn of Afrkc Tecnnial Deparment 1969; and 'Latn Ameia- New Ditons for Agrkultural Credit Projects and Ruwal Fiaci PolIcis, Trade, Finance ad Industry Division, Latin Anerica Techncl Depa0nwit 1989.
22 31. The potentVal vlability of existing speclalized agricultural credit Institutlons In a reformed competitive onvironment should be a conditlon of thelr participation In Bank sponsored rural credit operations, In many Instances, a signlficant Institutlon building component may be warranted, Involving an overhaul of the Institutlon's structure and mode of operatlons focus on enhanced efficiency akmed at reducing transactlon costs and knproving loan collections. Reliance on savings mobilizatlon, Instead on rediscounting facilities and applying adequate accounting, auditing procedures, and managerial Informatlon systems at e ssentlal for achieving viabillty. Approprlate staff tralning and staff and borrowers Incentives, emphasis on strict loan collectlon and Its proper measurement are key Ingredients of viable Institutions. The managerial Informatlon system should make transparent the social cost of state support to the crodit Institution, to allow public debate on Its desirability, is well as tracing changes In the subsidy dependence over time.

32. The impressive experience of the rural credit system of Bank Rakyat Indonesia - Unit Desa (BUD)25 sugoests that, In contrast to the frequent failures of rural credit systems, a well designed rural finance program can be successful and profitable. In a relatively short period the BUD program became subsidy Independent and achloved high return on Its equity. It Increased Its assets annually by more than real 30X over the perlod 1986-89, and applied positive lending and depositing Interest rates. BUD succeoded to rely on saving mobilizatlon as Its main growth factor, reaching saving amounts that significantly exceeded Its loan portfollo by the end of 1990. This suggests that there was a tremendous demand for saving services In the rural areas which allowed BUD to become, after a very short period, Independent from donor funds. Loans were granted to all Income-gonerating 25 J, Yaron, Succesful Rual Finance insions' The World Bank, Diussion Paper, fortfcoming 1992.
23 activitles and were not limited to agriculture, thereby achieving a more balanced lender risk distributlon.

33. Where smaliholdere' access to credit Is a valId concern within a Bank credit operation,<sup>proJect</sup> design should make as much use as possible of self-help groups and other grassroots voluntary organizations which allow the reductlon of transactlon costs and lenjing risks. However, given<sup>the</sup> lessons learned about the prerequisites for successful outcomes with such arrangements, attention must be paid to the likely effectiveness of existing organizatlons. Cautlon must also be exercised so as not to make the existence of local organizations overly dependent on external funds, lest<sup>this</sup> change thelr character and cause thelr demise. This, however, implies a limited ability of such organizatlons to absorb largo volumes of external funds.

34. Preferred Mode of Assistance to the RFI. State or donor financial support, In the form of making financlal resources avallab!e (not necessarily at a subsidized Interest rate), can constitute an Important contributlon to a newly established Rural Finance Program durlng the Initial, negative cashf low stage of the RFi's development. Savings mobilization should not become the minor residual balance - as has often happened wlth supply-led credit institutlons - that constitutes the difference between the loan portfolio and concesslonal borrowed funds. On the contrary, state or donor lending to the RFI should only assist In temporarily closing the gap between an RFi's fully motivated savings mobilizatlon and Its bankable loan portfolio. BUD's successful exporlenco clearly supports this notion. This implies that state or donor support could generally be used for a shorter perlod of tine when compared wlth past practice of cooperatlon between supply-led fInanclal
24 institutional and do,tors. Obviously, the servicing of new clients, opening of now branches, and renderlng services to an Increased share of the rural populatlon, are factors whIch define the length of the period In which the financial support to the RFI may be useful. The Indonesian example Indlcates that making funds available was kIportant to the program's rajoid growth during Its Initial stage of development. However, no subsidy In the form of concessional borrowed funds was necessary for Its growth, as is demonstrated by Its full 1989 subsidy Independence. The Issue that donor support had to resolve during BUD's Initial stage of operations was the avallabillty of funds, not subsidizing their cost.

35. Institution Building. State or donor support to an RFI should concentrate on Institution building and developing to become a viable rural finance institution. Targetted credit witlout adequate component of institution bullding Is almost always a guaranteed recelpe for prolonged future dependence on donor or state funds and b4il-outs. The more notlon that It Is consldered socially desirable to Intervene In the financial market and to use scares resources for achieving specific objectives hkples, In most Instances, a need for Institutional bulding so as to ensure that the financial Institution Involved Is on Its way to becoming mature, autonomous, and officient. Care taken In institutlon building Is often the prlne difference between an RFI that could eventually become seif-sustalning after a few years of support granted during Its start up period and an RFI that would need permanent subsidles and ball-outs. The iack of adequate e. phasis on Institutlon building In RFls Is a common characterltic of supply-bd credit institutions. Too few resources are devoted to guarantoolng adequate tralning, officlent and meaningful managerial information systems,
26 staff Incentive systems, promotlon of saving mobilization and the like, all of which are cruclal to an AFI becoming an Independent, well-balatced, and Increasingly self-sustainable Institution.

.
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|WPS870|Economic Shocks and the Global<br>Environment|F. Desmond McCarthy<br>Ashok Dhareshwar|March 1992|M. Divino<br>33739|
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|WPS871|The Distribution of the Benefits from<br>Social Services in Indonesia, 1978-8|Dominique van de Walle<br>7|March 1992|A. Bhalla<br>37699|
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|WPS873|Measure and Interpretation of<br>Effective Protection in the Presence<br>of High Capital Costs: Evidence from I|Francois M.Ettori<br>ndia|March 1992|F. Ettori<br>32340|
|WPS874|The Trade Restrictiveness Index: An<br>Application to Mexican Agriculture|James E. Anderson<br>Geoffrey Bannister|March 1992|G. llogon<br>33732|
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