metadata: authors: 0: author: Kislev, Yoav
1: author: Lerman, Zvi
2: author: Zusman, Pinhas
count: Israel
docna: 0: docna: Credit cooperatives in Israeli agriculture
docty: Policy Research Working Paper
subtopic: Agricultural Economics,Banks & Banking Reform,Financial Regulation & Supervision,Food Security,Inflation
teratopic: Finance and Financial Sector Development
abstracts: cdata!: In the last two or three decades,
            moshavim and kibbutzim developed entensively, adopted new
            technologies, reacted quickly to changes in market
            conditions, and established a network of farm services owned
            and operated by farmers and their representatives. Financial
            cooperation helped to make this intensive development
            possible and was effective when appropriate conditions
            prevailed. Cooperation in credit also caused overexpansion
            and overinvestment. Debt grew to crisis proportions.  When
            macroeconomic conditions changed and the expansion of credit
            slowed down, the sector found itself trapped in financial
            impossibilities. Now cooperation ties farmers and
            organizations together and intensifies the dimensions of the crisis.
geo_reg_key: 119229,517191
repnme: repnme: Credit cooperatives in Israeli agriculture
display_title: Credit cooperatives in Israeli agriculture
listing_relative_url: /research/1989/03/700543/credit-cooperatives-israeli-agriculture
topicv3: Commercial Banking m1326069 1236,Agriculture and Food Security m1326205 435,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Agricultural Credit m1327605 1962,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy Plan & Prog Review Dept
no_of_pages: 60
model_extractions: <!-- Start of picture text --> Plo,Planning, and Research<br><!-- End of picture text --> <!-- Start of picture text --> Agricultural Policels I<br><!-- End of picture text --> In the last two to three decades, moshavim and kibbutzim developed intensively, adopted new technologies, reacted quickly to changes in market conditions, and established a network of farm services owned and operated by farmers and their representatives.

Financial cooperation helped make this intensive development possible and was effective when appropriate conditions prevailed. But in its strength lay dangers.

- Cooperation in credit together witih a government policy of easy money and broad - public support also caused overexpansion and overinvestment. Warnings from within the government about overcapacity were overruled by political decisionmakers eager to show progress, however shortsighted. Debt grew to crisis proportions.

When macroeconomic conditions changed and the expansion of credit slowed down, the sector found itself trapped in financial impossiFilities. Now cooperation ties farmers and organizations together and intensifies the dimensions of the crisis.

The authors recommend: ^ Minimizing the extension of agricultural - credit under preferential terms and reducing subsidies.

* Continued (but limited) government commitment to aid farmers in financial distress caused by environmental fluctuations or temporarily depressed markets but not by other factors.

* Government participation in the creation of institutional structures (e.g., the revival of concentrated credit) to control overborrowing by farmers and farmer associations.

* Changes in cooperative laws and regulations that improve control over the cooperatives' financial integrity and strengthen the credit cooperatives' governance structure.

This paper is a product of the Agricultural Policies Division, Agriculture and Rural Development Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Cicely Spooner, room J2-074, extension 37570.

The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy. Planning, and Research Complex. An objective of the series is to get these rmdings out c.uickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Center
# Credit Cooperatives in Israeli Agriculture by Yoav Kislev, Zvi Lerman, and Pinhas Zusman

# Table of Contents

|A. Introduction|1|
|---|---|
|B. The Moshav Cooperative Association as a Financial||
|Intermediary|4|
|C. Regional Cooperation|12|
|D. Credit Markets and Institutions|22|
|E. Credit in the Economy and in Agriculture|25|
|F. Government|36|
|G. Crisis|39|
|H. Recapitulation, Lessons, and Conclusions|44|

# List of Tables

|Table 1.|Inflation in Israel|2|
|---|---|---|
|Table 2.|Balance Sheet Composition of a Representative<br>Moshave|6|
|Table 3.|Balance Sheet Composition of a Supply Cooperative|14|
|Table 4.|Credit Months, Moshavim's Debt to Mishorim<br>Relative to Sales|17|
|Table 5.|Two Regional Enterprises in Mishorim Regional<br>Cooperative|20|
|Table 6.|Outstanding Bank Credit: Total Economy,<br>Agriculture, Industry|26|
|Table 7.|Ratio of Outstanding Debt to Gross Product and<br>Net Capital|26|
|Table 8.|Share of Agricultural Credit held by Moshavim<br>and Supply Cooperatives|26|
|Table 9.|Distributior. of Outstanding Bank Credit by Source|27|
|Table 10.|The Dollar-linked Component of Outstanding Bank<br>Credit|29|
|Table 11.|Real Annual Cost of Credit in Israel, 1979-1987|33|
|Table 12.|Consolidated Financial Position of the Moshav<br>Sector|41|

Messrs. Kislev, Lerman, and Zusman are from Hebrew University, Rehovot, Israel. The theoretical basis for the paper's approach to cooperative economic behavior is developed in Zusman (1988). It is not repeated here and only partially summarized in sections B and C of this paper.
# EXPiRAY"-. WITH CREDIT COOPERATIVES IN ISRAELI **AGRICULTUREt**

## A. ITOsSO

Eighty percent of Israel's agricultural product comes from cooperative farms. A major form of cooperation in agriculture has been financial. It has flourished for a long time but financial cooperation found itself recently in deep trouble and will need massive public assistance to overcome its difficulties. It is now too early to predict what kind of cooperation, if at all, will emerge from the crisis. Yet, important lessons can be drawn even from this incomplete experience. We summarize our observations in the following: Financial cooperation was effective and supported intensive development of the cooperatives and their members when appropriate conditions prevailed.. But there was danger in its strength; when credit supply expanded with inflation, the cooperative structure, its mode of operation, and the public support it enjoyed--encouraged over-extension, and when macro economic conditions changed and credit's expansion was slowed down, the sector found itself trapped in financial impossibilities. Now cooperation ties farmers and organizations.together and intensifies the dimensions of the crisis.

# 1. Inflation

cooperatives and many other producers view themselves as victims of policy; for the crisis in agriculture (quite a few manufacturers are also facing financial difficulties) erupted when stringent measure to curtail inflation were instituted and rigorously followed. Indeed, inflation has been always a problem in Israel, but it reached ominous proportions in the 1970s. It caused a great harm when it ran rampant and for some, its effects were catastrophic when it was stopped. Readers will find it useful to familiarize themselves with the l magnitudes of price increases in Table 1 and in Figure 1. In step with inflation, exchange rates, generally fixed up to 1975, were 'We had helpful discussions with many; particularly we acknowledge information received from A. Marvid, and I. Nun. The responsibility for data presented in the paper and for its interpretation is ours.

1
TABLE 1

# INFLATION IN ISRAEL: YEARLY RATE (PERCENT)

|Year|Inflation<br>rate, %|Year|InflpUon<br>rate,%|Year|Inflation<br>rate,%|
|---|---|---|---|---|---|
|1949|-12.5|1962|10.2|1975|23.5|
|1950|6.0|1963|5.0|1976|39.0|
|1951|20.2|1964|4.4|1977|42.5|
|1952|66.4|1965|7.1|1978.|<br>48.1|
|1953|19.1|1966|7.8|1979|111.4|
|1954|7.5|1967|0.2|1980|132.9|
|1955|4.8|1968|1.9|1981|101.5|
|1956|4.6|1969|3.9|1982|131.5|
|1957|5.2|1970|10.1|1983|190.7|
|1958|4.2|1971|13.4|1984|444.9|
|1959|2.1|1972|12.4|1985|185.2|
|1960|3.4|1973|26.4|1986|19.7|
|1961|9.0|1974|56.2|1987|16.'|

Source: Central Bureau of Statistics, Statistical Abstract of Israel. 1987.

Notes: 1) Change in Consumer Price Index.

- 2) Yearly rate is December index over December index of previous year.

- 3) The annualized rate of inflation for the first 3 quarters of 1985 was 257.0 percent; the annualized rate for the last quarter of 1985 was 29 percent.

corrected from time to time. A crawling peg regime followed, and it was replaced by a free market in 1977.

The three digits inflation was halted abruptly in July 1985. The program adopted included price and wage freezes, reduction of government deficit, and a return to a regime of fixed exchange rates. As part of the new policy, the Bank of Israel limited the expansion of credit and a severe squeeze developed. Produc.-rs who relied on large volumes of short term credit--as many in agriculture did--found themselves in the midst of a painful crisis.

# 2. Outline

In the paper we concentrate on the experience with credit in the family farm sector, the moshavim--villages run by cooperative 2
<!-- Start of picture text --> Figure 1. Inflation in Israel<br>Annual rate. X<br>400<br>300<br>200_<br>100<br>O Mm<br>1949 1952 1955 1958 l981 1964 1t97 1970 1973 1970 1979 198 1985<br><!-- End of picture text --> associations; the communal sector, the kibbutzim, will generally not be discussed at this time. There are 420 moshavim in Israel with, on the average, 66 farm families per moshav. Seventy seven are "veteran" moshavim established before the creation of the State of Israel and the rest are "young"--established after 1948. The moshavim are again organized in 9 regional and 3 nation wide supply cooperatives (termed "purchasing organizations" in the Israeli parlance; for short, we refer to all of them as "regionals") and in several "movements," each associated with a political party. The movements represent the moshavim in the political arena and attempt to set standards and guide the moshavim in cooperative life-style.

Financial cooperation has been reduced drastically in reaction to the current crisis. But some of the moshavim and a few of the regionals, those with a stronger cooperative basis, are still active in credit intermediation--perhaps in a modified mode of operation. In the paper, we survey financial cooperation as it was before the crisis, and discuss the crisis itself separately. Other sections are devoted to the analysis of credit supply to agriculture and to the role of public intervention in the credit market, both in increasing and strengthening 3
cooperation' and in precipitating **its** crisis. The paper concludes with a discussion of policy issues.

## B. THE MOSHAV COOPERATIVE ASSOCIATION AS A FINANCIAL INTERMEDIARYP

# 1. Background

- A moshav (plural moshavim) is a farming community in which all farms are family owned and operated, and all farmers are members of the multipurpose, democratically run, village cooperative. In principle (practice varies) the cooperative association in the moshav purchases all farm requisites and supplies them to its members, it also markets the members' farm product. The cooperative usually owns and operates a variety of service facilities such as water supply installations, farm implements, sorting and packing sheds, and storage facilities. It may also manage directly some jointly operated productive enterprises (citrus orchards, cotton fields). In addition to serving production activities in the moshav, the association encompasses all municipal and many other social functions in the village. Besides all these, the association also serves as a financial intermediary through which credit is being channeled to the farmers. The moshav is therefore a supply, production, service, municipal, and credit cooperative.

Moshavim were settled mostly by penniless individuals on national land leased by membera and associations from the state; members do not own the land. Initial public allocations of capital and nationally alloted resources, such as rights to land and water, animals, and machinery, were distributed equally. However, differences in farm structure and personal preferences have evolved over the years. The heterogeneity evolved is a major factor in creating conflicts of interest in the moshav and a complete adherence to its principles therefore requires high standards of cooperative ethic.

The alloted rights to land, water, and production quotas are, in OThis section draws on Zusman (1988, Chapter G).

4
principle, inalienable; but a market has developed and membership in the moshav together with the attached rights may be transferr.id. The buyer has however to be accepted as a member by the cooperative. It is therefore practically impossible for lenders, particularly suppliers and commercial banks, to repossess farms, and this deficiency--that land and buildings cannot be used as collateral--is the principal economic justification for the evdlution of the moshav-cooperative as a credit intermediary and for its itode of operation.

# 2. Financial structure and functioning

The nature of the cooperative's activities, and particularly the pivotal role of credit intermediation, can be seen by examining its balance sheet (Table 2). A few qtualifications are in order before we turn to numbers. The financial reports of a moshav are summaries of the activities, the assPts nne the lI.shilities of the assoc.Jtirnn. rot consolidated reports of the whole village--the cooperative and its members. Complete and accurate information on the economics of individual farms is generally not available. Book-keeping follows historical accounting principles and financial statements are prepared in nominal, historical terms and are therefore bound to be highly affected by inflation. The moshav in Table 2, is a representative of a group of young moshavim; in many of them agriculture is limited by meager resources; similarly, their cooperatives are generally weaker than those of veteran and better endowed villages. We remark further on these points below.

Accounting for more than 75 percent of the liabilities in Table 2, the regional supply cooperative is by far the most important source of finance for the moshav (more on regionals in the next section). The second most important source of credit in Table 2 are members' deposits with their associations, amounting to 13.5 percent of the liabilities. These deposits usually earn the same rate of interest that debtor members are charged, which encourages internal lending whenever money is dear. When outside credit was available at negative real interest rates, as was often the case in the early accelerating phases of inflation, members with surpluses usually held their savings in 5
TABLE 2

# BALANCE SHEET COMPOSITION OF A REPRESENTATIVE MOSHAV ASSOCIATION, SEPTEMBER 30, 1981

(in percent of total assets)

|ASSETS||LIABILITIES AND MEMBERS'|EQUITY|
|---|---|---|---|
|Fixed assets|3.7|Equity|0.7|
|Long-term investments<br>and loans to members|3.5|Long-term debt to<br>Settlement Dept.|2.1|
|Inventories|4.0|Other long-term debt|2.1|
|Accounts receivable<br>from non-members<br>Members' debit balances|12.2<br> <br>76.7|Short-term bank ioans<br>Short-term loans from<br>regional supply coop.|0.6<br>76.9|
|||Suppliers' credit|3.9|
|||Members' credit balances|13.5|
|||Other payables|0.2|
|Total|100.0||100.0|

Source: Zusman (1988, Table G.2).

Note: The data are for an average association in a sample of 13 moshavim in the "Mountain Region" (a fictitious name).

inflation-protected bank deposits or in government bonds--often with the blessing and the advice of the association.

Long term credit in agriculture comes mainly from the Settlement Department of the Jewish Agency and from the government. The 'Settlement Department is responsible for newly established moshavim supplying them with start-up capital for the early stages of their development--until they take off and can operate independently, generating savings and raising credit. The government supports investments in preferred agricultural development projects. By 1981 6
the development assistance of the Settlement Department and the government (most of the "other long term debt" in the table) dwindled to a small percentage of the liabilities of the moshavim in Table 2-partly due to the emergence of alternative sources, partly due to inflation wiping out the real value of these long term and mostly unlinked loans.

Inflation is also responsible for both creation and understatement of equity in the association's balance sheet. Equity contributed directly by members is a very small sum. Most of the equity accrued as inflationary gains when the real value of the unlinked loans the association took to finance its own investment projects eroded and these profits were not distri.buted to the membership-. The equity is understated because the association's assets (orchards, buildings, machinery) are also reported-in historical, highly undervalued terms. It wan estimated that the true value of equitv Is approxiMAteA V 15 percent of the association's l.iabilities (30 percent for veteran and stronger moshavim).

The role of the association as a financial intermediary is clearly demonstrated on the assets side of the balance sheet by the dominant share of members' debt which accounts for more than three quarters of the reported total. Money raised from outside and from internal sources is channelled to members, who thus have a permanent line of credit with their association. When credit supply from outside sources was limited, the association would ration the loans it could allocate among th.e members in the moshav. When not--and especially the regional cooperative at times offered an elastic supply of credit-members were restrained only by the cost of capital, by the rate of interest charged daily to their accounts. Government and Settlement Department long term loans are mostly transferred to members back to back. Due to inflationary erosion, members' long term debt also forms only a negligible percentage of the association's assets. Here and in other forms of credit, the cooperative transfers loans to its members together with the inflationary gains associated with their use.

Correcting inflationary distortions in the balance sheet of the cooperative association will reduce the proportion of external and 7
internal sources of credit and members' debt. Even then, items reflecting financial intermediation will occupy a paramount position in the moshav's financial statement. Cooperative credit intermediation has several advantages, but it alzo entails dangers and difficulties.

# 3. Advantages

In the absence of cooperative financial services, individual members would have to handle their finance independently. It is reasonable to expect (and it is happening these days, Section G) that the structure of the farm credit institutions can be adapted to deal with individual farmers: credit would be extended, as it is now, by .suppliers, marketing agencies and banks; but its amounts may be more limited and its cost higher if the advantages of cooperation are n- realized. These advantages are of several kinds.

With cooperative financial intermediation, all members finances are handled by a single professional officer--often hired, not a member of the moshav. The members enjoy access to financial expertise, particulary important in an inflation-prone and high-tax economy such as Israel's.

Being a comprehensive cooperative is another advantage of the moshav in its role as a credit intermediary. As members in a well run cooperative purchase all farm inputs and market their product through the offices of the association, credit, supply, purchasing, and marketing are interlinked: factor suppliers extend credit and the marketed output serves as security both for suppliers and for bank loanss. Since the moshav is a relatively small community, intimate relations exist between the association and the members. Officers in the association are familiar with the farm operation of the members and can assess, better than any outside institution, credit risks and soundness of investment.

By pooling their demand for credit, members in the moshav improve their bargaining position in the market- they can attempt to

> 3 Haruvi and Kislev (1984) study the relations between joint marketing and capital intensity in the moshav.

8
appropriate a comparatively large part of the saving lenders realize when the association, dealing with every member separately, does the retailing phase of credit marketing. This advantage, needless to say, is not limited to the credit market.

Perhaps the greatest advantage of cooperative credit in the moshav lies in risk pooling, w.ich is implemented in two ways. In the short run, the association can service from its own resources the debt of a farmer who happens to be in a temporary shortage. The association extends further credit to the needy member on the understanding that<sup>it</sup> will be repaid in due course. Outside lenders do not have to deal<sup>with</sup> transitory difficulties of individual borrowers.

A more fundamental mode of risk pooling is mutual liability and guaranty. According to this arrangement, the association borrows funds from external lenders with all members sharing the association's iahtilitv. The association then uses these funds to extend credit to its members or to invest in its own service and production enterprises. Should a member default on his repayment obligation (or should a village enterprise fail-to cover cost of operation) the association can still honor its obligations by drawing on the resources of the other members, and ultimately, if the association fails to service its debt, lenders can collect directly from the members. The social pressure to comply with cooperative norms is stronger under mutual liability arrangements. The probability of association default is thereby reduced substantially. Banks and other lenders evidently recognize the advantage inherent in this arrangement, as credit is often conditioned on renewal of mutual liabilities.

# 4. Weaknesses

- Most crucial of the potential. structural weaknesses of cooperative

- credit in the moshav is the possibility of moral hazard behavior. Under mutual liability arrangements, the social cost of a member's default exceeds private cost. Members may purchase inputs through the cooperative and market the produce privately, depriving the moshav of the ability to collect the accumulated debt; or a member may simply cut all his economic ties to the cooperative, perhaps without directly

9
repudiating his debt, but not sharing any further in the village obligations. Such behavior reduces the moshav's credit worthiness; the damage to the individual member is only 1/n of the damage caused to the whole village with its n moshav members.

Enforcement of the moshav's ethics, and in practice--enforcement of product marketing by the moshav and channeling of all-the proceeds through its offices is therefore critical to its continued functioning as a comprehensive cooperative. In some cases, technology or administrative consideration dictate cooperative marketing: milk, for example, is collected by a single agent who pays through the association; or proceeds for exported farm products are also paid -centrally through the village office. But in many other cases-vegetables, fruits, eggs, poultry, beef--members can easily market privately, bypassing the cooperative and its obligations. In a moshav with high ethical standards, social Pressure will ensure compliance with the cooperative moral code. But where ethics is more relaxed, when some members demonstrate that they can "get away" with a breach of the cooperative contract,-cthers are tempted to follow suit. Given the many intimate relations between moshav members, decision makers are often reluctant to take punitive action against defaulting members: the penalty may have to be imposed on a neighbor, a closed relative, or on a potential voter whose support may be solicited afterwards.

# 5. Cost Allocation

As we have seen, credit transferred by the moshav to its members can be divided into two parts: Credit specified by the lender for a particular project or a particular member (Settlement Department and government development credit is often so specified), supplier credit attached to a factor, or credit from marketing agents for specified products--is **g** transferred by the association back to back at the same terms it was received.

Other sources of credit raised by the association are pooled and transferred to members in the form of drawing rights.

10
The association faces an upward sloping supply curve of credit for its pooled resources. Typical steps in this credit supply function (in ascending order) may be: Medium term bank loans Current bank drawing rights Members' credit balances Bank overdraft Regional supply cooperative Other open market credit.

These steps raise the issue of the cost allocation rule: what interest rate or rates should the association charge its members? (In a moshav this will be a single, uniform rate regardless of risk differentials, if such exist.) Economically, the optimal rule is tocharge members the marginal rate: the association will tap credit sources according to members' demand and the association's readiness to borrow, and charge the highest rate it has to pay. The same rate will also be paid on members' credit balances (thus determining the ranking of this step in the supply function). This rule may cause some difficulties: (1i How to distribute surpluses? (what side payments?) (2) A technical difficulty may arise if the marginal rate varies over time and the association has to keep track of members' loans and deposits and charge their accounts differently or. a day by day basis. (3) The moshav is governed democratically, and it may be hard to convince the members to adopt marginal rate charges. The marginal rate is usually viewed as "too high" even if coupled with redistribution of surpluses. As a consequence, the practice in the moshavim has been to charge the average rate of interest. Since most of the non-specified, pooled credit came from the regional supply cooperative, which was often also the most expensive source for the moshav, average charging was not far from optimum.

B~~~~~~~~~~~1
# C. REGIONAL COOPERNTION'

Regional cooperation started on a modest scale and developed into a set of "empires" with more than 300 enterprises around the country serving kibbutzim, moshavim, and private farmers. The regionals have played a major role in the development and growth of agriculture in the last 20 years, but they were also among the main causes of the current crisis.

# 1. Secondary Cooperation

In terms of a modern economy, the moshav is a small unit. To increase scale of operation in farm services, the moshavim establishrl secondary regional cooperative ventures. These include regional supply ("purchasing") cooperatives and a variety of service establishments such as fruit and vegetable sorting and packing operations, storage facil.ities, poultry meat processing and packing plants, machinery maintenance centers, and feedstuff elevators. Some ventures with litt:Le or no connection to agriculture were also established to increase employment and-income in the regions.

-The regionals, both the supply cooperatives and the service enterprises, are associations of associations owned and operated by participating moshavim; individual farmers are not directly members in these second order cooperatives. The regional supply cooperatives are almost always the supplier of inputs to the service enterprises, often they are also partners in the ownership of the regional ventures. Like the moshav associations, the supply cooperatives are also active in financial intermediation--channeling credit to the moshavim and to the service enterprises in their regions.

The mode of operation of the supply cooperative is also similar to that of the moshav association: it extends credit to the moshavim, mostly in conjunction with the supply of inputs; it relies on mutual liabilities; it requires all its members to channel the proceeds from the marketed farm product through its offices to facilitate monitoring "This section draws on Zusman (1988, Chapter K) and on Cohen (1984), Kadishay (1985), and Kislev, Marvid (1988).

12
and debt repayment. But size, complexity, and organizational remoteness create some fundamental control problems which in the context of the moshav association were practically negligible but attain significant proportions in higher order cooperatives.

# 2. Roles of Regional Cooperatives

At the time of their establishment, the goal of the regional supply cooperatives was to pool together the purchasing power of several moshav associations in order to strengthen their bargaining position in the markets and to ensure reliable provision of farm inputs and household goods. Relying on mutual liabilities of their members, the supply cooperatives soon became major instruments for raising credit--initially it was chiefly factor suppliers' credit, then the government began channeling directed short term loans through the regionals, and as the apparent stability of the regionals was established, commercial banks were also willing and eager to offer credit. Financial intermediation thus expanded over the years.

Serving as a focal point for regional activity with an improved access to credit, the supply cooperatives assumed a leading role in setting up and operating the regional enterprises and other cooperative ventures. In addition, the supply cooperative became a center for political, particularly lobbying, activity and, as a result, regional public service became the route to political involvement at the national level. The economic and the political roles of the supply cooperatives reinforce each other; economics provides a firm basis for political operation, and political lobbying promotes the economic interests of the moshavim and their regional activity.

# 3. Financial Structure

Like the moshav balance sheet, that of the supply cooperative also 'reflects its role as a financial intermediary. In Table 3, 60.9 percent of **thE3** assets of the regional organization is members' debt and an additional 18.3 percent is debt incurred by regional service and production e-aterprises. The sources of short term credit are commercial bankE, suppliers, and gray market lenders (Section D).

13
# TABLE 3

# BALANCE SHEET COMPOSITION OF A SUPPLY COOPERATIVE, SEPTEMBER 30, 1981 (in percent of total assets)

<!-- Start of picture text --> ASSETS LIABILITIES AND MEMBERS' EQUITY<br>Fixed assets 3.5 -S Equity 3.0<br>Long-term investments Long-term debt 19.5<br>and loans 13.7 22.5<br>17.2 Short-term loans 34.5<br>Receivables:<br>members 60.9 Suppliers' credit 21.8<br>regional enterprises 18.3<br>-<br>marketing agents 3.6 Notes payable 21.2<br>Total current<br>Total current assets 82.8 liabilities 77.5<br>Total 100.0 Total 100.0<br><!-- End of picture text --> Source: Kadishay (1985).

Note: The data are for the regional supply cooperative in the "Mountain Region." Up to the end of the 1970s, the supply cooperatives had relied mostly on short term credit. But then, as part of policy reforms, the government curtailed its supply of directed short term loans, and banks were also constrained in the expansion of credit. At the same time, the banks were permitted to raise capital on the stock exchange and on the world markets. They began offering medium and longer term loans linked to the exchange rate. This was the major source of the long term debt (19.5 percent in Table 3) which in 1981 was a relatively recent phenomenon. Unlike other sources of long term credit, mostly development assistance, these loans were not tied to specific users or projects and were therefore not transferred back to back to the individual moshavim. The shift to long term debt, which may have been then more expensive than short term, unlinked credit, served the 14
regional cooperatives well because it reduced the need to secure continuously large volumes of new credit, volumes that grew at least<sup>in</sup> their nominal values as inflation accelerated.

Again as in the moshavim, due to inflation and the historical accounting practices, the financial statements underestimate fixed assets in the supply cooperatives. But even if adjusted, they will<sup>not</sup> occupy an important-place in the balance sheet. For the<sup>supply</sup> cooperative acts as an intermediary, a traffic control in factors, consumer goods, products and credit; and=apart from some<sup>office space,</sup> equipment, and a few cars, it does not hold aay property.<sup>Similarly,</sup> equity is understated but it will not become a substantial source of capital even if adjusted for the effect of inflation.

Not all the obligations of the supply cooperative are reported in its balance sheet. In a study of Mishorim, another supply<sup>organization</sup> (Kislev, Marvid 1988) it was found that, in addition to extending credit, the cooperative guaranteed loans and co-signed notes for the moshavim and the regional enterprises. The sum of these off-balancesheet liabilities amounted, also in 1981, to 64 percent<sup>of the</sup> cooperative's reported liabilities.

Credit to its moshavim was the principal item among the supply cooperative's assets (60.9 percent in Table 3). Likewise, the regional cooperative also occupies a prominent place in the economy of its member moshavim: 76.9 percent of the moshav<sup>liabilities in Table 2 is</sup> debt to the Mountain Region cooperative. This ratio, however,<sup>varies</sup> over time and with the nature of the cooperative<sup>and the participating</sup> moshavim. Figure 2 depicts the ratio of<sup>debt to the supply cooperative</sup> to total current debt over several years for two groups of moshavim: Mountain Region and Valley moshavim. The first group increased its reliance on the regional cooperative between 1977 and 1981; the second, if anything, reduced it. Valley moshavim are<sup>veteran and stronger</sup> economically than the moshavim in the Mountain Region, their cooperatives--both at the moshav and at the regional level--are also healthier. Evidently they directed their comparative<sup>advantage to</sup> strengthen their cooperatives independently--not to increase<sup>inter-</sup> reliance.

15
Figure 2. Reliance of Moshavim on Supply Cooperatives <!-- Start of picture text --> 1o0x<br>Current mochaw debt to supply cooperatUte<br>R Total current moshav debt<br>60% iaountain momhavim<br>R<br>40X<br>20X Valley mosh.wis*<br>0 -. .- ..<br>1976 1977 1978 1079 1980 1981 1982<br><!-- End of picture text --> The financial dependency of the Mountain Region moshavim on their supply nooperative did not increase the regionals' control over its members. On the contrary, it reduced control: because the moshavim in this region have only limited access to alternative-sources of credit, the supply cooperative is committed to their continuous funding and the managers of the regional organization could hardly afford the dire financial, social, and political consequences of members' bankruptcies. This is born out by the following observation.

A reasonable rough measure of the financial exposure of a member moshav is the ratio of the ou'standing debt to its monthly sales through the regional office ("credit months"). Kadishay (1985) found that, during the period 1977-1981, only 3 out of 20 moshavim observed by him in the Valley Region exceeded 12 credit months and that too only for short durations. In the Mountain Region, with stronger interreliance, 13 out of 24 observed moshavim exceeded 12 credit months and for relatively long durations.

Thus, while the "strength" of the supply cooperative's power over the individual moshav association is considerable, the "cost" of its application is also very high. The financial power of the supply cooperative over its members, the moshav associations, is thereby 16
TABLE 4 CREDIT MONTHS, MOSHAVIM'S DEBT TO MISHORIM RELATIVE TO SALES

|1970|12.1|1974|5.9|1978|6.0<br>:|
|---|---|---|---|---|---|
|1971|9.9|1975|5.3|1979|9.0|
|1972|7.5|1976|4.6|1980-|10.2|
|1973|5.9|1977|5.7|1981|10.7|

Source: Kislev, Marvid (1988).

Note: Credit months = (average annual debt of moshavim to Mishorim)/(annual moshavim's sales through Mishorim)x12.

blunted=. As a result, heavy financial inter-reliance of first and second order cooperatives lead to moral hazard behavior on part of many of the borrowing associations and was one of the major factors that exacerbated the severity of the current crisis. The alarm signals were building up for a long time and are worth examining further. Evidence comes from the third regional organization we are studying.

Data for Mishorim, a-supply cooperative with young moshavim similar to those of the Mountain Region, shovfthat not only across moshavim of different vintage, but over time for the same moshavim too--financial exposure is affected strongly by economic performance of the members of the regional organization. Mishorim's credit months ratio (Table 4) improved significantly in the mid 1970s with the expansion of export crops, in which the region specializes, but evidently the moshavim found it convenient not to cut back on their credit in the regional organization in 1979-1981 when agricultural terms of trade deteriorated with the weakening of the European currencies against the dollar and the region's production of exportables and products for the domestic market was reduced.

Differences are also found between moshavim in the same region. In a sample of 13 moshavim, members of Mishorim, one moshav owed nothing to the supply cooperative--it did all its procurement for cash. Another held the record for 1981 with 55 credit months. The next in °For a relevant theory of social power, see Harsanyi (1962).

17
line had 42 credit months. There is no way that moshavim with such heavy burden of debt compared to their production capacity will ever be able to repay it. Heavy debt burden does not happen overnight, it evolves gradually as the moshav purchases factors and consumer goods in the regional cooperative and either fails in its attempts to reach reasonable levels of agricultural production, or it diverts its produce to private channels, bypassing the regional offices. Moshavim with 55 or 42 credit months again testify to the weakness of the regional organization a weakness that breeds permissiveness~and lax financial discipline.

# 4. Regional Enterprises

Regional service enterprises were ordinarily organized as limited lihilitvy ronpetrp;iva sctri4t iort. Thpir membership consisted of moshav associations, mostly potential patrons of the service offered. The establishment of the regional enterprises was financed mainly by development grants and soft loans from the government and the Settlement Department; the rest was financed by some equity capital and loans from a variety of sources, including supply cooperatives. In addition, the supply cooperative becomes naturally the agent providing the regional enterprises with factors and credit and, in many cases, it also invests directly in their equity capital. The two kinds of regionals, the supply cooperatives and the regional enterprises, thus maintain strong economic connections; a relationship that proved detrimental when the recent financial crisis developed.

Zealous adherence to rural development by public agencies, easy. access to credit through the supply cooperatives, and strong political regional lobbies--resulted in over expansion of service enterprises. This occurred particulary in the 1970s when credit was in ample supply and economic optimism ran high. Consequently, in the early 1980s many service enterprises operated under capacity. Estimated capacity utilization in slaughter houses and feed mills run by regional - enterprises for 1982-86 was 50 60 percent (Marvid, Arian 1988). Moreover, this was a conservative estimate, based on the assumptions of 18
one shift a day in the slaughter houses and two shifts in the feed mills. True capacity utilization was much lower. Not unlike firms in a cartel, regionals scrambled to get their share in the service enterprises and the expected benefits they were to yield. The final outcome, however, was tFhat many of the enterprises did not cover their operating costs.

The supply-cooperatives in their role as the financiers of last resort, found themselves financing not only operating losses but also debt service of the regional enterprises. To see how this happened, consider the feed mill (Mazon) and the slaughter house (Off) in the Mishorim region (Table 5). Both are owned by the moshavim in the -region and initially Mishorim, the supply cooperative, had no share in their ownership. Plans for the establishment of both enterprises were initiated in the early 1970s; the aim was to provide fa..rmers in the r-. pa-t;^.|l>-l pouitry groTiers, with convenient. reliable service. In terms of cost, the establishqents are of similar size, investment was $9.7 and $10.9 million in Mazon and Off, respectively. Construction of Mazon began in 1976 and of Off in 1977; by 1981 both enterprises were in operation.

Differences in the fate of the enterprises emerged right the beginning. Financing in the early stages of investment was with concessionary unlinked credit, but in 1978 the government modified its credit policy and new development loans were indexed or dollar linked. Late financing, and particularly budget overruns, were expensive. Off, being constructed one phase behind Mazon, ha<sup>4</sup> to rely comparatively more on linked loans. Mazon also enjoyed stronger government blessing and a grant of one million dollars, which was not available to Off.

By 1981, Mazon accumulated inflationary capital gains of $4.9 million on its unlinked debt .nd a negligible operating surplus; Off accumulated only $2.4 millions in inflationary capital gains, and had $1.5 million in operating losses in its first year of production. As a result, in September 1981 the enterprises emerged with equity (including retained earnings) of $8.6 and $2.9 million for Mazon and Off, respectively. In addition, in 1981 both enterprises serviced their past debt and accepted new short term obligations, most of which 19
TABLE 5 MAZON AND OFF TWO REGIONAL ENTERPRISES IN MISHORIM REGIONAL COOPERATIVE (in millions of US $, September 1981w)

||MAZON|OFF|
|---|---|---|
|Investment and finance|||
|Equity (reported)|2.7|2.0|
|Grants|1.0|-|
|Long-term debt|||
|<br>Indexed|1.4|5.2|
|Not indexed|4.6|3.7|
|Total investment|9.7|10.9|
|Changes durinP construction period|||
|Inflationary capital-gains|4.9|2,4|
|Operating surplus|0.03|-1.5|
|Total|4.9|0.9|
|Ec'tlitv Pdic.qted tioincKtlude<br>grants and|||
|inflationary capital gains, Sept. 1981|<br>8.6|2.9|
|Debt, Sept. 1981|||
|Long-term|||
|Indexed|1.9|5.6|
|Not indexed|-- 0.5|0.3|
|Short-term|1.3|3.5|
|Total debt|3.7|9.4|
|Financial flows. 1982|||
|Uses of funds|||
|Operating expenses|9.0|10.2|
|Debt service (interest+repayment<br>of|||
|<br>principal)|0.5|3.4|
|Total uses|9.5|13.6|
|Sources of funds|||
|Sales revenue|9.3|10.3|
|Increase of short-term loans|0.2|3.3|
|Total sources|9.5|13.6|
|Debt, end of 1985 (estimated)|||
|Long-term|1.5|4.3|
|Short-term|2.7|19.9|
|Total|4.2|24.2|

Source: Kislev, Marvid (1988).

Notes: a) Agricultural years in Israel are from October to September.

20 '3..
was suppliers' credit passed-over to their own customers. Outstanding debts were at the end of 1981 $3.7 and $12.5 million.

By 1982, Off also succeeded in balancing its costs and revenues, but with no surpluses. Both enterprises had to raise additional loans to service their debt. Most of the loans were short term, borrowed from the regional supply cooperative. Mazon borrowed $200,000, and Off $3.3 million.

No figures were available beyond 1982, and costs, revenues, and financial flows were estimated using information on volume of operations, equipment renewal, going rate of interest, and repayment schedules of past debt. By these estimates, at the end of 1985, the .debt of Mazqn was $4.2 million of which $2.7 million was short term, mostly to Mishorim. The corresponding numbers for Off were $24.2 and' $19.9 million.

Thdifferences in the fate of Mazon and Off _are_ *vpica) of many investment projects in recent years. The key word is timing. Producers (and households) that were fortunate enough to invest in the early stages of accelerating inflation saw their debt evaporate. Latecomers who relied on recenftexperience, and accepted projects whose feasibility depended on negative cost of capital, ended with enormous debt burden.

However, earlier construction did not rescue Mazon either. With over-capacity in feed mills in the country, Mazon could not cover both the operating costs and its comparatively modest debt service. Thus enterprises which were constructed with the initiative of the economic regional elite concentrated around Mishorim and with the assistant of public agencies, striving to promote economic development and well being, became a drain on the economy of the regiLn. So long as Mishorim could finance Mazon and Off, even if at relatively high rates of interest, farmers in the region's moshavim did not feel the burden (particularly that financial reporting was always behind and being prepared in historic value was considered irrelevant). But once further finance was not forthcoming, Mishorim's members found that they were being asked to foot the bill--they, through their moshavim, signed mutual liabilities guaranteeing Mazon's and Off's loans.

21
# D. CREDIT MARKETS _AND_ INSTITUTIONS

Israel has fairly developed money and capital markets. The markets are strongly dominated by government intervention, but most of the financial transactions are handled by commercial banks, supplemented by a well-developed securities exchange.

# 1. The Banking Systems

Commercial banking in Israel is widely accessible and at the same time highly centralized. There are 29 banks, but the industry is dominated by 5 banking groups which together account for 94 percent of all bank assets. More than 1000 bank branches offer competing service in all parts of the country. The commercial banks also act as major securities investment brokers and most of the highly developed mutual funds industry is owned and m-anaged by the banks.

AFricuJture is additionally served by two specialized banks whose major activity is channeling investment funds. They account however for only 15 percent of total bank credit to agriculture.

In the early 1950s, the number of cooperative credit societies in Israel exceeded My far the number of commercial banks. But they found it hard to compete with the banks and in the long run had to fold, many absorbed by Bank Ha'Poalim, the labor movemernt's bank. By now, despite Israel's deep rooted cooperative tradition, there are only two cooperative financial institutions in operation, and both are small, strictly local, and hardly known to the public.

# 2. Bonds<sup>7</sup>

Through most of its history the securities market in Israel was dominated by bonds, which since 1955 have all been linked to the price level or to foreign exchange. Linkage allowed the market to survive inflationary vagaries. Also for most of its history, the bond market 'This subsection draws on the publications of the Supervisor of Banks and on Heth (1966).

7 For the history of Israel's securities market, see Sarnat (1966) and Levy, Smith, Sarnat (1978).

22
was dominated by the government which first mobilized resources by borrowing from the public--sometimes by fiat, but more often by open market operations--and then had to roll over the internal debt thus created. Government dominance crowded out private capital raising, and to keep the cost low, the government also limited by regulation private bond issues. Only a few financial institutions and utilities were permitted to issue bonds and that only to raise capital for government approved projects. Consequently the government is also the biggest lender of long term funds. The situation has changed when a "general permit" was enacted in 1986 enabling all corporations to issue bonds and use the proceeds without seeking specific approval. As a result, -linked bond issues of non-government corporations were in 1987 ten times their 1984 level. As part of the liberalized bond market, two major kibbutz movements also raised $75 million in four 12-year bond isc,qR linked to the consumer price index, with the proceeds intended to help first- and second-level agricultural cooperatives roll over and convert their burdensome short term debt.

# 3.-Stocks

The market for equity issues in Israel began its accelerated development in 1959, in response to legislation encouraging investment in stocks. Since then the market has had its ups and downs, following policy measures and changes in the economic environment. When the market was bullish, new corporations went public and old public companies came out with new issues. Equity value exceeded bond value for the first time in 1977.

The most recent bullish market crashed in 1983 in two waves. First the prices of the so-called "free" or "unsupported" stocks--shares of companies not affiliated with major financial and banking concerns-dropped by tens of percent. The second crash came in October 1983 and it involved all the bank and financial stocks. The banks had been regularly manipulating the prices of the "supported" stocks as part of their secondary market activities and their crash made it clear that this was not a sustainable practice. The stock market has not recovered fully since the 1983 crash, despite a generally positive 23
trend-in 1985-1987 following the government's anti-inflationary policy. Agriculture has never been prominently represented on the Israeli stock market. Only 4 citrus growers, 8 food processors, and the 2 agricultural investment banks have publicly traded stock out of the 250 odd corporations listed on the Tel-Aviv Stock Exchange in 1987. No cooperative has ever raised equity on the stock market. This is not incidental; cooperatives, with their member-oriented and patronagebased policies, are usually not built to have two kinds of stock holders, members and non-members. Some cooperatives in the UK and the USA have recently started raising new equity capital through stock issues to the public, introducing appropriate organizational measures. .Probably, so long as credit was ample and cheap the need for such reforms was not felt in the Israeli cooperative sector.

On the other side of the-market, farmers and farm organizations invested savings and temporary surpluses in securities, both stocks and bonds. Stocks were particularly popular in the late 1970s and early 1980s; and when the market crashed, it was revealed that at least one kibbutz movement suffered a substantial loss. Up to 1982, moshavim could borrow at nominal interest rates that reflected inflation, write the cost off as a tax deductible expense, and let their members invest in securities whose capital gains were tax exempt income. Many in the moshavim held therefore bank shares that were considered safe investments so long as the banks supported their prices. No data are available on the volume of these investments or on the associated profits and losses.

# 4. Other Markets and Sources of Credit

Gray, non-bank credit markets have always operated in various guises in Israel. These markets channelled consumer and business savings to borrowers, bypassing the liquidity and interest regulations of the commercial banks. Part of this activity was quite respectable: insurance companies, for example, held for some time more than 10 percent of their assets in the gray market. At the same time, the market probably accommodates some who operate on both sides of the law. It is not known to what extent agriculture was active in the gray 24
market, but the involvement of the kibbutzim received some publicity recently when one of the movements suffered a considerable loss through a gray market intermediary and the case ended in court. Folklofe has it that kibbutzim and moshavim were lending to each other through the gray market without being aware of the identity of the other party to the deal.

Other sources of credit--as reflected in the cooperatives' balance sheets--were suppliers, marketing agents, government directed credit, and members' deposits. Members in moshavim attempting-to bypass their cooperative associations generally found it easy to get private wholesalers to finance working capital needs. Evidently, these creditors could secure their loans by methods that the moshav or the regional cooperative could not afford to follow.

# E. CREDIT IN THE ECONOMY AND IN AGRICULTURE

Inadequacy of "suitable" sources of credit has often been blamed in Israel for the financial difficulties of agriculture, particularly in cooperative farming. Contrary to this popular claim, the findings of the survey, presented in this section, on the development of bank credit in the economy and in agriculture suggest ample supply, mostly at low cost.

# 1. Growth of Credit

From 1969 and up to 1979, outstanding bank credit to agriculture grew at the same pace as credit to other sectors in the economy (Table 6). But since 1980, agricultural credit has been growing faster than that of industry. Despite the deceleration of inflation, credit continued to grow after 1985, and by the end of 1987 real credit to agriculture was 33 percent higher than its volume at the end of 1984; the corresponding economy-wide increase was 25 percent. These recent developments pose a puzzle: if credit grew in 1986 and 19J7, where was the credit squeeze allegedly created by the anti-inflationary policy of the central bank after July 1985 (Section A.2)? We shall attempt to 25
# TABLE 6

# OUTSTANDING BANK CREDIT: TOTAL ECONOMY, AGRICULTURE, INDUSTRY (Selected years, end of year balances in real values)

||In Pe|rcent of|1969 credit|In percent of|total credit|
|---|---|---|---|---|---|
|Year|total<br>credit|credit<br>agricult|to<br>credit to<br>ure<br>industry<br>...|credit to<br>agriculture<br>------------------------------|credit to<br>-<br>industry<br>-------------------------__---|
|1970|138|136|<br>124|10|32|
|1974|236|209|<br>219|9|33|
|1979|351|335|<br>327|10|33|
|1984|427|491|<br>352|12|29|
|19137|535|655|<br>402|13|27|

SoLrce: Annual Bank Statistics, various issues.

# TABLE 7

-

RATIO OF OUTSTANDING DEBT TO GROSS PRODUCT AND NET CAPITAL (Selected years, end of year data, real values)

|Year<br>----------------------------|total<br>credit,<br>% of gnp<br>-------------------------------------|credit to<br>agriculture,<br>7. of agricul-<br>tural product|credit to<br>agriculture<br>% of net|credit to<br>industry<br>capital<br>__--|
|---|---|---|---|---|
|1969|31|48|19|52|
|1974|48|76|35|69|
|1979|57|101|48|75|
|1984|57|177|67|70|
|1986|67|182|79|64|

---------------------------------------------------------------------

Source: Credit balances from Annual Bank Statistics, various issues. GNP and agricultural product from Statistical Abstract, various issues. Capital stock data from Buch (1984) and privately communicated updates

# TABLE 8 SHARE OF AGRICULTURAL CREDIT HELD BY MOSHAVIM AND SUPPLY COOPERATIVES

(Selected years, end of year data, current values) r

|Year|moshavim<br>percent|supply<br>cooperatives<br>percent|
|---|---|---|
|---------------------------|--------||
|1971|10|14|
|1974|6|23|
|1979|10|20|
|1984|15|26|
|1986|14|28|

____________..______________________ Source: Bank Credit, various issues, and Current Bank Statistics, Bank of Israel, Supervisor of Banks, Jerusalem.

26
TABLE 9

# DISTRIBUTION OF OUTSTANDING BANK CREDIT BY SOURCE (in percent, end of year data)

|YEAR<br>_________|free<br>credit<br>________________|government<br>directed<br>credit<br>____-<br><br>TOT|short-term<br>directed<br>credit<br>------------<br>__-________--_----_<br>AL CREDIT|investment<br>loans<br>----------|earmarked<br>loans|
|---|---|---|---|---|---|
|1971|38|62|18|14|30|
|1974|38|62|16|13|33|
|1979|29|71|22|7|42|
|1984|28|72|14|10|49|
|1986|35|65|10|9|47|
|||AGRICUL|TURAL CREDIT|||
|1971|17|83|36|33|14|
|1974|16|84|33|37|1S|
|1979|23|77'|28|13||
|1984|12|88|13|16|59|
|1986|23|77|9|12|56|

Source: Annual Bank Statistics, various issues.

answer this puzzle below when considering cost of debt.

Credit did not grow only in absolute terms, it also grew relative to product and capital (Table 7). In the economy at large, debt to product ratio increased from 0.30 in 1969 to 0.67 in 1986. Reported product in agriculture is not exactly comparable to product as calculated in GNP, but rates of growth are: debt to product ratio increased in agriculture between the 1969 and 1986 by a factor of 3.8, much more than the economy's average. Another measure of debt intensity is the ratio of credit to net capital. While for industry the ratio hovered around 0.7 since 1969, for agriculture it grew steadily from less than 0.20 in 1969 to nearly 0.80 in 1986.

The share of the moshavim in agricultural credit grew Dy 40 percent from 1971 to 1986 (Table 8). Multiply this by the growth of credit to agriculture (Table 6) and one gets that real credit to the moshavim grew 7 fold between 1970 and 1986. And this calculation is only for credit received by moshavim directly from commercial banks, it does not 27
cover growth of credit channeled through second order-cooperatives.

# 2. Sources

Thirty to forty percent of the credit in Israel is free credit supplied by banks from their own sources and distributed to borrowers at the banks' discretion (Table 9). The rest is under government control--either originating from the government budget and the central bank or from bond issues and deposits administered by commercial banks but designated as funds for earmarked, government approved projects.

Public involvement in credit supply to agriculture is even larger, with more than 80 percent government directed. The decrease in the .share of investment loans and the corresponding increase of the share of earmarked credit apparent from Table 9 is a change in form more than a change in substance. The decrease in the share of short term directed credit, however, is real: it reflects gradual withdrawal of the government from the financing of working capital except for the financing of production for export and export shipments.

# 3. Dollar Linkage

-

Foreign-currency (primarily US-dollar-denominated) loans have been used in Israel for a long time as an alternative form of linkage side by side with consumer-price indexation. Foreign currency did not exchange hands in these transactions (except for credit for imports): it was credit in domestic currency at values linked to the exchange rate.

Linkage, either to foreign currency or to the domestic price level, reduces uncertainty associated with fluctuating inflation. When inflation reaches the two digit level, every day counts. Foreign currency linkage is more convenient than indexation for short term debt, because the exchange rate is known on a daily basis while the **r** price index is measured only once a month in Israel and published with a 2 week delay. Despite obvious advantages, dollar linkage of short term obligations was introduced only gradually (Table 10). Linkage of free credit was almost completely eliminated after July 1985 when the confidence in the stability of the shekel had been restored. This 28
TABLE 10 THE DOLLAR-LINKED COMPONENT OF OUTSTANDING BANK CREDIT (in percent of each source, end of year data)

|||All Sources|||Free Credit||
|---|---|---|---|---|---|---|
|Year<br>-----------------|total<br> <br>economy<br>-------------------------------------|agriculture<br>--|industry|total<br>economy|<br>agriculture<br>----------------|industry|
|1971|35|7|43|27|__<br>1|14|
|1974|42|15|54|54|37|46|
|1979|51|39|67|68|68|64|
|1984|51|44|67|60|39|46|
|1986|36|28|54|30|9|22|
||S|hort-Term Dire<br>|cted<br>w||Earmarked Loa|ns|
||total|||total|||
|Year|economy|agriculture|industry|economy|<br>agriculture|industry|
|1971|<br>52|9|63|NA|NA|NA|
|1974|<br>41|4|60|NA|NA|NA|
|1979|<br>79 fr||84|24|11|19|
|1984|<br>91|85<br>|91|34|36|45|
|1986|100|ite-|100|27|24|39|

Source: Annual Bank Statistics, various issues.

move, however, was costly to the borrowers: free credit carried extremely high real interest rates (see below) while linked credit was usually supplied at "civilized" rates. Restricted to export financing, directed short term credit was 100 percent linked in 1985 and 1986.

# 4. Term Structure

- It was repeatedly shown that agriculture relied on short term

- credit to finance production assets (Lowe 1955; Sadan and Kadishay 1967; Sarig Committee 1979). It was also often claimed that the mismatch in the term structure of investment and its finance and the creation of the "financing gap"~ (between terms of credit and the productive life of assets) was the result of government policy of

29
encouraging capital formation while supplying too little long term credit.

Investment can be financed by short term credit; but then the credit may have to be rolled over for the length of the economic life of the new asset. Credit of adequate maturity reduces uncertainty as to the availability and cost of future sources of finance. Future availability was perceived to pose no problem and cost was low, even negative for long periods of time. Farmers in the moshavim and their associations may have been tempted to finance investments with short term credit. Moreover, they were then saving the paper work and the time needed for the administrative approval of development loans.

Looking at the issue from another perspective, the moshav is an ongoing concern with many assets and liabilities. The association manages a portfolio of liabilities similar to that of assets and changes its composition as relative prices change. When short term credit is comparatively cheap, the moshav's balance sheet will show a wide financing gap. The danger is that when circumstances change and short term credit becomes scarce and expensive, those who relied on it may fifid. that the cost of capital is much too high for the projects they promoted. Many in agriculture enjoyed cheap credit at its time, and many others were caught with inappropriate term structure and paid dearly for it.

In some cases, circumstances beyond the control of the moshavim or their farmers induced comparatively heavy reliance on short term credit and the responsibility, at least partly, could be the government's: Development loans were often delayed, mostly due to bureaucratic sluggishness. Investors had to turn to short term credit for intermediate financing; in periods of inflation, delayed credit created not only temporary but also permanent gaps in financing due to the erosion in the real value of the loans which were late to arrive. The government recognized the problem and even requested the supply cooperatives to bridge the gaps.

Inflation and policy introduced yet another distortion. Soft loans were often offered by the government at nominal interest rates in excess of the real rate but lower than the rate of inflation. Such 30
rates mean (a) negative real cost of debt, and (b) early repayment of the principal. As an example, consider a two year loan of l00 shekels, zero real interest, the yearly rate of inflation is l00 percent. There are two repayment alternatives, in both the principal is returned at the end of the second year: (a) a 70 percent nominal rate of interest, (b) the loan Is linked to the price index. Debt service will then be as follows

|Alternative a|Alternative b|
|---|---|
|End of first year<br>70|-|
|End of second year<br>170|400|
|Present value at the beginning||
|of the first year<br>77.5|100|

The non-linked loan, since it carries a nominal interest lower than the ra-8r of inflAt4nn involves a grant of 22.5 shekels. But it requires, in the example, repayment of 35 percent of the principal at the end of the first year. In this sense investors may be forced to short term financing of their projects--loans carrying nominal interest rates are of shorter terms than their specified maturity.

Whatever the origin of the financing gaps, as cost or availability of credit changed, farmers turned to the government and to the Settlement Department for help, usually with the appropriate political backing. There were many cases, in recent periods almost one each year, of "conversion"--rescheduling of loans: short term credit was replaced by long term loans, mostly on concessionary terms. Many of the conversions were specifically oriented to certain groups of farms or regions, others were more general. Their recurrence was one of the major reasons for the confidence that agriculture would not be allowed to collapse; it would be rescued if it gets into troubles.

The remedy was however not always effective. Sadan and Kadishay (1967) report a case of debt rescheduling in 1956 covering 72 kibbutzim. Within 3 years all but two of the kibbutzim were back were they started in terms of the maturity structure of their debt. The State Controller (1986) reports a similar experience for a group of moshavim. Despite the lessons, today too, the prescription for the 31
Figure 3. Interest Rates and Inflation <!-- Start of picture text --> bpercent<br>00<br>60 lnnation<br>50 52 54 56 58 61 63 65 87 69 71 73 75 7? 79<br>Ftr Cr dt + ST Dwreett S* Invedtmmnt O hoauen<br><!-- End of picture text --> solution of the current crisis in agriculture involves large scale debt refinancing (more on this in Section G).

# S. Cost of Debt

Perhaps the greatest damage that inflation inflicted on the Israeli economy was the distortion of the cost of capital. Real interest rates varied tremendously, cost of borrowing was at times exceedingly high while at other times and for other loans it was negative. This is not a recent phenomenon. Interest rates have always lagged behind inflation, and rates of bureaucratically administered loans lagged further and longer behind price changes. But apart from a two year burst in the early 1950s, up to 1974 inflation was lower than 20 percent per year. The distortions introduced were small compared with those reached in the second half of the 1970s (Figure 3).

More detailed data than those summarized in Figure 3 are available for the last 10 years (Table 11). In this period, real interest rates rwere not only too low, they were also, particularly recently, too high. Real rate of interest on overdraft facilities reached the 100 percent mark in 1985. A year earlier the real rate on short term directed credit in domestic currency was minus 59 percent. The rate of interest on investment credit was -25 percent in 1978 but credit from 32
TABLE 11 REAL ANNUAL COST OF CREDIT IN ISRAEL, 1979-1987 (PERCENT PER YEAR)

|Year<br>---------------|Overdraft<br>facili-<br>ties(1)<br>---------------------------------------|Free bank<br>credit,<br>short-<br>term(2)<br>-<br>------------|Short-term<br>directed<br>credit in<br>domestic<br>currency|<br>All short-<br>term<br>directed<br>credit(3)|All short-<br>term<br>credit(4)<br>|Long-term<br>investmen<br>credit<br>--------.|
|---|---|---|---|---|---|---|
|1978|<br>2%|NA|-24%|NA|-11%|__<br>-25%|
|1979|<br>-11%|NA|-45Z|NA|-10%|-26%|
|1980|<br>19%|NA|-39%|NA|1%|-9%|
|1981|<br>342|NA|-28%|NA|17%|-6%|
|1982|<br>5%|NA|-38%|NA|4%|-2%|
|1983|<br>-3%|NA|-44%<br>-|NA|8.5%|0.5%|
|1984|<br>67%|40%|-59%|6.37<br>-|26%|0.0%|
|1985|<br>100%|36%|-23%<br>|0.9%|20%|2.5%7|
|1986|<br>317|167.|_-37_|-9.0%|7%|1.6%|
|1987|<br>39%|27%|+3%|-0.6%|20%|0.92|

Source: Bank of Israel, Annual Report, 1980--1987 issues.

Notes: (1) Overdraft facilities are the most expensive source of free bank credit: this represents the marginal cost of credit after all the othler sources have been exhausted.

(2) Free bank credit includes the overdraft facilities as ofle"of is components, but the average cost of the entire mix is much lower.

(3) The weighted average of short-term directed credit in dbmestic and foreign currency (mainly US dollar-linked).

(4) The weighted average cost of all sourccs of short-term credit.

this source was then linked and its real cost became positive. Still the cost was negative for tax paying enterprises since linkage charges, even if not yet paid, were treated as tdx-deductible financing expenses. For many of those, linking of investment loans reduced and did not increase the cost of credit. This distortion, at the time unexpected, was eliminated in 1982 with the introduction of inflation

> **r** adjusted income tax regulations which basically recognized only real interest expenses as tax-deductible.

The information in Table 11 is fragmentary and collected from incomplete statistics. To double check, we consider the average cost of debt from all sources calculated from sample balance sheets.

33
Figure 4. Real Cost of Debt: Average for Two Moshavim and Two Supply Cooperatives <!-- Start of picture text --> 100 percent<br>50<br>-50<br>-100 .4<br>1971 1973 1975 1977 1979 1981 1983 1985 1987<br><!-- End of picture text --> The real effective cost of outstanding debt of one of the largest industrial corporations in Israel was around 20 percent (before-tax) in the 1964-1970 period. In 1978, with accelerating inflation, the real effective cost of debt of this corporation plunged tonminus 20 percent (again before-tax), reflecting the erosion of the massive financing from non-linked government-directed sources (Levy 1979). For a sample of 13 industrial corporations, the real effective cost of all loans declined from -6 percent in 1971 to -40 in 1980 (Levy and Lerman 1987).

Preliminary results obtained for four agricultural cooperatives (two moshavim and two secondary regional cooperatives) reveal a similar picture (Figure 4)0. The real effective cost of outstanding loans from all sources became progressively more negative between 1971 and 1984. In 1983-1984, with inflation rates rising to 300-400 percent per annum, the nominal average cost of debt soared, but still not fast enough, so that the real cost of debt reached an all-time low of between minus 40 and minus 60 percent in 1984. But then inflation slowed down by government policy, and nominal rates were caught on their upward path °The time development of the cost of debt of the 4 cooperatives was almost identical; the figure depicts average cost.

34
and overshot, producing a prohibitive<sup>real effective cost of debt in</sup> 1985-1986.

With these high rates of interest,<sup>may lie the solution to the</sup> puzzle posed at the beginning of the<sup>section; namely, where was the</sup> squeeze if credit in agriculture grew by 33<sup>percent between 1984 and</sup> 1987? The explanation we offer is that the additional<sup>credit</sup><sup>**was**</sup> needed to maintain the growing liabilities<sup>of the productive secVor.</sup> As interest accumulated, and the principal<sup>was not repaid, growth of</sup> debt showed up in banks' balance sheets<sup>as additional credit, requiring</sup> an increase of monetary reserves. Loans<sup>to replenish reserves would</sup> come from the Bank of Israel but it supplied<sup>them only reluctantly--</sup> .further-increasing the pressure for higher<sup>interest rates.</sup>

# 6. Provision for Bad Debts"

Here is another facet of inflationary<sup>distortions: provisions for</sup> bad debts are usually around X percent of<sup>total credit balances. In</sup> Israel in the galloping inflation years<sup>of 1975-83, writeoffs for</sup> questionable debts in the banking system<sup>were an insignificant amount,</sup> much lower than the normal 1 percent va4ue. Inflation<sup>and the ample</sup> supply of credit it entailed bestowed a feeling<sup>of economic security</sup> and success even where the underlying structure<sup>was shaky.</sup> Writeoffs increased in 1981-84 in reaction<sup>to difficulties in the</sup> diamond industry, but even then they were<sup>only 0.1-0.3 percent of</sup> credit balances. Substantial provisions for<sup>bad debts appeared in the</sup> banks only after 1985, when many enterprises,<sup>not only in agriculture,</sup> suddenly faced sever financial difficulties.

Bankers were familiar with over capacity<sup>in agriculture, with debts</sup> accumulated to levels that some of the farmers<sup>and some of the moshavim</sup> could not be expected to repay, and with the<sup>lax financial discipline</sup> in the cooperatives--at both the village<sup>and the regional level.</sup> 'Evidently, as revealed by their behavior,<sup>if they did not provide for</sup> bad debts in agriculture, they were fooled<sup>by the appearance of</sup> 9The data in this subsection are frum the<sup>publications of the</sup> Supervisor of Banks.

35
affluence that their own credit created and they expected to be bailed out with public money if the need arose.

Had bankers been suspicious of the soundness of agricultural loans prior to 1985, they would have increased the allowance for this debt at that time. But, given their familiarity with cooperative financial structure, the arousal of this suspicion would have caused them to curtail further credit to agriculture and thus precipitate an immediate crisis--as actually happened in 1985.

# F. GOVERNMENT

Agricultural settlement in Israel was, from its inception, a public undertaking. Most of the newly settled farmers had no capital of their own and were provided with land, means of production, and some capital for current expenses from national funds. The Settlement Department was responsible for agricu4ture before the establishment of the State of Israel, and after 1948 it has continued with newly settled farms. Government's deep involvement has therefore been a natural taking over of responsibilities. This involvement, particularly in credit, was augmented by the government being the channel for large amounts of capital transfers from abroad--Israel probably holds the world record in terms of per capita foreign assistance.

Israel was governed, from 1948 through 1977, by coalitions with Labor at their center. These governments favored agriculture and favored cooperation'°. Thus in the early 1950s, when population was doubled in 3 years and tripled in 13--mostly due to immigration-settlement in cooperative farms was seen as one of the major solutions for unemployment and for food shortage. More than 250 young moshavim were then added to the 77 veterans which had been established before '"Had Labor maintained its hegemony, agriculture may have been assisted more lavishly and the current crisis postponed. It could not, however, be postponed for ever.

36
the creation of the state. The settlers in the new moshavim were as a rule unfamiliar with agriculture and with cooperation; they were sometimes brought to the moshav directly from the port of entry, often without realizing where to and to what kind of life they were going. New settlers were free to leave, many did, those who stayed in their moshavim despite the hardships accompanying any new agricultural venture, did stay because of the relatively low alternative income that was then available in town and because of the intensive assistance they received from the Settlement Department and the government--mainly in capital and close personal guidance.

Governments in all developed countries assist and protect agriculture in water supply, subsidies, planning and removal of surpluses, research, and extension. In Israel, in addition to the functions performed by other governments, the special circumstances of the early stages of development created what amounted to fosterage relations between the moshavim and the public agencies that looked after them. These special relations were particularly strong for the moshavim which were settled in agriculturally inferior regions (our Mountain Region of the earlier sections included). Over time many of the operators in the young moshavim acquired farming skills and cooperation was also well established--independence was strengthened. But the view, held not only by farmers, that it was the role of the government to maintain the welfare of the farming sector and the expectation that the government would actually shoulder this responsibility did not wane.

In cooperative agriculture the government plays a special role. Partly through the Knesset (parliament) and partly through regulations enacted by its offices, the government (in the wide sense of the term) is responsible for the laws and the regulations of cooperative activity. Two instances of interest to our discussion can be mentioned: (a) Attempts to pass a "law of moshavim," strengthening the power of the association over individual members, including in matters of credit and cooperative marketing, failed because of opposition from some of the members fearing infringement of freedom and the support they received from right-wing parties. (b) A regulation was recently 37
issued that a cooperative cannot force members to participate in covering its losses. The argument is that a cooperative is a limited liability entity and members are responsible only up to the value of their shares (the limitation does not apply to cases of mutual guaranty). A judge already applied the new regulation in one dispute and the case is now on its way to the supreme court. If upheld, it - will mean a revolution in the mode of cooperation.

The most profound public involvement was, however, in credit. By deciding on the allocation of subsidized credit, the government (we do not always make the distinction between the government and the Settlement Department) affected regional development, lines of

-production, and farmers income (Kimhi 1986). The dependency on the government and the expectation that it will bail out farmers and moshavim in trouble created Moral hazard problems, not unlike those that moshavim and regional cooperatives face. Investors were willing to take risks that they might have avoided if the danger of bankruptcy and loss of property and of income was real. Lacking the usual mechanism of collateral and effective guaranties, the government turned to close monitoring--"concentrated credit." It worked in the following way: a moshav, or a kibbutz, concentrated all its financial activity in a single bank; its operation was monitored by a steering committee made of representatives of the government, the foster bank and the movement; credit was supplied, either for investment or for short term needs, only with the approval of the steering committee.

Joining concentrated credit was voluntary, moshavim were lured by additional loans that were made available to participants. And, indeed, the program, that started in the early 1960s, covered in a few years most of the moshavim in the country. However, the increasing credit supply in the 1970s, and particularly the convenient source of the regional cooperatives, eliminated the advantages of concentrated credit as seen by the moshavim and the program folded in the mid 1970s. The problem of moral hazard in the moshavim was recognized, tools to overcome it, at least pertly, were created, but the will to maintain a stringent policy did not stand the flood of available credit (concentrated cr-dit is now proposed again in reaction to the current 38
crisis). Moreover, the government then supported the supply cooperatives and encouraged them to expand their role--they often received directed credit on favorable terms, they were assisted in the establishment of the regional service enterprises, and they were made parties to development loans by advancing short term credit to finance delays in government approved loans. Evidently, despite the experience with credit in the moshavim, the dangerous implications of unconstrained operation of financial intermediaries were not understood or, perhaps they were understood but goverrments are often slavs of circumstances more that they are their masters.

# G. CRISIS

The crisis developed gradually. Sensing difficulties as interest rates rose in the second half of 1985, intermediaries in the gray market pulled their money out of many agricultural enterprises or asked for rates that even cooperatives in distress were not willing to pay. The banks were evidently not coming forth with enough funds to cover the emerging shortage and regionals were collapsing one by one. But it takes even seasoned bankers some time to recognize a lost cause, particularly if they may be the ones to lose most. For a while banks cushioned the collapse, continuing to supply credit to the regional cooperatives. Suspicion and difficulties mounted, however, and within a few months, 9 of the 12 supply cooperatives of moshavim were insolvent, banks refused to renew credit, demanded loans to be repaid and charged the highest delinquency rates of interest on overdue moneys. With the supply cooperatives in financial difficulties, they could not support the regional service enterprises and many of them also collapsed.

- Inflation was still running at 15 20 percent a year, raising the needed nominal balances. But agriculture--particularly cooperative agriculture--was cut from its sources of additional bank credit and required to honor previous obligations. This was impossible. Panic spread and the accepted view was that production in the kibbutzim and the moshavim was coming to a halt. Political pressure was mounting and

39
at the beginning of 1986 an emergency rescue program was set up: a sum of $242 million was budgeted for the moshavim. The money was given to the supply organizations in the understanding that they will channel it to the moshavim in order to relieve the burden of short term credit. Most of the organizations kept the money, it lightened their financial burden but not directly that of the most distressed moshavim.

The time gained was to be used for analysis of the situation and formulation of a comprehensive solution. Two committees were nominated in succession (Gibton Committee 1986; Ravid Committee 1987), with representatives of the major banks participating in both in an effort to reach an acceptable solution. The first committee assessed<sup>the</sup> severity of the crisis and suggested a set of basic structural changes. By its assessment (Table 12) the liabilities of the sector of the moshavim were $840 million, not including private debts of moshav members to creditors other than village cooperative association. The estimated farm gate value of production was $870 million and off farm income $140 million. Deducting expenses, the amount left to service the debt was estimated -as $120 million a year. This sum, the committee noted, seems as if it could suffice if interest rate were not too high,if most of the debt could be taken as standing, and if high repayment were not required. But the assessment in Table 12 was an aggregate estimate. Some moshavim and a few of the regionals could continue with convenient cash flows, others could not even pay the interest on their debt.

The suggested solution involved rescheduling of debt with terms tailored to the repayment ability of each cooperative--the moshav and the supply cooperative. A prerequisite for assistance is the implementation of structural changes believed to safeguard against recurrence of the circumstances which led to the current crisis. Among th'em: supply cooperatives will limit their operation to inputs supply and product marketing; no financial intermediation is to take place. Failing regional enterprises will be closed or sold. Aid will come through the association and its distribution within the moshav will be left to its members to decide. Moshavim will deal independently and directly with banks; preferably concentrating their financial affairs 40
TABLE 12 CONSOLIDATED FINANCIAL POSITION OF THE MOSHAV SECTOR (in millions of US dollars, September 1986)

# A. LIABILITIES

SuDPlV Cooperatives Long-term bank loans 190 --Short-term bank loans 120 Suppliers' credit 130 Other sources 40 Moshav associations - Bank loans 230 Other debtors (incl. gray market and intermoshav debt) 130 Total liabilities of the moshav sector 840

# B. RESOURCES AND USES-

## Resources:

Uses:

|Farm income (farm gate<br>value)|870|Farm expenses (incl. hired<br>labor)|490|
|---|---|---|---|
|Non-farm incomeb|140|Living expensesb|230|
|||Depreciation of production<br>assets|70|
|||Financing expense on working<br>capital|30|
|||Income tax expensec|70|
|Total resources|1,010|Total uses|890|
|||Available for debt repayment<br>and retention as equity|120|
|||= - = = =|A~~~<br>= =|
|Source: Gibton Committee|(1986).||0|

Source: Gibton Committee (1986).

- ,Notes: a) Consolidated estimates including all moshav farmers. b) Non-farm income: it was estimated that out of 48,000

participants in the labor force in the moshavim, 26,000 hold non-farr occupations with an average monthly income of $450; living expenses estimated as 27,500 families X $700 average a month.

- c) Including tax liability on non-farm income.

41
in a single foster bank. Regulations will be modified to enable trade in land, water rights, and production quotas. These will then become assets for the farmers to use as collateral, reducing the reliance on mutual guaranties.

By the time the second committee submitted its proposal (May 1987) the estimated debt of the moshavim was $1 billion and growing. The -cbmmittee worked out the details of the proposed financial settlement: a rescheduling of approximately $600 million to long term debt (15-20 years) at 7-8 percent real interest, and writeoffs of $200 million. Most of the money was to come from the government and the Settlement Department; the banks would contribute $165 millions to rescheduling -and 66 millions to writeoffs. Moshavim and farmers with positive deposits in cooperatives will also "write off" part of the debt due to them in the same proportion as the banks wi.ll do. Again, terms of ASS4stance will depend on the individual ability to pay of each farmer and moshav. Each member in the moshav will have to provide a guaranty or collateral for his own liability plus a mutual guaranty limited to the average liability per member in the village.

Debt will be written off only to farmeri-that will be judged unable to repay theirs even if rescheduled. They will then return their means of production and marketing quotas and will not be agricultural producers any more. A cooperative in a moshav in which a third or more of the members will cease functioning as farmers, will be split into a municipality and a separate agricultural association for the remaining producers. It was estimated that 38 moshavim will turn into pure residential communities and 2600 farmers will have to exit agricultural production.

The proposals were reached in the committees by consensus--each party accepting that the suggested solution minimized the damage it was to suffer: the government will rescue the family farm and the banking industry, the banks will get most of their debt back, and the leaders of the moshavim's movements were also happy with the proposals seeing an opportunity to rescue cooperation, even if at the cost of jettisoning some moshavim and quite a few farm families in the process. Consequently, an administration was set up to implement the new debt 42
settlement moshav by moshav. Not asked as for-their opinion were the farmers in the field, but they were expected to join gladly the new settlements, as the understandi,g was that they were hard pressed, lacking credit for current production and renewal of investments.

Meanwhile, life continued: without declaring it, farmers in moshavim that collapsed financially set a moratorium on payments to the banks, thus freeing themselves of immediate financial burden.

Suppliers and marketing agents continued to offer credit (broilers production, for example, can be financed completely in all stages by slaughter houses competing for the right to market the product) and operators' equity was evidently added to finance gaps--if there were any. Banks that attempted to force farmers to repay their debts by foreclosing on private property, found that this was next to impossible--justice is slow,--the police is not exactly eager to fight sturdy farmers now cooperatine fierc.ely. and thp mere magnitude of the problem with 15,000 to 20,000 families in arrears seems to make a forceful solution impractical. Moreover, many banks are ready to offer credit to moshavim and farmers with appropriate collateral (saving programs and pension funds are-popular). Agricultural production did not suffer, markets are bountiful.

The crisis uncovered and intensified differences in the family farm sector. As of now, it seems that approximately a third of the moshavim continue with comprehensive cooperation, including cooperation in credit. In the rest, farmers are reluctant to be parties to the suggested solution. They see the problem as that of the banks, "let them worry," and they do not wish to join a settlement that will again force them into mutual guaranties, however limi.ted. For many of the weaker farmers, this may mean exit from agriculture. The administration, on its part, promises early joining moshavim better conditions and threatens that funds will not suffice for latecomers. Carrot and stick not withstanding, after a year of the administration's efforts no more than a dozen moshavim joined. The crisis is alive but it subsided and the participants retreated into waiting positions.

43
# H. RECAPITULATION. LESSONS. AND CONCLUSIONS

Many businesses suffered severely when economic conditions changed with the introduction of the anti-inflationary policy in 1985. But it is only in agriculture that a whole sector--the cooperative sector-collapsed financially. The reasons for this general failure lie in the particular character and mode of operation of cooperative credit in Israel.

In the last 2 - 3 decades, moshavim (and kibbutzim) developed intensively, adopted new technologies, reacted fast to changes in market conditions, and established a network of farm services owned and operated by fLrmers and their representatives. Much of the credit for this development is due to cooperation. But cooperation in credit, together with a government policy of easy money, also caused overexpansion, over-investment, and enlargement of debt to crisis proportions. Examination of the accumulated experience reveals the weaknesses as well as the strength of cooperative credit and suggests - possible reforms.

# 1. Experience: Cooperation

Moshavim and supply cooperatives developed from transferrers of suppliers goods and credit into full fledged and powerful financial intermediaries. Cooperatives at both levels--the village and the region--face, in theor, and in practice, basically the same management and control problems (Sections B, C) and, since the center of gravity of financial activity has shifted in the last 20 years from the moshavim to the regionals, we concentrate the discussion on the latter's experience.

The supply cooperatives have done remarkably well in the last 15 years. Despite a late start, they became a prominent feature of the agricultural scene in Israel. They performed a central role in the economy of the great majority of moshavim, especially the new ones, and served as the principal instrument in the development of regional economies. To some extent, their success was due to a generous and preferential public support in the form of soft loans and 44
grants-in-aid. It is doubtful, however, that this preferential treatment alone can account for the remarkable performance. The potential gains from collective actions were apparently sizeable.

Yet, the great majority of the supply cooperatives failed financially. They failed when a weakness in the cooperative structure was subjected to the effects of an unanticipated shift in government policy that brought an accelerating inflation almost to a complete halt and changed interest rates form low, sometime negative, to exceedingly high values.

The structural weakness is to be found the relationship between the moshavim and the managements ofVthe regional supply cooperatives. Firstly, the same type of moral hazard as in the moshavim (Section 8), albeit in a magnified form, is produced by mutual liability arrangements at the second order cooperatives. Secondly, goal disparities between the member-moshavim and the management of thf supply organization give rise to a costly "agency relation." In particular, the management of a supply cooperative aspires to expand its role and scale of operation beyond those that would be considered optimal by the ultimate owners and residual claimants. Membership control over management was inadequate; in part, because no member would find the control worth the effort from his own individualistic point of view; in part, due to lack of market control mechanisms (ownership is not tradeable); and in part because of insufficient expertise. Management, on its part, found it difficult to overcome internal political obstacles and establish financial discipline among its member-associations.

Finally, it seems that the management teams in many supply cooperatives did not possess the required profession:,1 expertise to run big and complex organizations and that managers were often motivated by personal political interests rather than by the economic needs of the organizations (Gibton Committee 1986).

As a result of the two-layer moral hazard behavior, the inadequate control, and the willing of the creditors to expand loans, when interest rates were low and credit was in easy supply, indebtedness grew rapidly. At the beginning everyone benefited from the influx of 45
the generous financial flows, but when in 1985 real rates of interest soured sky high, and lenders were reluctant to refinance, many moshav associations and supply cooperatives found themselves in untenable financial positions. The stage was set for a full scale financial crisis.

# 2. Experience: Government and Policy

Up to 1985, the government monopolized the capital market in Israel. When credit supply expanded in the 1970s, the government followed the trend and increased i':s supply too. This shift in supply was the major cause in enlarging the volume of credit in agriculture _(Kimhi 1986). Further, the danger of over-extension of credit in the moshavim was recognized as early as in the beginning of the 1960s, but efforts to monitor and control the moshav association and its members with "concentrated credit" failed. Despite this experience, the government encouraged uncontrolled growth of the regionals, both the supply cooperatives and the service enterprises.

It was policy together with structural weaknesses in cooperation that bread the crisis in agriculture, but policy carries a major share of the blame. Lessons drawn from history are generally based on hindsight, but not all is hindsight in this case: overcapacity in service enterprises was pointed out by officials in the Ministry of Agriculture and the Settlement Department long time ago, but they were over-ruled by the political decision makers. Several factors contributed to this behavior: high national priority given to agricultural development, the need to strengthen the weaker sectors of the family farm, and the political pressure exerted by the farmers through their regional and national organizations. Evidently, the desire to show progress, even if fictitious, and to satisfy local demands, even if shortsighted, overcame economic rationality.

Policy and behavior created the impression, in agriculture and outside, that farmers and their organizations will be bailed-out if encountering strains. This confidence increased moral hazard behavior on part of the farmers, their organizations, and their creditors. The resulting over-capacity was not limited to the regional level, idle 46
capital was created on the farms too. In addition, several studies suggest that during the late seventies and early eighties saving rates in moshavim declined considerably (Gal 1984, Artzy 1985, and Zusman 1988) which, along with increased investment in productive capacity, housing and other durable consumer goods led to increased borrowing and excessive farm financial leveraging (debt to capital ratios).

Evidently, cooperative agriculture thas followed an inefficient path: over-investment in productive capacity, especially in support services; over-investment in housing and durable consumer goods, and considerable under-saving. Besides the welfare losses experienced in the last decade, present conditions in agriculture are certain to entail additional welfare losses in the future. This is because the present composition of physical capital is non-optimal and because farmers' financial exposure-and existing credit arrangements will 1intir qmonth functioning of agricultural credit mPrket-, t 1-t. co some of the farmers. Tn particular, the weaker farmers are bound to face grave difficulties in raising capital resources in the future as a result of the disintegration of first and second order cooperatives. Of course, to the extent that more efficient alternative institutions will replace those that failed, there may be a net benefit; but whether this would actually happen is not at all certain.

The distributional effects are somewhat inconclusive. Welfare losses in the past were only partly borne by farmers. It is not impossible that for some time, at least, farmers even benefited. The main losers, apparently, have been banks and tax payers. The distribution of future losses depends on the way the current crisis is solved. If the debt settlement promoted now (Section G) is eventually accepted by all parties and implemented,- the main losers will again be the tax payers. Otherwise, the banks and the farmers will have to share the losses in yet unpredictable proportions.

# 3. Evaluation

It may be that we are witnessing end of cooperation in credit in the family farm in Israel (the kibbutzim conduct all their economic activity collectively and credit will not be an exception). Clearly, 47
for many years now financial activity in the moshavim will by and large differ substantially from its mode of operation before 1986. We are already witnessing members in moshavim raising privately credit for investment in capital assets. Since a great pars f the investment on the farm can be done piecemeal--particularly inves ment in orchards and livestock--most farmers may find that they do not lack the resources to expand their operation at an-optimal pace. Marketing agencies and wholesalers are also ready to finance short term needs, again mostly on a private basis. At the same time farmers are reluctant to return to any form of mutual guaranties. It may well be therefore that cooperation will continue in agriculture; but it will be limited to cooperation in production services, in jpurchasing of inputs, and in marketing--some specialized and partial cooperative associations, of. dairy farmers for example, have already sprung up in moshavim--and there will not be a return to the earlier form of comprehensive cooperation. On the other hand, it may also turn out that some of the moshavim will attempt to maintain or revive comprehensive cooperation, including in credit. Revival of cooperative credit was the goal of Gibton and Raviv Committees (1986, 1987) and is the intention of the . administration of the new arrangements for the solution of the crisis.

The major issues and intellectual challenges in considering revival of cooperation in credit are: (a) To identify environmental conditions conducive to successful agricultural credit cooperatives, and those under which failure is most likely; setting up credit cooperatives under the latter conditions is certainly inadvisable. (b) Where cooperation stands a good chance of succeeding, to determine the structural and procedural designs of cooperative organizations that maximize expected net benefits; that is, the expected gains from cooperative action minus expected losses due to structural weaknesses.

# 4. Prerequisites

The principal prerequisites for successful credit cooperation are cultural. Successful cooperatives can evolve only in a cultural environment supportive of cooperation and collective actions. Unrestrained individualism is not likely to breed successful 48
cooperation. This applies especially to the moral basis of society4". Credit cooperatives also require leadership and professionals, primarily accountants and financial experts. Without a proper and updated accounting system, a credit cooperative is bound to fail. In addition to intellectual and moral integrity, which are absolute requirements of the leadership, it should also possess some understanding and have familiarity with financial affairs. No internal or external control mechanism can substitute for intellectual and moral integrity; and complete leadership ignorance cannot be fully remedied by hiring professionals.

Members' default on their obligations of debt repayment is the primary cause of failure of credit cooperatives. The availability of inexpensive enforcement mechanism is, therefore, a necessary conaition for a successful credit cooperative. Adequate control over the marketing of members' output ia'a good enforcement device. Where such control is impossible, other, easy to handle forms of collateral are required. In this respect the credit cooperative should be able to act - as any other lender.

# 5. The Moshav Association<sup>1 2</sup>

The recent financial crisis has brought out very clearly the failure of mutual liability; it encouraged over-borrowing when that was possible and could not be enforced when the need arose. Restricting mutual liability arrangements is, therefore, the principal structural reform necessary. In particular, the size of debt secured by mutual liability that any member is entitled to should be strictly limited. A member wishing to borrow above that ceiling should be required to provide personal guaranties by way of appropriate collateral or third party guaranty notes. It is thus implied that the mutual liability obligations of every member of the moshav would also be limited. These limits should, perhaps, be established as moshav by-laws and thus be

# "See, for instance, Banfield (1958).

'<sup>2</sup> Many of the conclusions presented below are based on Ravid Committee (1987).

49
integrated into the moshav constitutional setup.

# 6. Second Order Associations

The underlying structural faults that made the regioanls the mainspring of the recent moshav financial difficulties are poor members' control characteristic of second order cooperation, the moral --- hazard behavior associated with mutual liability arrangements<sup>and the</sup> political nature of the organization. Several lessons can be derived from this experiendc.

(a) Regional purchasing cooperatives should not function as financial intermediaries and should concentrate on requisitioning alone, passing-over suppliers credit to their patrons the moshavim.

(b) Secondary cooperatives should never guarantee loans to other borrowers. Neither should they seek external guarantees for their own debt.

(c) Secondary cooperatives should have sufficient equity to back their fixed payment obligations.

(d) A regional supply cooperative should not own equity in other secondary cooperative enterprises, neither-should it extend<sup>loans to</sup> these organizations. The equity capital of all regional second<sup>order</sup> cooperatives should consist solely of contribution by member associations, who would thereby retain full. and undivided<sup>decision</sup> control over these ventures.

(e) Control of the supply cooperatives should be strengthened by<sup>adding</sup> external independent directors to their boards.

(f) Exit from second order cooperatives should be facilitated.<sup>To this</sup> end, a certain part of the secondary cooperatives' capital<sup>should be</sup> maintained in the form of returnable funds, which would allow a member-association to redeem at least part of its equity share<sup>upon</sup> termination of membership. Control through exit will thus be reinforced.

(g) The role of auditors should be strengthened. Boards should be able to change auditors freely.

50
# 7. Policy

Given the propensity of first and second order moshav cooperatives to over-borrow, could the government avoid the associated welfare losses?

It should first be emphasized that the government cannot and should not seek to control directly the borrowing behavior of farmers' cooperatives. The membership should see to it by creating more effective governance structure, and by setting up internal mechanisms designed to check over-borrowing. Financial intermediaries, such as banks, should be aware of their share in the risk of the ventures they support and should therefore provide the necessary external controls. Government policy seems to have erred on two counts: (i) it followed an excessively liberal credit policy; and (ii) it created the false impression that the government will always provide farmers and their cooperative organizations with a financial safety-net.

We summa.ize our conclusions in the following recommendations: (a) The extension of agricultural credit under preferential terms should be minimized. This should be reflected in lower subsidization rates and in reduced amounts 7f subsidized credit.

(b) Government should avoid by all means the creation of any misconception regarding its commitment to aid farmers in firencial difficulties. To be sure, the government should take measures to alleviate farmers' financial distress caused by adverse environmental fluctuations or by temporarily depressed markets. However, little or no assistance should be extended when the financial difficulties are due to other reasons. Furthermore, even when financial support is justified, it should be limited so as not to create unfounded expectations regarding future government support.

(c) The government should be instrumental in creating institutional structures to control over-borrowing by farmers and farmer associations. The suggested revival of concentrated credit (Section F) is worth exploring, for it may contain the potential for productiove collaboration between banks and farmers' credit cooperatives.

(d) The government should legislate changes in cooperative law and regulations that will enhance internal and external control over the 51
cooperatives financial integrity. The<sup>credit cooperative governance</sup> structure should be strengthened. The<sup>registrar of cooperative</sup> societies should be authorized and<sup>required to exercise external</sup> control on credit cooperatives' financial<sup>integrity.</sup> 52