World Bank Reprint Series: Number 410 Avishay Braverman and I. Luis Guasch Ru:ral Credit Markets and Institutions in Deeveloping Countries Lessons for Policy Aalysis from Practice and Modern Theory Reprinted with permission from World DevelopmeWt, vol. 14, no. 10/11 (October/November 1986), pp. 1253-1267, published by Pergamon Joumals Ltd., Oxford, United Kingdom. World Development, Vol. 14, No. 10/11, pp. 1253-1267, 1986. 0305-750X/86 $3.00 + 0.00 Printed in Great Britain. Pergamon Journals Ltd. Rural Credit Markets and Institutions in Developing Countries: Lessons for Policy Analysis from Practice and Modern Theory AVISHAY BRAVERMAN The World Bank, Washington, D. C. and J. LUIS GUASCH* University of California, San Diego Summary. - We present the evidence of government intervention in rural credit markets of LDCs in the past three decades and confront it with modern theory. That evidence shows a significant failure of subsidized credit programs either to achieve an increase of agricultural output cost-effectively or to improve rural income distribution and alleviate poverty. In addition, many of the financial institutions that were created to channel rural credit have been shown to be inept and lacking accountability. Modern theory has focused mostly on two areas, credit rationing in competitive markets and interlinking of credit contracts with labor and land contracts. We outline the policy implications of these theories and find them insufficient to account for the empirical evidence. We contend that a more systematic and rigorous analysis of institutions and institutional environments is essential for understanding and implementing effective policy reforms of rural credit markets. We present suggestions for undertaking such an analysis. 1. INTRODUCTION The failures of subsidized rural credit are frequently laid at the feet of the institutions that It is currently a mark of sophistication in presenting were created to manage it. Their performance econQmic models not to mention institutions. But raises serious doubts about the efficacy of for all that, it is a significant trait of contemporary government-funded financial institutions in the economics that, despite this omission, it manages rural sector. There are some success stories, somehow to find support for institutional change. It however, which demonstrate the possibilities of is a neat trick, but it cannot hide the fact that in .' thinking about institutions, the analytical cupboard approprate envlironments and effective policies is bare. (Schultz, 1968)' and shed light on the ingredients necessary for successful institutional reforms. During the 1960s and 1970s subsidized rural Policy choices should be based on clear de- credit was seen as one answer to low productivity scriptions of the policy objectives and on analysis aind poverty in the agricultural sectors of of the expected effect of each policy considered, developing countries. There is now an emerging given specific socio-potitical and economic con- consensus among the development community that rural credit subsidies do not work. Increases in agricultural output have not been achieved *The World Bank does not accept responsibility for the cost-effectively, and rural income distribution views expressed herein which are those of the authors and rural savings rates have deteriorated. Faced and should not be attributed to the World Bank or to its and rural disappoingsratingv desulterratefl Fedes affiliated organizations. We are thankful to Ed Schuh, with these disappointing results, careful students Joe Stiglitz, Judith Tendler and Jonathan Morduch for of rural credit markets such as Dale Adams, helpful comments and to Colleen Roberts for editorial Claudio Gonzalez-Vega, and John von Pischke assistance. In addition, Guasch gratefully acknow- have concluded that rural credit should not be ledges partial support from the National Science subsidized. Foundation under Grant #SES-840219. 1253 1254 WORLD DEVELOPMIENT straints. The main objectives of rural develop- sound methodologies for formulat.ng effective ment are wide-ranging. They include increasing policies in light of practical experience and new agricultural output and productivity, inducing the developments in theory. It is structured as optimal rate of new technology adoption and follows: The following sectioti summarizes the input and output mix, improving income distribu- conclusions regarding the impact of rurai credit tion, reducing rural poverty, and increasing rural subsidization and the funding of rural financial employment. Though subsidizing rural credit is institutions in LDCs from case studies over the commonly discussed as a means of reacching many last two decades. The third section compares this of these sometimes conflicting objectives, it is evidence with the insights provided by the clearly only one of the policy instruments used to modern theory of incentives and credit markets. achieve them. Therefore any methodology for Finally, the fourth section suggests conceptual policy analysis in rural credit markets should frameworks for: (i) a methodology for credit integrate the whole set of the other policy policy analysis which allows comparison with instruments. More often than not, however, each other policy instruments and (ii) a methodology policy instrument is analyzed separatelv without for analyzing reforms of rural financial institu- the appropriate framework for comparison with tions. Specifics of these frameworks will be other policy instruments. presented in a companion piece. The relevant policy choices open for examin- ation fall into these hroad categories: (1) Abolish credit suibsidies but maintain the existing institutions under the assumption that abolishing subsidies 2. RURAL CREDIT MARKETS: EVIDENCE will remedy major inefficiencies and disorders mainly due to excess demand Until recently conventional wisdom held that for underpriced funds; or imposing low ceilings on interest rates and (2) dismantle government-funded financial allocating massive amounts of credit to rural institutions and abolish credit subsidies, financial markets would speed rural development letting the informal markets and com- and improve income distribution. But by and mercial banks fill the gap. In other large policies directed along these lines have words, retreat to the position prior to failed. Indeed, most often they have made government intervention, or matters worse. Low interest rate ceilings provide (3) do not rule out the possibilities for rural income transfers to loan recipients, distorting the credit subsidies or public financial in- real price ratio of investment opportunities by stitutions. On a case-bv-case basis, undervaltuing the real cost of capital in different analyze the institutionai structure and sectors. To the standard cost of distorted re- then, if possible, design and implement source allocation, add the specific costs and institutional reforms with appropriate consequences of implementing credit programs incentive schemes in order to produce in rural financial markets for the full measure of sound management. Then compare the impact. The record overwhelmingly shows credit costs and benefits of credit subsidies programs' objectives have not been met. with feasible price or non-price policy These credit policv failures can be attributed to instruments, including the non- basic flaws intrinsic to formal rural credit markets interventioni state.2 out of which arise persistent problems as de- Though so far institutional reforms have not scribed in Table 1. We elaborate further on had great success, efforts to achieve them cannot some of these points below.3 be completely abandoned. Depending solely on indigenous market forces to emerge and achieve the desired results is unrealistic, and since many LDCs initially exclude the role of private banks, (a) Allocadtion of credit there is no other way than to continue struggling with the challenge of institutional reforms. This If indeed one of the objectives of a credit may be attempted through movements to in- program is to reach a large number of targeted crease privatization and decentralization of small rural farmers, then by and large most financial institutions, and through properly de- programs can be deemed failures. Despite the signed incentive mechanisms which mimic remarkable expansion of credit throughout rural competitive forces in reducing incentives for areas in developing countries over the last three corruption ahd lack of accountability. decades, only a small fraction of the farmers in This paper's purpose is to explore potentially low income countries seem to have received or RURAL CREDIT IN DEVELOPINCi COUNTRIES 1255 Iable 1. (haracrerisdcs of r uxral financial markets Basic flaws Weakness of competitive forces. Weak legal enforcement of contracts. Corruption and lack of accountability in in.,fituaion-,. patronage and income transfer practices, which are partly due to poorly designed or non-existent incentive mechanisms to inducc accountability on both sides of the market. Significant information problems and uncertainty regarding the abilitv of borrowers to meet future loan Inalbilitv to monitor the use of funds. Lack of collateral often due to land tenure arrangements or ill-defined property rights (e.g, parts of Africa). Lack of coherent financial savings mobilization program. Hligher opportunity cost of capital in other sectors because of interest rate ceilings. Persistent problemns Credit loans to wealthy farmers, small farmers rationed out of the credit market. Loans for agricultural programs diverted to non-agricultural uses. Credit policies that encourage consumption and discourage savings. The term structure of agricultural loans contracts or fails to expand. Low adoption rates of cost-saving technologies in agriculture and in financial services. Low recovery rate. Significant distortions in the optimal allocation of resources across markets. Extensive use of interlinking credit contracts with labor and land contracts. benefited from such credit. It has been estimated information about rural customers, Their credit that only 5(% of farms in Africa and about 15% in allocation policies tend to be based on observable Asia and Latin America have had access to wealth or ability to provide collateral. Therefore fortnal credit. Rather than equalizing income they do not ration the large landholders. But the inequality, low interest rate credit programs have intermediate or medium-size landholders are increased it; 5'X) of borrowers have received 80% rationed, and the small farmers are screened of the credit. Policies that allocate credit to out.4 Substantial costs in processing and farmers indiscriminately provide larger loans to administering loans, with returns increasing as a larger landholders when all credit demands are function of loan size, strengthen the incentives to fulfilled. This is because larger landholders re- maintain such policies;5 because of those scale quire larger loans even if there are decreasing effects, targeting small farmers is a problem returns to credit per hectare and per farm size. whether or not interest rates are subsidized. This is also true if excess demand gives rise to Hlowever, subsidized credit worsens the problem, rationing. since it increases the demand for loans at all If credit program interest rates are not market levels. Thus, given a fixed supply of capital the rates - this is so for most programs implemented rationing to small farmers will be even more in rural financial markets (RFM) - they do not severe. reflect the true cost of capital. This results in a Formal credit has not often reached the small sutbsidy or income transfer to loan recipients. The farmers, just as often this credit has been shifted larger the size of the loan, the larger will be the out of the agriculture sector altogether. Esti- subsidy or income transfer. Thus larger landhold- mates of the percentage of rural credit channeled ers receive larger income transfers and income for non-agricultural purposes have ranged from inequality increases. The problem is exacerbated 20% to 40% of total funds. Fungibility of loans because rationing is not equiproportional to and distortions in the opportunity cost of capital demands. Since commercial banks and special- across sectors are the explanations. The obvious ized farm credit organizations tend not to be consequence is a further slowdown of the rural located in rural settings, they possess limited development process. 1256 WORLD DEVELOPMENT (b) Improper credit practices at the expense of the an increasing likelihood that small fariners are poor screened out of the loan market. Loans at fixed nominal interest rates are predictably generators of poor investments, mis- (d) Savings mnobilization allocations, borrowing for arbitrage and become even more attractive to the well-to-do in the Interest rate ceilings have detrimental effects presence of high inflation rates (e.g., in Latin not only on the viability of financial institutions America). Under these circumstances, it is not but for the economy as a whole. Ceilings create surprising that credit is allocated in return for disincentives for savings or accumulation of political bncrefits or as compenisation for favors, capital; limitations on external borrowing make rather than according to need or efficiency. internal generation of capital vital for a proper Examples abound (see Landman and Tinner- functioninig of the rural sector. meir, 1981 in Bolivia and Robert, 1979 in India Commercial banks and state-funded institu- for a sampling). This phenomenon is reinforced tions have not mobilized much rural savings. The by the specialized farm credit institutions that estimate of the percentage of loanable funds operate without active competition or account- from rural sources has ranged from 5% to 40%, ability. Monopoly power from nonprofit institu- with the median much closer to the former than tions fosters patronage, corruption, and other the latter figure. Most of the high estimates came forms of inefficiency and inequality wherever -from farmers' cooperative efforts like rotating markets lack the forces of competition. savings and credit associations, chit funds, and Widely used schemes by countries searching other forms of forced savings or insurance for revenue-generating mechanisms tax agricul- programs. Taiwan and Korea have been among tural output - often to the detriment of poor the most successful examples of savings mobiliz- farmers. Brazil, for example, has among other ation, due to the bottom-up formation of an things, a value-added or export tax on agricul- extensive network of cooperatives, coupled witk tural output. A subsidized credit policy is often a government policy of positive real interest rates the consequence of such taxes; subsidized credit (see Lipton, 1981, for an illuminating analysis of is provided as a means of offsetting the export the problem). taxes, both implicit and explicit. In these cases, those who do not receive credit bear most of the burden of the tax. This makes possible the (e) Recovery rates and bankrtuptcy perverse situation whereby small farmers - the nonrecipients - subsidize large farmers - the Successful credit programs have high recovery recipients of credit. rates. Subsidized credit programs also fail in this regard. Most studies report low recovery rates. Defining default as a loan overdue for repay- ment, those studies have indicated default rates (c) Loani termn structure ranging, with a few exceptions, from 40% to 95% for credit programs in Africa, the Middle East, Public institutions' main operations are short- and Latin America. Similar results have been term loans to organized groups or single farmers. reported in South and Southeast Asia. East Asia Oinly a small part is long-term. For example, in is the exception: the high recovery rates for Mexico, Banrural does not have more than 151% Korea, Taiwan, and Japan are frequently attri- of its portfolio in long-term loans. Commercial buted to strong village cooperative systems which banks there also tend to finance largely short- have provided a strong incentive and enforce- term loans to large farmers and agrobusiness. ment system. The rationale for this emphasis on short-term Looking at the timing of default over the life of loans in the rural sector varies. Perhaps the most a credit program illuminates some of the issues common is the belief that cheap loans should be behind default rates. The history of programs not collected quickly, especially in regimes of high requiring any collateral - making all farmers inflation, since inflation often decapitalizes banks eligible - shows that the recovery rate is when interest rates are set by decree. Clearly, unusually high at the beginning, but declines lack of collateral due to land tenure arrange- gradually over a program's life. The reasons are ments or lack of well-defined property rights declining screening quality over time, lax super- (e.g., in parts of Africa) are contributing factors, vision, and stronger incentives to default as The consequences are further inefficiencies in the the prospect of future loans diminishes. For use of capital, increases in noncompliance, and example, the BIMAS credit program in RURAL. CREDIT IN DEVELOPIN(G COUNTRIES 1257 Indonesia, implemented in 1970, reports recov- landlords and tenants are often in the form of ery rates of 9(5% for the first two years. After production loans and tied to the purchase of five years, however, recovery rates dropped fertilizer, seeds, and other forms of capital (see to 6O'";. Singh, 1984, Chap. 10; Braverman and Stiglitz, While there is no conclusive e idence regard- 1985) with different tenants paying different ing the relative compliance of small farmers interest rates on their loans (see Bardhan and versus large farmers, studies in Bangladesh, Rudra, 1978). These interlinkage practices have Bolivia, Colombia, Costa Rica and Ethiopia been viewed as a way to address the adverse show that on average poorer farmers have ' etter selection problem (Braverman and Guasch, records than the well-to-do farmers. They also 1984) and the moral hazard problem indigenous indicate that larger farmers have a poorer com- to these markets" (see e.g., Braverman and pliance record regarding cre(lit from organized Srinivasan, 1981; Braverman and Stiglitz, 1982; markets, while small farmers have a poorer Mitra, 1982; and Bell and Zusman 1980). record regarding credit from informal credit markets. But it should be noted that most larger farmers obtain credit from organized credit (g) Sucscess stories: Ingredients for refor,n markets while the smaller ones get it from the informal credit market, so these findings are Not every sinigle rural credit program predictable. Furthermore, the level of aggrega- implemented has failed. Some successes are tion in most of the studies is too high to allow reported here in order to examine which compo- sensible inferences. nents work best. The INVIERNO Development Bank pro- gram, implemented in Nicaragua in 1975, served (f) Iniforral lenlding and interlinking of credit the region containing the largest number of small contracts U'ith labor anid lan(d contracts producers and the lowest rural family incomes. Its results were extraordinary: the participation Informal lending was once the only form credit rate of small farms was more than 80%; the took in rural settings. Evidence stuggests that as maize yield per hectare doubled that of tra- farm size increases, private credit sources, village ditional methods; the rate of adoption of modern moneylenders and pawnbrokers, chit funds with technology was significantly high; and the an array of implicit interest rates, and friends or delinquency rate was only about 10%. Internal relatives grow less important than banks. With auditing of local office operations, cost the implementation of developmenit plans, offi- monitoring, technical help for operational cial lending complements but clearly does not procedures and new methods were combined in a supersede informal sources. policy that supported these successes. Sample surveys supply the infornmation on the Expeditious loan application and credit dis- extet'i of informal lending practices. They indi- bursement was also a major factor, together with cate that its volume is far greater than that of a long-term credit policy suggested by efficiency organized institutions, It is characterized by a arguments. Line of credit was devised for a five- much shorter processing time, better screening year period with flexible schedules for loan techniques or enforcement devices (noted in the repayment built into the contracts. lower default rate), and higher interest rates, A different success story emphasizing savings with a median around 50% and a variance much is found in the Republic of Korea (Lee, Kim and higher than institutionalized credit rate (see Adams, 1977). It is fairly representative of most Singh, 1968; Hlarris, 1982; Bottomlev, 1975 and East Asian countries. In the 1960s, Korea im- Desai, 1983). plemented an extensive network of rural coop- The lower delinquency rates reported in infor- eratives. They were organized in three levels: mal credit sources are to a large extent due to primary cooperatives at the tosvii;hip level; better assessment of creditworthiness ability to county cooperatives; and the National Agricul- exert social pressure for repaymen, and the ture Cooperative Federation at the national frequlent practice of tying (interlirKing) credit level. Participation levels were about 80%. The contracts with other input or output contracts. cooperatives provided farm inputs, farm product Docuimentation of the use and characteristics of marketing, credit and savings deposit services, the latter practice is quite extensive. Sharecrop- mutual insurance, and technical education. The ping contracts are quite often interlinked with stress on mobilizing rural financial savings was credit contracts (e.g. see Bharadwaj, 1974; perhaps the most distinguishing feature: while Bardhan. 1984; Binswanger et al., 1984; Bell deposits contributed only 20% of loanable funds and Srinivasan, 1985). Credit contracts between in 1961, and government funds nearly 60%. by 1258 WORLD DEVELOPMIENT 1975 the figures reversed to 51% and 19%, tions, however, began to raise doubts. Hodgman respectively. A strong government policy of (1960; 1962) was one of the first to present an positive real interest throughout most of the equilibrium theory of credit rationing based on period was crucial. Equally important may have profit-maximizing lenders operating under the been the bottom-up design of the cooperative assumption that the default risk was a function of system which was quite effective in providing loan size. He postulated that if the borrowers' secure and dependable savings opportunities for liabilities are bound by an amount no greater small farmers, thaii fir wealth, lenders find it optimal to set Kenya's Cooperative Saving Scheme initiated credit limits. No increase in interest rate could in 1970 is also noteworthy (von Pischke, 1983). It compensate lenders for the increased default risk is based on a system of weak forced savings. associated with a loan over the critical size. This Cooperative members are mostly small coffee asymmetry, or truncation, in the distribution of farmers. The scheme arranged payment to grow- returns is what makes credit limits the most ers for coffee sales by crediting it to their profitable strategy for lenders. His formulation accounts with the cooperative, rather than paying had a few limitations though. First, it could not cash. Along with positive real interest rates, this explain the fact that some borrowers obtained generated a viable lending organization - a kind loans while others, seemingly identical, did not; of implicit insurance or collateral scheme which this was so-called loan-quantity rationing as was very sucCessful in achieving high participa- opposed to loan-size rationing. Second, the tion rates and relatively low delinquency rates. interaction between lender behavior and borrow- More recent success stories are the UNO er demand was not built into the model. And program in Brazil and FUNDE in Nicaragua.7 finally, it did not take account of competition for The critical features in those programs were (i) making loans. that no new loans were to 1be given until old loans Jaffe and Modigliani (1969; 1976) extended were repaid, indicating that intertemporal linking Hodgman's work by explicitly introducing the of loans is an effective way to induce compliance, interaction between lender behavior and borrow- and (ii) that strict auditing and accounting er demand but two basic problems tainted their procedures were to be followed, suggesting th2 results. Their analysis was constrained within a value of monitoring technologies in inducing the pure monopoly framework, and the monopolist's desired behavior.8 strategies were limited by exogenous ceilings on interest rates. From a formal theoretical stand- point, both of these limitations should have been 3. CREDIT MARKET THEORY-BRIEF explained. But for the purpose of explaining the LITERATURE REVIEW past activity in RFM, they may be appropriate because usually one institution is given control of This section surveys recent developments in the supply of funds and operates under an the theory of credit markets and their usefulness imposed policy of a nominal interest rate ceiling. for policy analysis. Modern economic theory has From the policy standpoint, however, the im- focused on two areas: credit rationing in competi- plications of disposing of these restrictions should tive equilibria and interlinking of credit contracts be considered. with labor and land contracts in rural developing Most of the early literature ignored the effects economies.' Some of the main contributions to of information asymmetries prevalent in credit these two branches of the literature are discussed markets. So-called adverse selection and moral below."' This brief review demonstrates the hazard incentive problems are the most common limitations of current theory as an adequate base types in these settings and have been studied for policy analysis and reform of rural credit in mostly under the principal/agent arrangement LDCs. wheq-ein the agent contracts with the principal to perform a service for a fee. In principle, the fee can be anything - a pure inconme transfer, a (a) Credit rationing share of the proceeds, or any nonlinear form of a payment function. The contracting process is Traditional economic theory viewed financial modeled by allowing the principal to present the markets as no different from other rnarkets and agent with an all-or-nothing choice between the interest rates no different from other commodity principal's contract and severing the relationship. prices. Allocation induced by non-price rationing With the advent of the economics of informa- was perceived as a temporary phenomenon or tion, a flourishing literature on defaulting and away from tile equilibrium path (Samuelson, rationing in credit markets has developed. Jaffee 1952). The persistence of credit-rationing alloca- and Russell (1976), Keeton (1979), Stiglitz and RUIRAI CREIDIT IN D)EVEL.O1PIN(i COUNTRIES 1259 Weiss (1981), Bester (1985), O'Connell (1984) that high interest rates and large principals are and Gale and I-ellwig (1983), have all analyzed relatively more attractive to risky borrowers; this short-run loan models where the incentive prob- is the adverse selection effect. Interest is paid lem that arises in asymmetrical information only when the borrower does not default. This is frameworks gives rise to equilibrium with credit one of Stiglitz and Weiss' (1981) arguments and rationing. Several aspects of this phenomenon their lender equilibrium handles the adverse are described below. selection problem. They also point out a motal Jaffee and Russell (1976) in a two-period hazard problem. Increases in the interest rate, Fisherian consumption framework with two types while raising the return to successful loans, may of borrowers - "honest" and 'dishonest" - lead to adverse shifts in the risk composition of developed a model of credit rationing in which lenders' portfolios, increasing the probability of the former repay their loans even whien there is a default. It follows that increases in the interest financial incentive to default, while the latter rate may lead to a decrease in the expected default whenever financially advantageous. Since returns to lenders. Then the moral hazard and lenders cannot distinguish among borrowers, it adverse selection effects may render a market- might be best to ration credit in order that clearing interest rate non-optimal, leading to dishonest borrowers will not default even though credit rationing. In the context of RFMs, the doing so reduces the profitability of lending to moral hazard aspects concerning choice of pro- honest borrowers. Thus the optimal credit- jects involve choice of production technology, rationing policy depends on the proportion of use of loans (production vs. consumption) and honest borrowers because of the adverse selec- input mix. The adverse selection issue is the tion problem. In the absence of competition same, making their results applicable. among lenders, the most profitable contract does Recently, Bester (1985) modified those results not involve credit rationing; it pools all types of by showing that credit rationing might not be borrowers together. That type of contract might necessary in equilibrium if banks can compete by not function in the face of competition - offering contracts with different collateral re- unsustainability of pooling contracts in quiremnents and interest rates, an option not asymmetrical information frameworks is stan- considered by Stiglitz and Weiss. Perfect self- dard, i.e,, a new firm can design a new contract selection is obtained when high-risk borrowers and make positive profits attracting onlv the choose contracts with higher interest rates and honest borrowers away from the pooling con- lower collateral. This result assumes that borrow- tract. The only equilibrium possible then entails ers (in particular, those with low-risk) are not separation, and in most cases, credit rationing at constrained by the amount of collateral they can the offered interest rate. provide. In rural markets, however, there is a Keeton (1979) analyzes credit rationing as a real constraint. The collected evidence indicates result of incentive problems. lie devised condi- that securing loans through collateral is not often tions for equilibrium loan-size and loan-quantity feasible. In fact, a fair amount of loans are rationing. The Stiglitz and Weiss (1981) model is supplied without any collateral to small farmers similar. But while Keeton analyzes the problem lacking title to their property and producing in terms of borrowers who change project risks under tenancy arrangements. In addition, some when the terms of the contract change, Stiglitz states in India legally prohibit agricultural lend- and Weiss discuss changes in the underlying risk ers from using collateral such as land as security. of the borrowing population in connection with That clearly hampers the self-selection equi- variations in the interest rate and a fixed loan librium, throwing it back to credit-rationing as size. described by Stiglitz and Weiss.'I Most models from the information school of Because the inability of borrowers to relin- credit markets depict the failure of interest rates quish control over bankruptcy is one of the main to clear the market as a result of incentive factors leading to inefficient allocation in the problems indigenous to monitoring costs and credit market, implementing indirect controls to imperfect information. This is because the raise the cost of default should be considered. possibility of default and limited liabilities place a These include interlinking current credit trans- floor on the distributioni of net returns to actions with future access to credit and with borrowers. In a sense this creates incentives to transactions in other markets. These interlinkage choose riskier projects since the down risk is practices have been put forward as a way to limited. Borrowers' investment choices to some address the adverse selection and the moral extent determine default risk. These cannot be hazard problems indigenous to the rural credit observed by lenders and thus cannot be specified markets, In using them, the lender attempts to in loan agreements. Lending institutions realize induce borrowers to behave in a desired fashion, 1260 WORLD DEVELOPMENT presumably, decreasing the likelihood of default especially for government-backed institutions and thus raising profits. where screening borrower creditworthiness is not The present lack of effective enforcement carried out very thoroughly. mechanisms raises doubts about the ability of intertemporal disincentives to provide implicit insurance against default. It is assumed that (b) Interlitikinig of credit with other agrarian defaulting will be punished by a credit embargo, contracts thus imposing costs on the defaulter in terms of future ability to obtain working capital or to Two approaches have been put forward in the smooth consumption. However, there is not a past to explain why landlords (employers) trans- convincing story for the sustainability of the act with their tenants (workers) in credit. They embargo when lenders do not cooperate. are: (1) reduction of transaction costs and (2) Long-term relationships can be quite effective exploitation of weaker agents by more powerful in overcoming incentive problems; any mechan- ones (e.g., Bhaduri, 1973). Though both have ismns that promote cooperation ought to be merits under certain circumstances, they fail to strongly considered since it is through cooper- explain such interlinkages under a wider range of ation that most inefficiencies can be eliminated circumstances.13 In particular, they do not pay given proper accountability. The successful cases attention to the particular information structure, of UNO in Brazil and FUNDE in Nicaragua Even though information costs are part of the exemplify the benefits from long-term rela- transaction cost, it is essential to specify them in tionships. order to explain the details of the contractual Hellwig (1977) developed a fairly complete equilibrium, e.g, why some landlords may model capturing the essence of long-term credit subsidize tenants' credit while others charge their relationships. The incentives for that type of tenants higher interest rates. The exploitation contract are the gains derived from temporal theory fails to explain why monopolist landlords consumption-smoothing and risk-sharing. At choosing tenants (workers) from a pool of the each point in time, the lender has to make two "reserve army of the unemployed" need any decisions: (1) whether to renew the loan or extra instrument (credit) for exploitation beyond extend additional credit and (2) which interest the rental (tenant) or wage (worker) contract.'4 rate to charge. The model shows that credit limits As mentioned before, the modern theory of are useful instruments to control the likelihood of contractual equilibrium under imperfect informa- bankruptcy. Several criteria for evaluating tion focuses on the moral hazard and adverse enforceability of credit limits are then selection features commonly found in rural proposed.'2 developing economies. The "moral hazard" fea- In summnary, allocation of credit under tures as pertaining to the interlinking credit with competition in the form of rationing seems to be labor and land contracts are: induced by a variety of factors: (1) finiteness of (a) Individuals are not paid on the basis of borrowers' wealth; (2) adverse selection prob- their input (effort) in general since this lems; (3) moral hazard problems; and (4) is not observable and they often do not insufficient number of instruments. rent land for a fixed sum since that Let us note that this theory assumes that no imposes too much ;' k on them. Hence restrictions are imposed ex-ante on any of the the contractual arrangements involve at instruments available to the lenders and that least some form of sharecropping; as a firms behave (as expected) as profit-maximizers result, tenants do not obtain the full under a yiability constraint of positive profits. marginal product of their efforts. While the former assumption can be easily (b) The landlord cannot completely specify relaxed, the latter one is crucial and significantly the actions to be taken by the tenant: affects results. the tenant has considerable discretion The adverse selection and moral hazard prob- both with respect to the allocation and lems seem less severe for the informal or village level of effort, and the choice of produc- money lenders than for the organized commer- tion technique. Some of these decisions cial lending institutions, indicated by the fact that may be easily monitored by the land- the default rate for the latter is much higher than lord, but there are others, perhaps for the former. Information available to the local equally important, for which the cost of money lender is more extensive, more accurate, monitoring would be very high. and easier to obtain than for the formal institu- The tenant's considerable discretion over his own tion. Indeed, as experience has demonstrated, actions combined with their significant impact on this is a major problem for organized lending, the landlord's expected profits - have some Rl'RAI. (CREDII IN DlIVFl.0)PIN(i (OUNTRIUS 1261 further implications. In particular, the landlord and Stiglitz (1986) have shoewn that thtere is no has an incentive to induce tenants to behave as he presurmlption that innovation results either in a wishes. This is attempted through influencing the reduction or in an increase in tenants' demand amount and terms (if credit the tenant borrows for credit. Whether the demand for credit itself is and by the goods he can purchase and the prices increased or decreased depends critically on both he pays. how the technical change affects the probability The behavior affected includes the effort distribution of yields and on tenants' utility supplied by the tenrant and the choice of tech- functions. The presence of interlinkage between niqLue (risk distribution) applied by him. For credit and land markets does not preclude either instance, if the landlord makes credit less expens- resistance to or encouragement of the adoption ive, unider reasonable conditions the tenant will of technological innovations. Either is possible. be inducetd to borrow more. If there are sesere In some cases, it might actually encourage the penalties aLssoCiatedl with default (e.g., bonded adoption of some techniologies which otherwise labor), the tenant will then need to work harder would not be adopted, even thiough the inno- to avoid this contingency. vation itself reduces tenants' demand for credit, Sim-ilarly the landlord mTay observe that his As explained before, the amount borrowed tenants are eCrlplovinu techniques of production affects the landlord's return (through its effect which are too safe; the landlord's income might both on the tenants' effort and on his decisions be increased if his tenants were willing to employ concerning choices of technique), and converse- techniques with higher means and higher ly, the terms of the landlord's contract affect vatrianes, lie may note that his tenants are returns to the lender (through its effect on the acting in a particularly risk-averse manner be- likelihood of default). Interlinkage was a method cause of the consequences of defaulting on bv which these "externalities" could be internal- outstanding loans. To change their behavior, the ized. What then concerns the landlord-cum- landlord may require that his tenants onlv lender is the total impact of the innovation on his borrow from him. lIe may charge them interest income; the decomposition of his income into a above the market rate in order to induce them to return as a lender, or return as a landlord, has no limit their borrowing, and at the same time lie particular significance. So it becomes clear that may offer a tenancy contract which is much more the impact of an innovation on a landlord-cum- attractive in some other dimensions. Such a lender mav be quite different from the impact of phenomenon (e.g., Braverman and Stiglitz, the same innovation on a landlord who does not 1982) prevails both in competitive and non- control the borrowing activities of his tenants. competitive environments and shifts the utilities possibilities frontier. Since interlinking is really the internalization of the externality from the (c) PolicY relevatnce credit to the labor/land markets in the absence of a complete set of markets, the utilities possibili- The credit rationing theory implies that under ties frontier moves outward while the distribution a policy of no restrictions on interest rates and in effects of interlinkage are ambiguous. The a competitive environment, credit will be rationale for interlinkage becomes ever stronger rationed. Anv intervention in that market other where law or custom restricts certain contractual than to alleviate informational constraints will do arrangements, for example usury laws or floors more harm than good. This theory assumes that en tenants' crop shares (see Braverman and institutions behave "appropriately." However, it Srinivasan, 1981). has little to say about rampant corruption or Another rationale for interlinking is the mishandling of funds by individuals in lending "adverse selection" effect, where interlinking institutions. It is only by correcting or allowing credit and tenancy contracts may screen the for that behavior in organizations that sensible high-ability from the low-ability types (see predictions about rural credit in LDCs can be Braverman and Guasch, 1984)."5 generated. A new theory of incentives and The phenomenon of interlinking credit and monitoring embedded within the actual oper- tenancy contracts was stated bv Bhaduri (1973) ational framework of the LDC's lending iuistitu- to be an obstacle to technological innovation. Hlis tions might be a more appropriate assistant for argument was that innovations which make analyzing and designing corrective mechanisms. tenants better off reduce their de-mand for credit The main conclusion of the interlinking theory and thus make landlords (cum-creditors) worse for policy is that partial reforms in the credit off. Sriniivasan (1979) using Bhaduri's model, has market alone, such as ceilings of interest rate in argued against Bhaduri's contentioii that innova- the informal market or disallowing credit linking tions lead to lower demrand for credit. B13averman may decrease efficiency, often without gains in 1262 WORM) IFVEL.OPMENT improving the distribution of income. Sound One is to construct a suitable framework for policy reforms, then, need to take accourt of the comparing credit subsidies with other policy institutional structure of the particular rural instruments. The other is to analyze institutions economy. Reforms in several markets simultani- and institutional environments based on indi- eously are required as well as recognition of the vidual and organizational incentives and importance of existing informal credit markets. monitoring schemes. Neither the theory of ciedit rationing nor the As stated in Section 3, the contribution of theory of interlinking has much to say about the current theory to policy analysis in this area is accountability issues of the institutions them- limited in several ways. First, the methods for selves in the face of weak or semi-corrupt legal assessing the impact of credit allocation have environments. Given such environments, any of most often been carried out in an operational the past or present subsidized interest rate vacuum. The effects of credit policy instruments policies is easily questioned. The most prevalent have been examined neither in comparison with argument in their favor is that, without them, other fiscal instruments (taxes or subsidies) nor adoption of technological innovations would be in the context of policy mixes. Second, the theory delayed and costly inputs like fertilizer would he is still weak on the internal oxganization of the underutilized, with the result that the growth of institutions and the legal/institutional environ- output and the development of the agricultural ment through which credit is channeled. Third, sector would be slowed. Hlowever, it is not clear predictions made using credit theory are mainly that either one of these objectives has been based on profit-maximizing objectives for private attained cost effectively. It has also been clainmed credit institutions facing positive profit as a that high-priced capital would foster poverty by viability constraint. This contrasts with the reality screening out small farmers from the credit of rural credit markets which operate in environ- markets. The institutional failure to channel ments where objectives are not often so well- credit to poor small farmers under subsidized defined and corruption is rampant. Even when interest rate programs ought to silence the latter legitimate objectives are defined, there is no argument once and for aBl. Given the overall system of incentives to accomplish them. adverse effects of cheap credit programs, In order to contribute to the formulation of continuation of rural credit subsidies should be sound economic policy, credit theory needs to seriously questioned. Only when the institutional incorporate all these factors. Otherwise, the structure has proven that it can channel funds current gap between theory and practice will appropriately should they again he considered continue to widen. and then only after comparison with alternative policy instruments. It should be remembered, though, that given (a) Afrwn?2ewlorkfoiretvaliuatiing mixvfesz the pk'evailing '"urban bias" in most LDCs,'" policy' instruments these arguments cannot be taken as advocating the increase of overall subsidization of the urban A suitable framework for policy analysis sector. Similar arguments concerning account- should include definitions of: (1) policy objec- ability and misuse of funds should be applied to tives; (2) policv control variables; and (3) the the urban sector as well. In addition, the evalu- institutional environment. Credit programs usu- ation of a set of particular subsidies to agriculture allv aim at a set of objectives including increased should be coniducted in the overall economic agricultural output and agricultural productivity, context. If there are sustained and successful reduction of the urban bias, improved rural political pressures to subsidize the activities in income distribution, alleviation of rural poverty, the urban sector, which are often non-economic and inducement of the optimal rate of adoption and regressive, utilization of countervailing sub- of technological innovations and optimal input sidies to the agricultural sector as "second best" and output mix. Given the institutional structure instrunents, are legitimate options to consider.17 of many developing countries, some of these The "first best" alternative is clearly to remove objectives are b ound to conflict. And some can the urban bias directly. be achieved with other policy instruments such as taxes, subsidies, and public investments. In the past, the relationship between the chosen objec- 4. SUGGESTED METHODOLOGIES FOR tives has not often been clearlv stated. H-ence the CREDIT POLICY ANALYSIS IN LDCs clear need for a framework to compare alterna- tive policy instruments, especiallv in the context There are two analytical steps to support more of their impact on the government budget. credible policy work, They are complementary. Two methods to do this have been recently RURAI ('RED)IT IN DEVE1ILOPING COUNTRIEES 263 (developed(. Tlhey compare alterniative agricul- "institutional school." modern economic liter- turail price policies (taxes arid stIbsidies.) in ature has largely overlooked the analysis of developing countries. One is theoretical (Sah and institutions, institutional change, and reform Stiglitz, 1984). It utilizes thle optimal coinimiodlit) mechanisms in general, treating them as exogen- taxation framework (i.e., it maximizes a social ous o'lenents seldom analyzed with any rigor.'9 welfare functioni, suibject tto a reveniue constraint) The need for serious analysis of institutions in ordter to analyve alternative agricultural price cannot be overstated. Without a rigorous study policies. The otlher approach dlevelopedl by of institutions, their internal organization, and Braverman and I lamrrmer is anl operational oile. It motivation, policy recommendations are 'of incorporates insights from bioth the new public questionable value. More attention must be economics and thie literatuLe on agricultural focused on social norms, historical patterns, legal householdl mondels, captturing key substitutions systems, and management procedures. Competi- among agricultural commo(lities in pr-oductionI tive market forces should be mnimicked to the and consumption in a multi-market framework. extent they serve the goals sought through rural 'T'his methotd has been used tor policy anatlysis in credit policies. various countries."h It compares the impact of We suggest here an approach for such analy- alternaltive price policies for both inputs and ses. It emphasizes the role of the credit- outpluts on goverrnment revenlLe foreign ex- dispensing institutions as intermediaries beiween change. and the real ilcomes of dlifferecnt troups several parties. The government or lending in the rural and3 urban sector. Ihere is no explicit agency (principal) establishes a contract or optirriality fraine%' ork. Tht welfare impact on1 reward structure with the financial institution different groups is aggregated into welfare in- (intermediary). That party generates another dices after teti anl\e.. contract or subcontract with the farmers (agents) In order to modifv eithier of these approaches or with a subset of themii. All parties receive so that credit subsidies can be compared with information, somne of it common to all parties, other price (tax) instrLumncits, the fungibilitv of some exclusive to one. The system can be viewed credit, the information failures and other im- as a three-or-more-tiered structure or as a perfections peculiar to rural cre(lit markets have sequence of nested principal/agent relationships. to be properly incorporated. First-best analysis is Also the institution itself is a collection of of no use in most socioeconiojimic environments of overlapping principal(s)/agent(s) relations. Each LD)Cs. To resort o*nlv to first-best lPareto contdi- layer in the hierarchy of an organization can be tions as guidlance for policv is oftenl inappropriate thought of as the agent for the level just above it and the -constrained Pareto efficiencv" criteria and the principal for the layer below jt.2mm Various differ according to tlle particular conistrainlts. It is constraints should be incorporated to assess the details of the second-best solutions that are alternative corruption possibilities. relevant for welfare comparisons of alternative The principal/agent literature has contributed policies in developing country circumstances. substantially to the type of contracts that should Our view is. that a positive analyvsis is cailled for be used given informational constraints. How- before resortinig to eitlher cumbersome welfare ever, the literature has been mostly concerned criteria or irrelevanit ones. with two-tiered structures: principal(s) and agent(s), ignoring nested relationships of the sort exposed above and the incentives they generate. (b) lsdi.i.tio,imi/ anlalvsis atd design Nested relationships have appeared mostly in the context of the theory of the firm and its internal The other major task is to develop a method- organization (Calvo and Wellisz, 1979; Stiglitz, ology for analyzinig institutions and institutional 1975; Rosen. 1182'; Milgrom and Genakepoulos, environmnents, and for comparing institutional 1984; and (Guasch, 1985, among others). These reforms in rural financial organizations. To some agents in the multi-layered structure of firms, extent, failure of credit subsidy policies can be however, were severely limited in the range of attributed to the lack of incentive devices within strategies they could implement. Their behavior the institutions and to the inefficiencies and was rather passive. corruption intrinsic to rural financial institutions But wvhen there are mnore than two layers or facing minimum accountability and not confront- nested principal/agent relationships, and each ing a botnafide profit constraint. Thus the success element in the structure can take an active role in of future credit programs will depend on in- issuing commands, designing reward structures, crcaised emphasis on institutions and the and conveying information, the possibility of implementation of schemes to eradicate corrup- collusion among two or more adjacent parties in tion. Following the decline in attention to the the structure should not be ruled out. An analysis 1264 WORLD DEVELOPMENT of the factors likely to induce that sort of performancX of the disbursement of funds, some collusion should help design built-in disincentive efficiency from scale effects may be lost. But at mechanisms when that behavior is considered the same time the incentives for corruption and inappropriate. This would provide the base for patronage may be reduced. Likewise, a rotation control of and compensation for corruption that policy of key employers may shorten the benefits is absent from the current theory. The incentive- those individuals might derive from undesirable compatible mechanism most conducive for policies since benefits of collusive behavior will information transmission across layers is the one be short-lived. In addition, there will be a which should be preferred.21 distinction between the incentive effects of short- Moreover, when there is more than one agent term and long-term relationships of farmers with associated with a given principal (number is lending institutions. Long-term relationships are endogenous), or when the latter has access to advantageous in incentive design to the extent performance data on other agents, nevw incen- that they can escape the inefficiencies usually tives schemes based solely on observed perform- associated with the short-term equilibria of "one ance rank and called "contests" or "tourna- shot deals."23 ments" become feasible. The theoretical advan- We contend that a more systematic and rigor- tages of contests over more general schemes are ous analysis of institutions and institutional en- that there are fewer information requirements vironments is essential groundwork for effective and that they have the ability to compensate policy reform in rural credit markets and hope automatically for changes in conditions or risks the evidence has been convincing. In a compan- common to all agents.2 ion piece, the principles outlined above are used In reorganizing institutions into several par- for detailed institutional analysis of financial allel divisions, forcing them to compete among environments in LDCs. each other, and basing the rewards on relative NOTES 1. 'I'his particular quote has been also used by 9. For example, the casc of landlords/employers who Adelman and h ead (1983) who, like us, advocate the are also money lenders to their tenants and/or workers. urgent need for studying institutional structures in developing economies to provide effective guidance for 10. This survey is by no means, and does not intend to policy reforms. be, inclusive of all contributions to these subjects. 2. Clearly. analvsis of the impact of credit subsidies 11. See also Virmani (1982), Allen (1983), O'Connell has to address the terms of credit (e.g., subsidies) of the (1984) and Krahnen (1984) for further insights on credit industrial sector as well. rationing. 3. A major source for the evidence and conclusions 12. Other studies that analyze the benefits of long- covered in this section is von Pischke, Adams and term relationships are Eaton and Gersovitz (1981), Donald (1983). Sachs and Cohen (1984), Stiglitz and Weiss (1983) and O'Connell (1984). The emphasis there is on the 4. The reality, though, is that recovery rates are implementation of credit limits to induce compliance, often as bad or worse among larger farmers than small emphasizing optimal ways to penalize default. farmers. See below. 13. See Stiglitz (1986) for comparison of these two 5. The productivtty effects of subisidized credit have approaches to the one of inperfect inf'ormation. not been clearly established. For example, the conven- tional wisdom has it that operating expenses and 14. See Newbery (1975). investment per hectare were often higher per borrower, but that production differences and net farm income 15. One of the results obtained there is that under a per hectare were not very notable. heterogeneous population a monopolist landlord will increase his ability to extract surplus out of his tenants 6. For elaboration of these points see Section 3 through the interlinking of credit and tenancy markets. below. This case supports Bhaduri's (1973) conclusion. 7. For a comprehensive evaluation of the FLUNDE 16. See lipton (1977). program see Tendler el ciI. (1985). 17. See Braverman and Kanbur (1986) for an analysis 8. For a related analysis of the evidence in this of agricultural price reform in the face of sustained section and lessons learnt, see Adams and Vogel urban bias. (1986). RURAL ('REDI)I'I N DEVELO.PINGi ('()COUNTRIES 1265 18. See Braverman, Hlammer and Ahn (1983), the small farmer is part of the objective, the reward Braverman and Hiammer (1984) and Braverman, structure would be designed appropriately to induce Hammer and (iron (forthcoming) for methodological that behavior, rather than just measuring overall discussions and references to other studies. profitability of the ourstandinie, loan portfolio. A pure private sector approach would only be concerned with 19. Noted exceptions are Arrow's (1974) eloquent the latter measure. exposition of the benefits and limits of organizations, followers of the Simon school and Williamson (1975). 22. 'Ihese commonly observed schemes have been Institutional aspects are also strongly emphasized in the studied bv Lazear and Rosen (1981), fIolstrom (1982). works of North and Thomas (1973), Ruttan (1982) and Nalebuff and Stiglitz (1983), (Green and Stokey (1983) Schultz (t908). 'I'his latter work is lucidly summairized and Bhattacharya (1984). in Schuh's (1981) presidential address to the AAEA. 23. We should note that we are not implying that 20. For a comprehensive analysis of hierarchies see short-terrn credit ought to be eliminated. In fact, a fair Williamson (1975). percentage of small borrowers seem to prefer that form of credit with low transactions costs (i.e., credit for 21. A word of cauition is warranted here. Our working capital rather than for investment). We also suggested methodology is to derive the right set of are not ruling out the use of discretionary power of the incentives, along the lines described here, to induce lending institutions to use short-term credit as a compliance with the desired set ol' objectives. 'I'hus it screening or information gathering device. 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