FiLnance at the Frontier Debt Capacity and the Role of Credit in the Private Economy J. D. Von Pischke 'l'il a ip ( _, 7 EDI DEVELOPMENT STUImES Finance at the Frontier Debt Capacity and the Role of Credit in the Private Economy J. D. Von Pischke The World Bank Washington, D.C. Copyright i 1991 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of Arneica First printing June 1991 The Economic Development Institute (EDI) was established by the World Bank in 1955 to train officials concened with development planning, policymaking, investment analysis, and project implementation in member developing countries. At present the substance of the EDIs work emphasizes macroeconomic and sectoral economic policy analysis. Through a variety of courses, seninars, and workshops, most of which are given overseas in cooperation with local institutions, the EDI seeks to sharpen analytical skills used in policy analysis and to broaden understanding of the experience of individual countries with economic development In addition to furthering the EDI's pedagogical objectives, Policy Seminars provide forums for policymakers, academics, and Bank staff to exchange views on current development issues, proposals, and practices. Although the EDI's publications aredesigned to supportits training activities, many are of interest to a much broader audience. EDI materials, incduding any findings, interpretations, and conclusions, are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Because of the informality of this series and to make the publication available with the least possible delay, the manuscripthas notbeen edited as fully as would be the case with a moreformal document, and the World Bank accepts no responsibility for errors. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to Director, Publications Department, at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions for dassroom use is not required, though notification of such use having been made will be appredated. The backlist of publications by the World Bank is shown in the annual Index of Publications, which is availablefromPublications Sales UnitTheWorld Bank, 1818 HStreet, N.W.,Washington, D.C. 20433, U.S.A.,orfromPublications, Banquemondiale, 66, avenue d'I1na, 75116 Paris, France. J. D. Von Pischke is a senior operations officer in the World Bank's Asia Country Department I. Library of Congress Cataloging-in-Publication Data Von Pischke, J. D. Finance at the frontier: debt capacity and the role of credit in the private economy / J. D. Von Pischke. p. cm. - (EDI development studies) Includes bibliographical references and index. ISBN 0-8213-1818-7 1. Finance-Developing countries. 2. Economic development. 3. Credit-Developing countries. 4. Economic assistance-Developing countries. 1. Title. II. Series HG195.V66 1991 332'.09172'4-dc2O 91-17956 CIP EDI Catalog No. 340/051 CONTENTS Preface vii PART I. FINANCE AND FINANCIAL MARKETS I 1. Financial Markets Create Value 5 What Financial Markets Do 5 Term Structure 9 Transaction Costs and Value 11 Creating Value by Refining Valuation Processes 17 2. Value Generates Risk 25 Why Risk Pervades Finance 25 Risks Managed in Financial Markets 28 How Financial Markets Manage Risk 31 3. Characteristics of Finance 41 Finance Is Social 41 Finance Comes in a Tube.... 50 Finance Is Fungible 51 Credit Earns No Return for Borrowers 55 Finance Works to Close Tolerances 56 Finance Attracts Attention 58 iii iv Contents PART II. THE CONVENTIONAL ASSAULT ON THE FRONTIER 65 4. Credit Needs and Related Allocation Criteria 69 Basic Weaknesses of the Credit Need Criterion 70 Definitions of Credit Need 72 Quantifying Sector or Area Credit Needs 74 Quantifying a Loan Applicant's Credit Need 78 Credit Constraints Are Ambiguous 82 Credit Demand 87 Filling Financing Gaps 90 5. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 93 Overemphasizing Credit 94 Externally Imposed Lending Targets and Credit Quotas 99 Neglected Transaction Costs 106 Overlooked Incentives 108 Emphasis on Institutions Rather Than Instruments 110 6. Policy and Practice That Reduce Value at the Frontier 117 Artificially Low Interest Rates 118 Inadequate Reporting and Insufficient Accountability 127 Innovation and Efficiency from Information: Two Cases 131 7. Signs of Poor Fits at the Frontier 143 Irrelevant Lending Criteria 143 Unnaturally High Transaction Costs 147 Intensive and Extensive Credit Rationing 151 Loan Substitution 155 Loan Diversion 156 Poor Loan Collections 156 Unprofitable Intermediation 163 Irrelevant Reporting 166 Inappropriate Funding 168 Contents v PART III. STRUCTURAL CONSIDERATIONS IN FRONTIER DEVELOPMENT 171 8. Value for the People: Informal Finance 173 The Malicious Moneylender Myth 174 Private Actions by Public-Spirited Citizens: The Credit Union Epic 187 The Quality of Efforts to Replace Usurers 190 9. Creating Value at the Frontier through Innovation 199 Sustainable Innovations Reduce Costs 200 An Overview of Financial Development Processes 202 Competition and Complementarity of Formal and Informal Finance 208 Considerations for Financial Development 220 10. Creating Value at the Frontier in Market Niches: The Grand Synthesis 225 Common Concerns Revisited and Recast 226 Grameen Bank's Market Niche 232 Market Research for Decentralized Operations 237 The Development of Grameen Bank 238 Grameen Bank's Franchise 241 Is Grameen Bank's Franchise Potentially Vulnerable? 243 PART IV. A SUSTAINABLE STRATEGY FOR FRONTIER DEVELOPMENT 247 11. Lending Strategies and Development Leverage 251 Asset-Based Lending 252 Cash Flow Lending 257 Do Development Finance Institutions Apply Cash Flow Lending? 262 Intervene at the Frontier to Develop Confidence 269 vi Contents 12. Defining the Role of Credit by Determining Debt Capacity 277 Debt Capacity Calculation 278 Extending Debt Capacity Quantification 282 Debt Capacity and the Lending Environment 294 Debt Capacity: A Useful Developmental Concept 298 13. Principles for Responsive Intervention at the Frontier 301 Responses to Low Repayment Capacity 302 Whither Savings Mobilization? 310 Safeguarding Lenders 312 The Debt Capacity Perspective 316 14. Measuring the Results of Efforts to Expand the Frontier 317 The Frontier Revisited 317 Monitoring, Evaluation, and Sector Work 320 Issue I: Subproject and Subborrower Performance 325 Issue 2: Intermediary Performance 332 Focus of Analysis: Project Subloan Operations or Portfolio Segment 333 Focus of Analysis: The Lending Institution 361 Summary of the Analytical Framework 364 Issue 3: Financial Development Impact 364 Issue 4: Macroeconomic and Macrofinancial Impacts 377 Annexes A. The Repayment Index 383 The Mathematics of the Repayment Index 383 Applications of the Repayment Index 386 Limitations of the Repayment Index 387 B. Algebraic Treatment of the Repayment Index 391 References 395 Index 415 PREFACE To increase the flow of rural finance permanently and reliably, internationa, donors and governments in developing countries must endeavor to work with, rather than against, financial-market forces. -Edward J. Kane (Adams, Graham, and Von Pischke 1984) The first purpose of this book is to suggest how good loans can be made to individuals and firms at the "frontier." This frontier is not geographic, but market based. One one side are those parts of the legitimate economy that are not usually considered creditworthy by formal financial institutions, and on the other are the generally more prosperous entities that do have access to formal finance. Good loans are loans that are repaid according to the terms agreed on when they were issued. The second purpose of this book is to suggest how lending at the frontier can be remunerative to commercial banks, development banks and other development finance agencies that retail credit and assume credit risk. Remunerative lending is important because most lenders, regardless of their ownership and institutional form, tend to avoid activities that are not attractive. Unremunerative lending is transitory, unstable, and not robust in the face of adversity. Credit markets function poorly when lenders are not adequately rewarded. Experience at the frontier clearly indicates that weak financial institutions do not do a good job serving society in general and firms and individuals at the frontier in particular. Making good, remunerative loans is also important because governments and development assistance agencies try to make more vii viii Preface credit available at the frontier. Their stated intention is to promote development by bringing more people and activities within the frontier of formal finance. One result of their efforts is the accumulation of bad loans, which is often reflected in the poor financial condition of the state-owned banks and other lenders that have been given the task of lending to target groups that would not otherwise obtain credit from these lenders. The Prospective Reader This book is intended for readers interested in the relationship between finance and development at the firm and household levels and in the use of credit by individuals in low-income countries. One reason for such interest is the desire to use credit institutions to increase the productivity of groups without effective access, or with greatly limited access, to the financial system. The sheer volume of development assistance and of government efforts devoted to providing credit at the frontier have led to the involvement of many officials, economists, politicians, and systems specialists who might not otherwise have been inclined to become involved in financial intermediation or in financial policy and who have had little experience with credit markets, accounting, or finance. It is precisely for these technicians, officials, and politicians that this book is intended. This book will be of particular value to readers who share three characteristics. First, they have direct or indirect responsibility for credit decisions. Direct responsibility is exercised by approving or rejecting loan applications; indirect responsibility is exercised by designing credit projects or shaping policies that influence credit decisions. Second, they lack familiarity with the culture and routines of financial institutions that are subjected to credit risk and guided by commercial principles. For example, they have not worked with balance sheets or income statements or constructed sources and uses of funds statements during their professional careers or have not found these tasks helpful or meaningful. Third, their status as officials of a government or of a development assistance organization shields them from personal financial, career, or professional risks related to the performance of loans for which they have direct or indirect responsibility. Where these characteristics coincide, there is potential to do tremendous damage to financial markets even with the best of intentions, or to create great benefits if intentions can be expressed appropriately in projects and policies. Preface ix Others, including bankers, cooperative leaders, trainers, and students of development in general, may also find this book responsive to their concerns. What Lies Ahead The book begins with three chapters that explain what finance is about and the context in which it operates. Understanding the raw material helps in fashioning the finished product. Chapters 4 through 7 explore ways in which governments and development assistance agencies often attempt to help people or activities gain access to credit. These chapters discuss the conventional view of what should be done and how to go about it, and why this view leads to bad loans and unremunerative lending. Chapter 8 discusses informal finance beyond the frontier, which is provided by friends, family members, shopkeepers, landlords, moneylenders, and many others. These sources are often held in disdain by those who do not patronize them and who want to direct credit to people and activities who they think deserve credit. Informal financial arrangements, however, serve individuals and activities not served by the formal financial sector. They appear to perform well in many respects and should generally be regarded as socially useful. Chapters 9 through 11 present a strategy for making good loans at the frontier. Innovation is emphasized as a means by which financial markets develop, and attempts to create market niches are cited as a sign of dynamism in competitive markets. Cash flow lending is an important feature of innovative developmental finance. It delinks loan size from the value of tangible security, permitting broader distributional impact and facilitating structural change in the economy. Cash flow lending can develop only where levels of confidence are high. Intervention in financial markets can destroy confidence, but to be developmental it should create confidence. Debt capacity is defined in chapter 12 as sustainable borrowing power. Debt capacity is usually small beyond the frontier, and creating it should be the centerpiece of development assistance and of government efforts designed to use financial markets to assist those at and beyond the frontier. Chapter 13 points out that some of the most effective ways of creating debt capacity do not require intervention in financial markets and that within financial markets debt capacity is created in many ways other than the traditional development assistance format that directly increases the supply of loanable x Preface funds. Sustainable borrowing power is impossible without financially successful intermediaries, which are also extremely important for financial market development and for development in general. Chapter 14 presents a framework for measuring the results of projects and policies that attempt to expand the frontier of formal finance. This framework includes the activities of borrowers at the frontier, the operations of financial intermediaries, the state of financial markets, and the macroeconomic and macrofinancial implications of projects and policies operating in or through financial markets. Shortcuts and Who Should Take Them Readers already dissatisfied with the procedures and results of conventional donor-assisted credit projects and receptive to a new formula may wish to read only chapters 1-3, chapter 10, and chapters 11-14. Other readers fall into two groups. The first consists of economists who hold an internally inconsistent position. According to this view, development can occur efficiently if investments can be allocated to activities with high economic rates of return, but the financial performance of credit institutions entrusted with the allocation of donor, government, or even private funds is a trivial matter in this grand process, or possibly something of a nuisance. The second group consists of devotees of the conceptual foundations of conventional credit projects: directed credit through quotas and controls, subsidized interest rates, the irnportance of meeting credit needs, the inability of ordinary people in poor countries to save, the evils of informal finance, and the imperative to get the aid money out though credit projects to stimulate development. Both groups will find that all the chapters challenge their misconceptions. Acknowledgments The book has benefited greatly from comments given on earlier drafts by, among others, Dale W Adams, Ph. K. Heinrich Bechtel, F. J. A. Bouman, Ingrid Buxell, Dennis Casley, Dieter Elz, Hunt Howell, Chita Jarvis, William I. Jones, Peter Kilby, Timothy King, Araceli de Leon, Hans Mittendorf, Paul Murgatroyd, H. B. B. Oliver, Bertrand Renaud, John Rouse, Walter Schaefer-Kehnert, Turto Turtiainen, Jack Upper, Horst von Oppenfeld, and Jacob Yaron. John J. Dean, Peter Bailey Mateen Thobani, and Zheng Kangbin offered good advice on techncial points. Valuable editorial assistance was Preface xi received from John Didier and Alice Dowsett, and wordprocessing support was provided by Corazon Centeno, Daphne Glass, Susan Lucinski, Ann Millard, Juliet Nkojo, and, especially, Carmen Alvarado, who prepared later drafts, the final copy and graphics. This book originated from policy work conducted in the late 1970s and early 1980s in the Economics and Policy Division of the Agriculture Department of the World Bank, under the leadership of Graham Donaldson. It was developed further and more intensively in the Studies Unit of the World Bank's Economic Development Institute, headed by Timothy King. David Davies provided invaluable assistance in facilitating the author's posting to the Studies Unit. This book was substantially completed during the author's assignment to the Industry, Trade and Finance Division of the World Bank's Asia Technical Department, under V. S. Raghavan. To all those who have provided comments, guidance and other assistance, the author expresses profound thanks. Views, omissions and errors are attributable solely to the author. This book is dedicated to Dale W Adams, who-in an article in the American Journal of Agricultural Economics-without guilt cast the first stone.1 1. Dale W Adams, "Agricultural Credit in Latin America: A Critical Review of External Funding Policy," American Journal of Agricultural Economics. Vol. 53, No. 2, May 1971. pp. 163-172. Part I FINANCE AND FINANCIAL MARKETS Financial markets create value that contributes powerfully to economic growth and development. This book explores creation of value at the frontier of the formal financial system,' where official programs offer credit to small farmers and small businesses, and where entrepreneurial lenders offer new services to attract new clients. Finance Inside the Frontier Inside the financial frontier, formal intermediaries such as commercial banks, stock markets, credit unions, consumer finance companies, investment banks and insurance companies make up the financial sector. They operate under government charters, are subject to government supervision and reporting requirements, and are restricted by usury laws and by limitations on the types of services they may offer. These institutions tend to be organized on a formal, structured, hierarchical, impersonal and often centralized basis. Financial markets in which they are active offer a great variety of services, and include primary markets that bring together the parties to financial transactions that create new financial claims, and secondary markets in which existing financial claims are bought and sold. Most transactions inside the frontier, except for routine consumer purchases, are settled through accounts maintained with financial 1. Many months after title of this book was selected, the author found that the concept of the frontier had already been applied to the boundary between formal and informal activities by Hemando de Soto. In The Other Path: The Invisible Revolution in the Third World (New York: Harper & Row, 1989) he observes that, "since 61 percent of the hours worked in Peru are informal, there is obviously a long frontier between the informal sector and the state authorities" (p. 154). l 2 Finance at the Frortier intermediaries that make transfers of funds largely by mail or courier or electronically. Savings are deposited with modem financial institutions offering a variety of deposit arrangements with different combinations of maturity and interest rates. These are frequently protected by government insurance. Individuals often devote part of their savings to buying life, old age and other types of insurance. Bonds and stocks also attract the savings of individuals and of institutions, such as pension funds. Credit is widely available inside the frontier and virtually always carries an interest rate, although these rates do not reach the heights sometimes found outside the frontier. Loans are available in a range of maturities,2 extending possibly to 30 years for the purchase of land or the construction of buildings. Formal ownership claims, liens and legal infrastructure assist borrowers to obtain relatively large amounts of credit by lowering risk and the transaction costs of credit. Finance Beyond the Frontier Beyond the frontier of formal finance, most financial transactions are personalized and conducted directly, without intermediaries. Participants in finance outside the frontier include small-scale farmers and businesses, and members of households of modest means. In terms of numbers, these private entities dominate most economies. At and beyond the frontier most transactions are small and involve simultaneous exchanges of cash and goods or services. Savings are not deposited with modem financial institutions, but held in cash or converted into assets such as livestock, jewelry and business inventory that are regarded as secure stores of value that may be turned into cash relatively quickly. Savings may also be loaned to kin and friends under terms and conditions that include reciprocal assistance upon demand. Credit beyond the frontier is often scarce, expensive, or both, or so closely related to social ties that it carries no interest and is readily available, but only in small amounts. Ownership claims are rarely represented by easily transferable registered titles. Loans may be made among friends, family members and others linked by social bonds; by landlords to tenants; by merchants and traders to consumers, farmers, small businesses, and to buyers and tradesmen in their service; and by 2. Maturity occurs when a loan or guarantee becomes due for immediate payment. Finance and Financial Markets 3 professional moneylenders. Creditors and debtors deal face-to-face. These transactions, beyond the reach of government control and supervision, are regulated by custom, the negotiating skills of the parties concerned, and by competition among borrowers and lenders. The Frontier and Development With development, people and firms at the frontier begin to use deposit, credit and other services provided by modem financial institutions. Their access is facilitated by innovations and economies within the financial system and because their personal and business incomes increase and become less erratic. Development moves the frontier outward to firms, households, and individuals that previously had severely limited or no access. Much development assistance in the form of credit for small enterprises and farms has attempted to push the frontier outward. This has led to the experience and frustrations upon which this book is based. This book's essential point is that outward movements of the frontier are sustainable only when the characteristics of finance and those of potential customers are related harmoniously. Innovations that create this synthesis are the only means by which institutions offering financial services to the public can independently advance the frontier. Recommendations are provided to stimulate this process, along with tips on how to avoid costly errors. This book explores the basic building blocks of finance that must be respected if efforts to push the frontier outward are to produce sustainable changes in financial markets. The fundamental elements of finance are value, risk and confidence These are discussed in Part 1. These fundamentals provide insights into the principal problems of official efforts to advance the frontier of the formal financial system: the extent and stubborn continuation of unremunerative lending and bad loans made to farmers and businesses. Value, risk, and confidence do not directly address issues such as how credit and the financial environment relate to overall government policies, fiscal and trade regimes, or to the objectives of development assistance agencies. This is not a disqualifying limitation, however. Attention to value, risk and confidence can assist policy formulation and refinement of development objectives that are implemented through financial markets. Use of financial markets to stimulate development becomes more costly 4 Finance at the Frontier financially, economically and socially when actions, policies and objectives destroy value, increase risk and diminish confidence. Finally, some readers may quibble with the concept of value stated here. An objection may be that it is not consistent with the concept of value in economic theory.3 In this sense value is a difficult word because its technical meanings vary. In the visual arts value refers to relationships between parts of an art work, to the boldness of a line, for example. In music it is the relative length of time for which a note is held. In religion and philosophy value has other meanings, and even in investment jargon its use varies from that presented here. The term is truly polyvalent. Acknowledgement of the diversity of its use blunts criticism that it is improperly applied. 3. Whatever that may be. See Joan Robinson, Economic Philosophy (Chicago: Aldine Publishing Company, 1962), pp. 26-46, and Robert L. Heilbroner, Behind the Veil of Economics: Essays in the Worldly Philosophy (New York and London: W.W. Norton & Company, 1988), pp. 104-133. 1 FINANCIAL MARKETS CREATE VALUE Value reflects desirable qualities that cause people to create, produce, control, obtain and use things that are considered to have such qualities. This meaning of value conforms to common usage and to the result of "valuation," which is financial terminology for the process by which financial markets price financial contracts. Financial contracts are claims and they consist primarily of written or electronic evidences of debt, shares of stock in corporations, and guarantees. It is only by creating more value that the frontier can be moved outward, so the starting point for examination of the frontier of modem finance is the way in which financial markets create value. What Financial Markets Do Active participants in competitive financial markets are preoccupied with the value or price of financial contracts. They relentlessly estimate, calculate and test their value. Transactions arise from this activity when financial contracts are bought and sold in efforts by buyers and sellers to obtain more value reflected in better prices. Transactions enable financial markets to create value. Promises are Bought and Sold in Financial Markets Financial transactions monetize promises, exchanging cash in the present for a promise of future reciprocity. Credit mnarkets create value in the form of loans in the present that are exchangedfor promises to pay in the future. These promises are often supplemented by additional undertakings regarding the rights and behavior of parties to credit transactions. Equity markets create value when a corporation issues shares 5 6 Finance and Financial Markets of stock, promising rights of control and allocations of expected earnings, that are traded for cash in the present. Value is created in markets for guarantees when one party pays another for a promise to assume a financial obligation related to the occurrence of a future event. Thus, value arises when a financial contract or promise is made or traded. The value of a contract equals its price. Exchange of cash for promises has tremendous social benefits. First, almost everyone can participate in this process. Second, it permits individuals and organizations to transcend the limitations of their present situation. By a spoken or written word, a thumbprint or a signature, or electonic keystrokes, a promise gives access to things that otherwise would be available only after expenditure of further time and effort. Finance brings the future forward telescopically. Borrowers are originators of promises that help them obtain funds that enable them to demonstrate their abilities, to define their place in the future. Lenders are buyers of promises who support and participate in the activities of those offering promises. Transactions among buyers and sellers of promises spread risks and returns, both actual and expected, over a larger number of economic units, as discussed in chapter 2. They also help to create an expanding network of confidence, as noted in chapter 3. These transactions contribute to economic growth and efficiency when they result in the allocation of land, labor and physical capital to activities that have relatively high economic retums. Because finance and land, labor and capital are scarce, achievement of growth and efficiency requires allocation mechanisms that avoid activities with relatively low returns. The fundamental valuation question is: How much is a promise worth? The procedures used to answer this question determine the amount of value created, which is the primary concem of this book. Elements in valuation include discounting, tenn structure, transaction costs and the process used to identify value. These basic financial parameters are discussed in this chapter; and risk is dealt with in the following chapter. Financial Decisionmaking Uses Discounting to Determine Value Discounting is the basic procedure underlying financial transactions and creation of value by financial markets. Discounting is any technique that compares values at different points in time. Discounting estimates value in the present in return for expected value in the future, and expected value in Financial Markets Create Value 7 the future for value in the present. Discounting works both forward and backward in time because value involves a trade-off over time. Discounting in financial markets is accomplished through a variety of techniques. Some are mathematical, represented by formulas used to calculate compounding and discounting tables.4 These formulas contain the quantity (1 + i)n, where 1 refers to the principal amount, i is the rate of interest and n is the number of periods for which the calculation is made. Mathematical applications provide precise valuation of a financial claim, and are used where quantitative precision is achievable and important, as in the market for government securities. At the opposite end of the range discounting procedures are expressed primarily by rules of thumb, tradition or industry practice, and judgment. These predominate where precision is difficult or where precise estimates are not important. In these cases quantification is used to demonstrate that a transaction meets predetermined standards of acceptability, or that a promise is worth at least as much as a specific minimum amount. Standards of acceptability are used to screen propositions and identify those that eventually create transactions following accept/reject decisions. Institutions lending to consumers purchasing household goods and cars, for example, accept or reject loan applications from individuals without estimating precisely the maximum amount of credit each applicant might be able to obtain from all sources. As a general rule, the greater the certainty attached to a promised retum, and the fewer the risks and constraints facing purchasers of financial contracts, the simpler the discounting procedure and the standards of acceptability applied. Between these two extremes are approaches that blend quantitative and nonquantative discounting. In terms of numbers of transactions, nonalgebraic approaches probably predominate. However, a staggering volume of funds is exchanged in highly organized markets where participants' decisions are based primarily on mathematical calculations. Government bond markets are an example: the average daily worldwide 4. Numerous textbooks discuss the application of mathematics to financial problems. American examples include Steven J. Brown and Mark P. Kritzman, eds., Quantitative Methods for Financial Analysis (Homewood, Illinois: Dow Jones-Irwin, 1987); Marcia Stigum, Money Market Calculations: Yields, Break-Evens and Arbitrage (Homewood, Illinois: Dow Jones-Irwin, 1981); Robert P. Vichas, Handbook of Financial Mathematics, Formulas and Tables (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1979) 8 Finance and Financial Markets trading volume in US Treasury securities alone reached $100 billion in 1986.5 Discounting requires assumptions about the future. These are distilled into a rate of interest in mathematical approaches. Interest rates form a fundamental part of economic theory and financial practice, which share the view that they reflect expectations. This commonality endures despite the fact that economists view the interest rate as a market clearing device and an opportunity cost,6 while financiers treat interest primarily as a measure of expense and revenue. In economic theory interest rates determine the trade-off between current and future consumption, with future consumption expressed as a function of current investment in goods and services. Financiers consider interest rates as a measure of the retum from sacrificing liquidity by committing funds, always at some risk. Common to both is compounding, the proposition that sacrifice is rational only if it seems likely to produce a larger return in the future. Value Creates an Incentive to Innovate The quest for larger retums leads financial market participants to seek greater value from their activities. This is seen in the bargaining and bidding processes from which many financial transactions evolve. A more subtle expression of this force is the introduction of new types of financial arrangements, which consist of financial instruments and financial institutions. Innovation provides a dynamic means of creating value where none existed before. Financial innovation, which increases wealth by creating value, is natural in competitive financial markets. 5. The Wall Street Journal. September 10, 1986. "Endless Dealing: US Treasury Debt Is Increasingly Traded Globally and Nonstop," p. 1. One billion equals 1,000 million. 6. Opportunity cost is an economic concept that refers to the cost of using limited resources for one purpose rather than another. The opportunity cost of an investment equals the return that could have been earned from the best alternative investment. The opportunity cost of the most attractive investment among available alternatives is the return that could be earned from the second most attractive investment. Opportunity cost is sometimes defined as a representative return. In economic planning this might be an estimated rate of return assumed generally to prevail in the economy. In finance, yields on government bonds or on savings accounts are sometimes used as benchmarks for comparing the yields on other investments available to firms and to individuals or households, respectively. Financial Markets Create Value 9 All current financial arrangements-paper money, checking accounts and credit cards, for example-were innovations when they were launched. Their survival demonstrates their sustainability. Innovation occurs because all financial market participants have an incentive to increase value over the long run. In an expanding economy borrowers seek larger loans and lenders have more funds at their disposal. Corporations and their shareholders want a higher price for their stock, and intermediaries seek more funds and transactions. Term Structure Discounting incorporates a time horizon. How far into the future do these calculations extend? Term structure is financial terminology that denotes a time horizon and movement toward it by decision makers operating in markets for debt. Term structure is created by exchanges of cash in the present for expected future value. Without term structure there would be no credit and no equity markets because promises would not command any value. Thus, term structure is essential for creation of value. Term Structure and Loan Size Term structure has two dimensions: maturities and interest rates. The maturities of financial contracts define the term structure of the markets in which they trade. Markets with short time horizons are dominated by short term contracts, and create relatively few long-term instruments. Long-term housing credit, for example, may be relatively underdeveloped, even though most people may be able to borrow for a few days or weeks against their next paycheck or harvest. The term structure of interest rates is the relationship between maturity and yield on promises differing only in maturity.7 Interest rates on longer term contracts are normally higher than rates on similar contracts of shorter term. This reflects additional risk that accompanies longer commitments. As term structures lengthen, the potential for creation of value expands. If a loan is made for a period of a week, the borrower's expected repayment capacity during that week is presumably the major determinant of loan size. By contrast, a loan having a maturity of five years could be 7. James C. Van Home, Function and Analysis of Capital Market Rates (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1970). 10 Finance and Financial Markets much larger, because five years' cash flow would nonnally be many times larger than a week's cash flow. This is why term structure is a critical element in the contribution that financial markets make to development. How Term Structure Is Lengthened Markets move naturally to extend term structures when long term interest rates exceed short-term rates, which is the relation normally found because risk increases with term structure. By borrowing short-term and lending long-term, intermediaries enjoy an interest spread between short- and long-term rates. However, this mismatch in maturities also subjects them to the risk that their short term obligations may fall due during a period when access to replacement funding (refunding) is limited or achievable only at an unattractive interest rate. Hence, the higher the level of risk, the shorter the term structure, other things remaining equal. Term structures tend to be longest when the uncertainties of the future are not perceived as threatening financial values. For example, longer term structures develop most easily when inflation remains low. Inflation undermines financial value by reducing the purchasing power of money. High levels of inflation create uncertainty that greatly complicates financial calculation and reduces its usefulness. Because of these characteristics, inflation and expectations of inflation tend to shorten the term structure of credit markets. Relatively dependable flows of funds over a long period help to lengthen term structures. Because of their power to tax and to create money, stable governments and their state corporations and agencies frequently are able to borrow by selling bonds having longer maturities than those obtainable by private issuers. Buyers of long term bonds include life insurance companies. Life insurance policies tend to remain in effect for long periods, and policyholders' premiums constitute a steady flow of insurance companies' income. Claims paid when policyholders die are also relatively predictable because mortality risk is highly quantifiable. In countries where mortality data are readily available, actuarial science makes it possible to predict with a high degree of accuracy the rate at which deaths will normally occur in large groups of people, although it is not possible to predict when any individual member of the group will die. Financial Markets Create Value 11 Pools of funds that are not required for daily transactions contribute to long term structures, as illustrated by life insurance. However, long time horizons are not necessarily restricted to low-risk investments. Venture capital provided by entrepreneurial investors in developed economies offers an interesting example. The purpose of venture capital is to assume the high financial risks of starting an enterprise or of rehabilitating a troubled firm, with the expectation that high risks will be rewarded with high retums. Venture capital normally includes equity contributions, represented by the purchase of stock. Equity has an unlimited life or infinite time horizon because corporations and their stock have no fixed termination date. Venture capitalists expect to sustain several relatively small losses for each large success, but the timing of their losses and gains cannot be accurately predicted. Therefore, venture capitalists commit funds they can afford to lose. Investments that do not work out may become worthless, and those that succeed may be sold to realize capital gains and to free funds for new investments. Transaction Costs and Value Transaction costs are admission tickets to financial markets; they govern access to financial services. They must be paid by all parties: depositors, borrowers, intermediaries, guarantors, insurers and others offering or using financial services. Transaction costs are the costs of establishing and conducting financial relationships. They include information-gathering, security arrangements to protect cash, documents and other data, recording systems for transaction processing, and queueing and decision-making.8 Transaction costs, along with the cost of funds and bad debt losses, are fundamental determinants of which products9 are generated in financial markets, who provides these products and who uses them. Innovations that reduce transaction costs widen access to financial services, expanding the frontier. 8. Transaction cost levels are discussed in chapter 7. 9. Financial markets produce services, which are called products by bankers, brokers and other intermediaries. In their vocabulary, for example, a savings account or a car loan is a product. 12 Finance and Financial Markets Customers' Transaction Costs at the Frontier The major transaction cost for savers and loan applicants at the frontier is gaining access to the fornal market, establishing financial relationships. Savers have to satisfy themselves that institutions willing to accept deposits merit their confidence and treat them respectfully. When they open an account they may have to provide a photograph or document their identity and residence. Personal identity documents, routinely available in many countries, may be difficult and costly to obtain in others. Modem financial establishments may not have offices in rural centers or in less prosperous urban areas where the frontier economy dominates, and their office hours may be inconvenient. Prospective depositors from these places have to spend time, and possibly money, walking, cycling or riding to banking offices. These trips often have their own challenges, such as temptations to spend, security worries, and possibly long queues for public transport and for service at the banking office. Would-be borrowers have to obtain information about sources of funds that may be available, and about the terms and conditions attached to each. Would-be lenders have to gather information about prospective clients. Establishing a credit relationship also requires documentation and possibly also a prior deposit account relationship. A loan application is subject to delays in processing, and in certain situations has to be accompanied by a "gift." As with depositors, transport and queueing may consume loan applicants' time, effort and expense. Time spent in these activities has an opportunity cost, consisting of lost opportunities to produce income or enjoy leisure. These costs decrease the attractiveness of borrowing and make it more difficult to obtain value. Intermediaries' Transaction Costs at the Frontier The transaction costs of modem financial institutions mount as they approach the frontier; depositors keep smaller and smaller balances while transactions tend also to be small, turnover in accounts may be high relative to average balances held, and related business such as money transfers and use of other fee-based services is limited. Relatively large amounts of noninterest-eaming cash have to be held to serve small depositors because they prefer to use cash rather than checks or money orders for transactions. The depository's fixed costs of handling an Financial Markets Create Value 13 account or a transaction are not related to the account balance or the transaction amount, making deposit collection at the frontier appear unattractive to many intermediaries. Borrowers at the frontier may be unaccustomed to making timely payments, difficult to contact and hard to trace, and often lack collateral or credible guarantors. It may be costly for lenders to obtain and verify information from frontier applicants, who may be spread over large geographical areas. Dealings with those who cannot read or who do not speak the business language of the country or of loan department staff take up more time. Loans tend to be small, borrowers' incomes erratic, and sources of repayment not at all clear. Special credit programs for borrowers at the frontier may be imposed on lenders, and these often have other transaction costs, such as organizing these borrowers into groups and extraordinary reporting requirements. Institutions that penetrate the frontier have to overcome the barriers that make frontier transactions so costly for intermediaries comfortably within the frontier. This is accomplished by innovation in management, by economies of scope and scale, and by devising appropriate financial arrangements; and is not necessarily so difficult as implied by a listing of the characteristics of frontier finance. In fact, the poor themselves have financial institutions beyond the frontier that achieve these ends in order to create value. One of the most common is the rotating savings and credit association, or RoSCA. RoSCAs Reduce Transaction Costs and Create Value Saving and lending often involve high transaction costs for poor people. Saving may be difficult, for example, because of pressing uses for funds among the relatively large but intimate social groups into which their society is organized, such as extended families, age groups, and villages. Most members of the group are aware of each others' income and wealth, and asking for and giving assistance are a normal part of daily life. Within the group, at least one person may be sick or need help at any time, there are lots of children to be clothed and educated, and rites of passage require gifts and other expressions of participation. Reciprocity is important, and implies transaction costs. Borrowing also requires transaction costs. Where no one is particularly wealthy, obtaining funds for a major purchase requires soliciting a number 14 Finance and Financial Markets of people. Each loan acquired bears its own terms and conditions, some of which may not be specified in detail but constitute relatively open-ended obligations. These types of obligations involve risks, and soliciting assistance may subject the applicant to gossip and speculation concerning motives and behavior. THE CLASSIC RoSCA. One of the oldest financial innovations, which survives in most parts of the world and is called by a variety of names, is known generically as the rotating savings and credit association.10 RoSCAs are a type of informal financial arrangement that reduces transaction costs and creates value by formalizing mutual obligations. The classic RoSCA is the financial institution beyond the frontier of formal finance because of its simple yet stunningly elegant design that accounts for its continued popularity and existence in millions of places in developing countries. It consists of members who know each other, usually as a result of social. employment or locational bonds; who have little or no access to formal finance; and who agree to contribute a fixed sum periodically to a pool or "hand" that is assembled and distributed by lot at meetings on agreed dates. One member receives the hand at each meeting. When each member has received a hand the cycle is completed, and the RoSCA disbands or reorganizes. RoSCAs create pools of funds that are usually difficult for each member to assemble individually, which is one incentive to become a member. RoSCAs permit accumulation because of the contractual nature of membership. Membership is generally taken very seriously-to default on 10. There are numerous accounts of RoSCAs in the sociological literature. The most active recent RoSCA researcher and analyst is F.J.A. Bouman. His major papers include "Indigenous Savings and Credit Societies in the Third World: A Message," Savings and Development. 1, 4, 1977, excerpted as "Indigenous Savings and Credit Societies in the Developing World," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., Rural Financial Markets in Developing Countries: Their Use and Abuse. (Baltimore and London: The Johns Hopkins University Press, 1983), pp. 262-268; and "Informal Savings and Credit Arrangements in Developing Countries: Observations from Sri Lanka," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., Undermining Rural Development with Cheap Credit (Boulder, Colorado: Westview Press, 1984), pp. 232-247. Notable books on the topic include C.P.S. Nayar's Chit Finance. (Bombay: Vora & Co., 1973), which describes Indian experience, and Carlos G. Velez-Ibanez's Bonds of Mutual Trust: The Cultural Systems of Rotating Credit Associations Among Urban Mexicans and Chicanos (New Brunswick, New Jersey: Rutgers University Press, 1983). Financial Markets Create Valse 15 a payment is a stigma. Accordingly, accumulating funds to meet RoSCA obligations is recognized as important by the community. This gives the RoSCA a senior claim over the myriad of other purposes that enable kin, friends and neighbors to dip into each others' meager savings. Information about who has how much money when, which otherwise tends to deplete and possibly even discourage individual and communal savings through social pressure, is transformed through RoSCAs into a means to accumulate funds and protect members. RoSCAs are organized so that transaction costs are minimized-no one except the organizer has to visit a number of people, and terms and conditions are relatively few, straightforward and applied consistently. Everyone's share can be equal, preserving social balance. Each hand is distributed at the meeting at which it is assembled, leaving no group assets requiring management or offering temptations between meetings. Distribution of the hand by lot greatly economizes one of the potentially costly aspects of RoSCA transactions. The frequency of meetings is determined with reference to members' cash flows. Shoeshine boys in Addis Ababa have daily ekub meetings because they receive cash every day. Office workers paid monthly have monthly meetings. Market ladies in West Africa have tontine or esusu meetings when markets are held, often on 4, 7 or 14 day cycles depending on locations and goods traded. Speculation about motives or behavior can be muted by giving the RoSCA a specific purpose shared by participants. A Society for Iron Sheets, for example, enables members to obtain funds to put roofs on their houses in Kenya, a rice chitty enables eacn woman member to accumulate a special stock of rice for bad times in Sri Lanka; and a hui in Hong Kong or a paluwagan in the Philippines enables shopkeepers and stallholders to replenish their inventory periodically. RoSCAs typically are established by an organizer who takes the first hand. The number of members is identical to the number of hands, and each member receives one hand during the life of the RoSCA. The sequence of distribution of the hand is determined by lot among "nonprized" members, those who have not yet received a hand. At any point before the final hand, members who have not received hands are net savers, while those who have are net borrowers. As the RoSCA moves through its cycle, these savings and borrowing positions rotate. RoSCAs' basic financial value-creating feature is that they accelerate access to 16 Finance and Financial Markets funds-all members except the recipient of the final hand receive the cumulative contractual amount of their contributions in the form of a hand before they could have accumulated it by acting alone, by saving the amount of their contribution each period. This mechanism equates each member's debt capacity and savings capacity, which amounts to the sum of a member's periodic contributions. Value is created by transforming future payments into hands and by accumulating small payments into large pools. Some members typically want early hands and may be called "borrowers," while "savers" seek later hands. RoSCA INCENITVES REDUCE RISK. The most interesting aspect of the RoSCA is how it sustains members' incentives to complete the cycle. While debt capacity equals saving capacity, at no point between the first and last hands does any member's net position equal either. A nonprized member's net position is the sum of her contributions, while the amount of the hand minus contributions made equals the net position of a prized member. In the first half of the cycle the majority of members have an incentive to continue contributing so that they can obtain a hand. At this early stage the burden of the obligation to contribute is highest; as periodic payments are made the obligation to make future payments lightens. In the latter half of the cycle prized members have an incentive to continue contributing because the people who could be hurt by their not doing so, the minority of nonprized members and the organizer, are a diminishing number who are increasingly identifiable. During this phase members' burdens in the form of promised future payments become relatively small; most of their obligations to contribute have already been met, making it easier to contemplate continued participation. Also, the claims of members on each other are by then quite complex, creating a solidarity that fosters continued payment. The juxtaposition of tension and resolution illustrated by RoSCA relationships is common to successful financial contracts. RoSCAs must incur transaction costs in order to create value for members. The first occurs in organization. Who should belong? How large should each member's contribution be? How many members should the RoSCA contain? These are financial decisions that require information about the character, motives and financial performance of prospective Financial Markets Create Value 17 members. Members will be especially interested in the stature and reputation of the organizer. In return for this trust, the organizer has control over who is admitted, and may be expected to make good any defaults arising from the failure of other members to make contributions in full and on time. The major credit risk is that a winner of an early hand may fail to make subsequent contributions The fixed term of RoSCAs permits exclusion of poor credit risks from future cycles. Organizational transaction costs are incurred to manage risk. These costs are borne most heavily by the organizer. For this service the organizer usually receives the first hand, which in effect constitutes an interest-free loan repaid over the life of the RoSCA. The value of this position is quite high because of discounting, as demonstrated by auction chit fund data provided by C.P.S. Nayar for India that imply annual interest rates of 20 percent or more. 1 The member receiving the hand is often responsible for refreshments at the meeting at which the hand is received, especially where RoSCAs meet in restaurants or bars. This transaction cost helps maintain group cohesiveness through eating or drinking together, and impresses on members the importance of continued loyalty to each other. Members can observe each others' health and moods, and gain impressions of each others' current financial status. While many transaction costs are an annoyance to those who pay them, the obligation to provide hospitality to one's friends at RoSCA meetings is usually regarded as an honor or as an opportunity for fun, something to be enjoyed. Creating Value by Refining Valuation Processes The transaction costs of financial relationships include the costs of maintaining the valuation process that results in transactions. Closely related to these costs are changes in the valuation process itself. While some changes are driven by efforts to cut costs, others are led primarily by efforts to create value where none existed before. Refinements in the valuation process give financial claims greater liquidity, which tends to increase their attractiveness and makes intermediaries more willing to provide or process these claims. Refinement 11. op. cit. In auction chit funds the order of rotation following the initial distribution to the chairman is established by competitive bidding for each hand by nonprized members. 18 Finance and Financial Markets occurs primarily through the creation of new instruments or types of contracts and of a market that makes them liquid, which in turn provides valuation. It also occurs through more precise valuation of existing instruments. Innovations in valuation are the most interesting type of refinement because they touch the heart of the fundamental financial question: How much is a promise worth? These constitute an especially important class of innovations that permits large entrepreneurial assaults on the frontier. Interesting simple illustrations include recent developments in mortgage markets in the US, the introduction of leasing in Bangladesh, and refinements in pawnbroking when it was a major source of small loans. The Secondary Mortgage Market in the United States Deregulation of the United States financial markets since the late 1970s increased competition, producing an explosion of innovation. One that has refined value is securitization of first mortgages on property, especially private homes.12 Lenders offering first mortgages, primarilv banks and savings and loan associations, traditionally held them through maturity, which was normally 30 years, or until borrowers sold their homes. 13 Once on their books, these assets were not subject to intense valuation because they could not be readily sold. Mortgage holders spent their efforts on administration, which was generally not difficult because of the high 12. Mortgage is an old French word derived from mort or dead and gage or pledge, pawn or security. The mortgage was an innovation that eventually replaced the vifgage or living pledge. Under a vifgage the borrower or a member of his family was given to the creditor until the debt was paid, usually by the labor of the pledge. This type of practice can still occasionally be found in a few developing countries. A first mortgage is the mortgage that is paid off first when payment is made from the proceeds of the sale of the mortgaged property. Securitization refers to the creation of a financial claim that is relatively easily marketable, backed by other financial claims that are not so easily marketable. 13. Over half of all American households own their own homes. Homes are often bought and sold because American society is mobile. Young families want to move into nicer neighborhoods as they grow older and wealthier, old people often move to smaller quarters requiring less upkeep, and lots of families move from one place to another to obtain better employment. These activities result in average mortgage lives of around eight years for many lenders. Financial Markets Create Value 19 quality of this fully-secured paper, on attracting deposits and on the development of new mortgage business.14 With increased competition and government encouragement, a secondary or resale market in first mortgages evolved. The market deals in single mortgages or in packages of mortgages, often in multiples of $1 million, with standard terms and conditions. (Nonstandard or "nonconforming" mortgages are traded on slightly less advantageous terms.) Mortgage lenders are now able to choose between holding and selling these assets, and the value of these assets is of great interest because they can be sold at any tine for cash. The lender's cost basis may vary from the market price, providing opportunities for profit or loss. This innovation has had two noteworthy effects. The first is that more of a lender's assets can be tied up in mortgages, and less held in cash reserves and short term investments. This has expanded the size of the mortgage market, advancing the frontier. The second effect is that more lenders now provide mortgages. Credit unions, for example, traditionally did not offer first mortgages because they were reluctant to make 30-year commitments of members' funds. The large size of a mortgage, compared to the car, consumer and home improvement loans that are traditional credit union business in the US, also posed two problems. One is that the credit union objective of service to members implies relatively open access to funds. Large loans to just a few members could impede open access by exhausting the supply of loanable funds, which could result in loss of membership and withdrawals of deposits. The second problem is that mortgage loans are large in relation to the capital base of many credit unions, concentrating risk. Credit unions can now offer mortgages by contracting with intermediaries that buy mortgages and assume the credit risk of these loans. By selling its mortgages, a credit union obtains cash that it can recycle into new lending, and the mortages that are sold and the risks that they entail are removed from its books. The buyer of a package creates a security backed by the mortgages and sells it in the capital market, where it can be traded. The credit union benefits from mortgage generation fees and through service to members, which helps to increase member loyalty and 14. For an economic critique of US housing finance, see Maxwell J. Fry, Money, Interest and Banking in Economic Development (Baltimore and London: The Johns Hopkins University Press, 1988), pp. 414ff. 20 Finance and Financial Markets interest in the credit union. This should increase members' transactions and average balances, making the credit union stronger. In addition, the credit union does not burden its capital with an accumulation of these relatively large loans issued to only a minority of its membership. Leasing in Bangladesh Finance leases enable lessees to use equipment belonging to the lessor.15 The lessor remains the owner of the leased equipment and is responsible for its maintenance. The lessor borrows to purchase equipment selected by the lessee, and the lease charge paid by the lessee covers the lessor's debt service, risk and administrative costs. The advantages of leasing stem primarily from tax treatment; the lessor's interest cost and equipment depreciation expense are operating expenses, as are the lessee's lease payments. Another possible advantage is that lease obligations do not have to be reported as liabilities by the lessee under accounting rules followed in many countries. In addition to tax and debt reporting considerations, leasing offers an alternative to lending and borrowing that benefits both lessor and lessee. Because the lessor owns the equipment used by the lessee and is responsible for maintaining it under a finance lease, the lessor has more control over the equipment than a lender whose loan is secured by a claim on the equipment. Repossession of equipment pledged to secure a loan that is in default requires judicial approval in many countries, and may be difficult to achieve without incurring relatively high transaction costs. In most countries a lessor can take back equipment relativelv easily if lease payments are not made on time. When leasing gives a lessee access to assets that could not otherwise be obtained, or obtained only at a higher cost, it is a refinement in the valuation process. Lessors can recognize value where lenders cannot when borrowing equipment is more advantageous than borrowing cash. Modern finance leasing was introduced into Bangladesh in 1985 tnrough fonnation of a leasing company owned by local interests, foreign leasing companies and a multinational investor. The company brought foreign exchange and expertise to Bangladesh that would probably not 15. Jonathan R. Hakim, ed., Equipment Leasing. IFC Occasional Papers, Capital Markets Series (Washington, DC: International Finance Corporation and the World Bank, 1985). Financial Markets Create Value 21 have been attracted to other financial activities. The overall loan repayment environment in Bangladesh was not attractive to foreign private lenders, but leasing offers greater security to a financial intermediary by providing lessees an additional incentive to honor their commitments. This combination created more value, giving lessees greater access to productive assets and giving lessors a better mechanism for recovery of funds. The leasing company recorded a profit within a year of starting operations, which would be unusual for conventional term lenders financing fixed assets. Collating Collateral The Provident Loan Society'6 was established as a not-for-profit pawnshop in New York City in 1894. At its peak in the late 1930s, before consumer credit, personal bank accounts and lines of credit were widely available in the US, the Provident had more than 750,000 customers. Its success reflects innovative valuation. Following industry practice, the Provident publicly auctioned unredeemed pledges, which consist of items pawned but not reclaimed by borrowers through loan repayment. The standard loan term was one year; a further grace period of three or four months was given before auction. Reflecting its objectives, the Provident innovated by refunding to the borrower any excess arising from an auction price greater than the amount of loan principle and interest due. This practice was not followed by commercial pawnbrokers, who kept any excess of auction proceeds over the amount owed. But if the auction price were below the amount owing, the Provident absorbed the loss. The Provident's policy led to conservative valuation. Assigning too high a value could result in a loss if the pledge were unredeemed and auctioned at a price below the amount owed. But too low a pledge value made the Provident uncompetitive with commercial pawnbrokers and defeated the purpose for which it was founded. Innovation was obviously required for the Provident to overcome this self-imposed limitation. Diamonds were the most frequently pledgea high-value item, and subjected the Provident to considerable valuation risk. The great majority of these were "brilliant cut" with the standard round shape and 58 facets. 16. Peter Schwed, God Bless Pawnbrokers (New York: Dodd, Mead & Co., 1975). 22 Finance and Financial Markets Diamond valuation was largely subjective; to become a skilled appraiser could require 20 years' experience. By the 1930s, partly because of the decline in immigration from Europe, it was difficult for the Provident to hire experienced appraisers from the jewelry and commercial pawnbroking trades in sufficient numbers for its 22 offices. A shortage of experienced appraisers increased the Provident's risk. On one occasion appraisers from six of its branches were assembled and given ten diamonds to value. To the astonishment and dismay of management, the values assigned to individual diamonds by its experts varied by more than 600 percent, and over 100 percent for the lot of ten stones. The Provident responded by innovating. The vice president in charge of the Appraisal Department, an engineer by training, systematized the valuation process. Studies and experiments, lasting more than two years by Provident staff who had no training in the jewelry trade, included detailed examination of possibly 20,000 diamonds and charting their values realized at auction. This led to the introduction of standard grading scales for brilliant cut stones incorporating cut, color, clarity and carat (weight). Color was the most difficult variable to standardize: lighting conditions varied from hour to hour and from branch to branch. This problem was addressed by making a series of identical metal rods with six diamonds mounted on them in ascending order of color. These were issued to all branches, permitting valuation of pledges by visual comparison. Cut and clarity grading scales were standardized through the use of charts showing common deviations from the ideal brilliant cut and the most common flaws, and the percentage reduction in value that accompanied them. The vocabulary used by the jewelry trade to describe diamonds was replaced by numerical scales and abbreviations for colors. Determining the weight of mounted stones required no changes in procedures: a caliper device used by jewelers permitted extrapolation from measurements of exposed dimensions. Grading scales for the four characteristics produced 252 classifications that were collated into tables that were periodically updated to reflect changes in the market value of diamonds. Reference to these collations enabled a relatively inexperienced appraiser to assign a precise loan value that closely approximated the amount the pledge would obtain at auction. This permitted the Provident to give better value to its clients, reduced its Financial Markets Create Value 23 risk of loss, made valuation much more consistent across its branches, and reduced staff cost. By demystifying diamond valuation, making it possible to become a skilled appraiser in 20 hours rather than 20 years, the grading system produced another interesting effect: it improved working conditions. The Provident did not have to recruit appraisers from the jewelry trade, and for the first time lower level staff could become managers by working their way up through the four office ranks: cashier, vaultman, appraiser, and branch manager. 2 VALUE GENERATES RISK Risk, the possibility of loss, pervades finance as gravity pervades physics. Risk causes the unceasing valuation that animates financial markets. To survive and prosper in financial markets, participants must manage risk in ways that increase their wealth. Risk, not tenn structure or transaction costs, causes financial executives to lose sleep. Why risk and finance are inseparable is explained at the outset in this chapter. Exploration of risk as perceived in financial markets follows, begining with a discussion of mismatched or nonsimultaneous flows found in all economies. Liquidity is an important financial concept that governs management of mismatched flows. It is defined in this chapter and its intermediation is dealt with. The discussion then moves to identifying maturity risk, interest rate or pricing risk, and credit risk. The chapter closes with examples of risk pooling, partition and redefinition, and assumption through financial intermediation. Why Risk Pervades Finance Risk pervades finance because finance trades the future against the present and the present against the future. Because the future is uncertain, risk is always present.1 Financial behavior responding to risk is seen even where money is not used. William Allan in The African Husbandman2 describes how clan groups practicing slash and bum agriculture accommodate risk. Their largest risk is that a harvest will be insufficient to sustain the group until the next harvest. If insufficient food is available, the 1. Risk and uncertainty are used synonymously here, as is nontechnical English. 2. William Allan, The African Husbandman (Edinburgh and London: Oliver & Boyd; New York: Barnes & Noble, 1967). 25 26 Finance and Financial Markets results are disastrous; clan members are weakened from malnutrition or die from starvation. The spirits of the ancestors may become out of sorts. The clan invests work in the present for a return in the form of a harvest several months in the future. The work is the tremendously demanding task of clearing bush with simple hand tools and burning it. This provides open space for planting, destroys competing vegetative material and produces ash that will help the crop to grow. One crop exhausts the soil, and the group moves on and clears a new area for the next season. A major strategic question is how much work should be devoted to securing a harvest-how large an area should be cleared? The response of these farmers, at this extremely low technological level, is to clear and plant a larger space than required to support the group under normal conditions. Based on the food required to sustain the clan and an estimate of soil fertility, the size of the clearing is determined by the expected yield achievable in a bad year. In the normal or good year the clan will not have to harvest the entire crop to survive. The difference between the expected normal year and the expected bad year harvest represents a risk expectation, a discount applied to the future to determine the rational level of investment in the present. Allan calls this discount "the normal year surplus." Finance Harmonizes the Risks of Nonsimultaneous Flows Where money is used, possibilities for dealing with risk increase greatly. Finance exists because nonsimultaneous cycles of flows arise in the normal course of production and consumption. For example, major dams and canals may require five or more years to build, it may take two years to build a ship, tradesmen can construct a house in several months, and a nail factory produces thousands of nails per day. Farmers work on a seasonal cycle, grocers turn over their stocks every few days, and most people eat several times a day. Each flow has a unique pattern, creating the risk of mismatched flows. Finance facilitates the management of mismatchedflows and diminishes their risk. If production and consumption were simultaneous, the economy could function without finance. But workers on the dam, canal, ship and house have to be paid frequently before their projects are completed. Raw materials and other supplies must be ordered long before the finished goods that contain them are sold to users. Because different activities have Value Generates Risk 27 different financial rhythms, finance in the form of savings and credit arise to permit their coordination. Savings and credit are made more efficient as intermediaries develop to transfer funds from firms and individuals that accumulate funds and are willing to shed liquidity to those that desire to acquire liquidity. Cash Alone Is Fully Liquid Risk management in financial markets centers on the sacrifice and preservation of liquidity. The most general definition of liquidity is "nearness to cash," with cash considered fully liquid and relatively riskless.3 Assets that can be easily sold, or converted to cash, are more liquid than those that are not easily convertible. Assets that can be easily valued in terms of cash are more liquid than those that cannot. Mathematical approaches to discounting are most easily applied to relatively liquid financial claims. The only way fully to ascertain the liquidity of an asset is to sell it. How long did it take to sell? How large were the transaction costs? Was the expected price realized? Did the price obtained approximate prices for similar assets sold in similar conditions at the same time, or shortly before and after the sale? Answers to these questions describe the liquidity of an asset. Testing liquidity by sale is obviously inconvenient for those interested in knowing the price of something they would like to keep, or in selling only when a certain price can be obtained. However, markets provide indications of liquidity because market transactions create liquidity. For example, when trades in the stock of a particular corporation occur frequently, and transaction volumes and the range of trading prices are published by sources in which a shareholder has confidence, the shareholder's stock can be valued easily and relatively accurately. In addition, high volumes of transactions enable dealers to offer firm price quotations. Transactions and competition promote the spread of market information, including price, trading volumres and the terms and conditions of sale. 3. In economies experiencing high inflation this assumption does not hold. People shed domestic cash for foreign hard currency and stockpile goods that are expected to retain value. 28 Finance and Financial Markets Liquidity Sacrifices: The Dramatic Tension of Finance Liquidity is the primary means by which value is given and restored in financial transactions. Buyers who pay cash for a promise sacrifice liquidity by reducing their holding of cash. The sacrifice continues until liquidity is restored when the promise is honored or sold to another party. Because modem finance expresses value in terms of cash, sacrifice of liquidity creates a valuation problem-the cash value of noncash assets is always relative and uncertain. Consistency in valuation helps reduce uncertainty and lowers the transaction costs of sacrificing liquidity. Well- functioning markets eliminate inconsistency as buyers shun overvalued assets and compete to obtain undervalued ones. A more important valuation problem arises because sacrifice of liquidity creates risk. This occurs because the exchange of liquid present value for illiquid future value is completed only in the future, when liquidity is restored. The future is inherently unpredictable, introducing the possibility that liquidity may not be fully restored. Risk and its impact on value is one of two reasons why financial analysis exists. The other reason arises from the tremendous private and social benefits created by rational markets. Things that belong to people and are traded have to be valued in order for markets to operate rationally. This fact is most easily illustrated by things that do not belong to people or that are not traded. In centrally planned economies, for example, financial analysis is generally not sophisticated because risk is centralized, individual ownership is curtailed and markets are repressed. Risks Managed in Financial Markets By intermediating liquidity, financial markets intermediate risk. Risks arise from inability to predict the future and from nonsimultaneous flows. The problems posed by lack of simultaneity are defined primarily as maturity risk and interest rate or pricing risk, which are often interrelated. Credit risk is also a dimension of nonsimultaneity. These three risks are discussed below. Maturity Risk Maturity risk arises when financial contracts do not fall due or mature at the same time. This occurs when the maturity structures of a firm or Value Generates Risk 29 household's assets and liabilities differ. An example is the situation of small farmers on settlement schemes in Kenya in the 1960s. Mismatches in the maturity of settlers' obligations and their ability to produce income, by turning assets in the form of crops into cash, resulted in insufficient liquidity to meet their obligations. Their land purchase loans were initially repayable in twice-yearly installments starting within a year of their moving onto their plots. These loans quickly went into arrears because the first payment became due before settler-borrowers had time to organize their operations. Repayment dates were unrelated to the seasonal schedule of harvests, creating another mismatch that heightened arrears. Matching of maturities is an important principle of intermediation, exemplified by the perfect matching of RoSCA finance described in the previous chapter. Although matching is a cardinal point of reference in financial planning, many intermediaries actively seek opportunities to mismatch maturities in order to create value. Commercial bankers, for example, usually obtain liquidity through customers' deposits, especially demand deposits (checking accounts) and savings accounts. These are so popular because they are usually withdrawable by account holders on demand, whenever they wish. Bankers often use these deposits to fund loans that are not due on demand but have a fixed term, which creates a mismatch on their books. Borrowers often prefer the certainty created by maturity dates, rather than signing a demand note that the lender can call for repayment at any time. Interest Rate or Pricing Risk Interest rate or pricing risk (with pricing used as an adjective) arises from the intervals at which financial claims are repriced. Repricing occurs when an interest rate is fixed for a financial contract. In the most simple case, repricing occurs at the maturity of a financial claim, when the lender recycles funds into new financial contracts, and when the borrower obtains new credit to replace the repaid loan. Innovations have unbundled or disconnected repricing intervals and maturities, as exemplified by floating rate notes and adjustable rate mortgages. These are assigned a new rate of interest periodically throughout their lives according to formulas incorporating reference rates. A five-year note, for example, may be repriced every six months. The choice of reference rate depends upon the market in which contracts are 30 Finance and Financial Markets traded. Government securities rates and commercial bank prime rates often govern adjustable rate mortgages in the United States, for example, while LIBOR (London interbank offered rate) is applied to Eurocurrency floating rate notes. The pricing risk is that the interest yields on portfolios of assets and portfolios of liabilities may vary. More precisely, variations in the spread between these rates can diminish the intermediary's income. A notorious example was the plight of the U.S. savings and loan (S&L) industry in the 1970s and early 1980s when inflation raised market rates of interest. Virtually all of the S&Ls' liabilities, primarily demand or short-term deposits from individuals, had to be repriced relatively quickly to prevent depositors from taking their funds elsewhere to obtain higher interest. This made the S&Ls' cost of funds tend to fluctuate with the market. However, the S&Ls' earning assets consisted largely of long-term residential mortages issued at fixed interest rates. Opportunities for repricing occurred only as these assets were slowly paid down, generally in monthly installments over their 30-year lives, or as they were repaid in full when mortgage holders sold their houses. When deposit rates moved sharply upward, the losses that resulted forced many S&Ls out of business. Those S&Ls surviving this crisis, the first in that industry, have innovated around this mismatch by offering adjustable rate mortgages, for example, that reprice periodically, usually every six months or annually. Credit Risk Another risk from nonsimultaneous flows is credit risk, the possibility that the borrower may not repay as scheduled at the maturity of a loan. Here the mismatch does not reside initially in the flows of the intennediary, but in the flows of the borrower. But when the borrower's flows do not provide sufficient liquidity to repay a loan, the lender's flows also suffer. Credit risk is essentially a valuation risk, because credit gives value in the present in exchange for expected future value. There are two contexts for examining credit risk. One is the risk inherent in any relationship with a borrower, which is that the borrower has more information about his activities than the lender does. This means that the lender bears the risk of innocently making poor credit decisions because of inadequate information, and also that the borrower may abuse the lending relationship. Value Generates Risk 31 In addition to this common view of credit risk is another that arises from the design of credit arrangements. Credit arrangements generate or diminish credit risk, and this dimension is especially important in attempts to nudge the frontier. Loans too large for borrowers to handle and lending programs too large and complicated for the lender to supervise and account for may result in losses because flows get out of control. For example, lenders may not be able to manage their loan portfolios effectively if their management information systems are overburdened or if they are too aggressive in entering markets in which they have insufficient experience or when they ignore experience. In these cases, lenders overestimate the future value of their activities, which are diminished by bad debt and related losses, as in the case of North American and European commercial bank lending to certain developing countries in the late 1970s and early 1980s. Credit risk includes problems such as fraudulent and opportunistic behavior, and incomplete documentation of claims through administrative lapses. In well-functioning formal financial markets these rank far behind poor planning and poor management by borrowers and by lenders as sources of bad debt losses. Value creation is extremely sensitive; where a significant proportion of contracts are not honored on time or where fraud is common, value evaporates and financial market development is retarded or reversed. International debt crises are examples of reversals that occur when credit contracts are not honored on time or are regarded as unlikely to be honored on time. How Financial Markets Manage Risk Financial markets manage risk by pooling, intermediation and assumption. These processes unbundle risk through partition and redefinition, and repackage risk to make it more attractive. This allows risk transfer to create value because those who seek comfort by shedding risk and those who seek higher returns from assuming risk move toward their objectives. A household or a firm's rational desire for comfort or for risk- taking with an opportunity to gain reflects its financial structure. The examples that follow relate financial structure and risk management, and indicate how risk can be managed through financial markets. While value generates risk, these examples explain why risk management creates value. 32 Finance and Financial Markets Risk Pooling in a Pension Fund Classic fixed-benefit pension funds offer an example, greatly simplified in this presentation, of risk pooling, of how a financial innovation responds to its users' financial situations, and of how efforts to manage risk shape an innovation. The pension fund product in this example is annuities, or fixed, periodic payments for pensioners. Annuities create value in two ways. They give pension fund members the prospect of stable income after retirement in return for their contributions to the fund before retirement. They also permit this objective to be achieved economically through collective action. The fixed-benefit pension fund is an attractive innovation because it responds to members' risk. Greatly reduced earning power in retirement following reasonably assured earning power during their working lives is a potentially formidable nonsimultaneity of flows. The task of the pension fund is to collect sufficient cash from workers during an accumulation phase before their retirement, which will yield the target level of annuity payments to these workers during a distribution phase over the rest of their lives. To manage the risk that insufficient funds are collected, pension funds may classify their members into groups having homogeneous expected retirement dates and life expectancy. The pension fund referred to here is for a homogeneous group of this type. Pooling risk through homogeneous grouping creates value for group members. Barring suicide, individual group members cannot know how long they will live following retirement. Prudent individual planning requires an assumption of long life expectancy to ensure that funds are available even if very old age is attained. For example, if the homogeneous group retired at age 60, prudence might require individual financial planning assuming survival through age 90. If each individual wanted to have an annual income of $10,000 for life, the total annuities would equal $300,000. However, actuarial predictions suggest that roughly half of the group will not achieve greater than normal life expectancy, which, for example, may be 75. In this case, the average total annuity per individual would be $150,000, or $10,000 per year for 15 years. If each member planned prudently individually and assumed a longer-than-normal life expectancy, the group as a whole would save too much, reducing consumption too Value Generates Risk 33 drastically during their working years in order to provide for their old age through age 90. By pooling their risks they enjoy greater value because each member's contributions are based on normal life expectancy of 75 years. Pooling enables the fund to intermediate risks: members who die before normal life expectancy receive fewer benefits relative to their contributions, while those who exceed normal life expectancy receive relatively more benefits. This simplified pension fund holds low-risk, long term bonds as assets. These are purchased during the accumulation phase from members' contributions, and from interest earned on bonds already purchased, less fund administration expenses. The fund manager structures the bond portfolio so that maturity dates are "laddered" to coincide with expected annuity funding requirements during the distribution phase. The composition of the fund's assets reflect its operations. As the recipient of a long-term inflow of contributions, eventually balanced by the outflow of annuities, the pension fund is willing to invest in long-term bonds. Fixed-benefit pensions are funded by variable contributions from members. Members' contributions fluctuate each year. Assuming a target level of benefits, constant life expectancy and projected interest income and pension fund administrative expenses, adjustments in contributions required from a group of members will reflect changes in the interest rate available on bonds. The interest rate determines the extent of compounding, which in turn affects the size of the pool from which annuity payments are made to group members. The higher the interest rate, the greater the compounding, reducing the level of current contributions required to fund annuity payments in the future. Discounting is applied in a straightforward, highly precise manner to determine the level of annual contributions at a given compounding rate that is required to support target pension payments and pension fund administration costs.4 Matching maturities avoids pricing or reinvestment risk. If short term bonds or bank deposits were purchased during the accumulation phase, changes in market conditions could make it impossible to reinvest the 4. In greatly simplified form and ignoring administrative costs, the compounded amount of cumulative contributions, (1 + i) for each year's amount paid in, with i representing the interest or compounding rate and n representing the number of periods remaining before retirement, is equated with the present value at the time of retirement of a constant annuity to be paid out each remaining year of members' lives. The present value of an annuity is (1 - [1/(1 + i)nI)/i. 34 Finance and Financial Markets proceeds from their maturity at the rate of interest required to achieve the target level of annuities during the distribution phase. If bonds having maturities exceeding the life expectancy of pensioners were purchased, they would probably have to be sold before maturity to fund annuities. Market conditions at the time of sale could depress their prices below the level required to fund annuities. Members of this sort of scheme place a premium on certainty, because they expect to be dependent upon annuity income in their old age. Their concem is reflected in the objectives of the fund managers, who follow a conservative investment strategy of minimizing risk by close matching of maturities. The bond portfolio is ideally structured to eliminate maturity and repricing risks in order to ensure that target annuities and all administrative costs can be paid from accumulation phase assets. The efficient fund will exhaust its assets at the same time the last surviving group member passes away. Risk Intermediation and Diversification by Partition and Redefinition Virtually all debt, equity and guarantees incorporate risk management and discounting. A fundamental risk management device is division of financing into debt and equity. Equity is the owner's share of an enterprise, represented by shares of stock in a corporation or cooperative, a proprietor's interest in a proprietorship, and the partners' interest in a partnership. Equity holders assume a disproportionate share of the risks of a project or enterprise. This asymmetry attracts creditors who are also willing to provide finance but only at a lower level of risk. Owners are equity holders. They stand to gain a disproportionate share of the benefits from a successful venture, and to lose all their investment in the event of failure. They bear the risk of variable retums, after all other claims on the project or enterprise are met. Creditors expect a steady return in the form of interest payments and principal repayments, secured by the knowledge that owners stand to lose all before the creditors lose any.5 Put 5. This is the ideal case, based on the classic legal distinction between debt and equity. In many countries and situations debtors have extraordinary rights and institutional factors limit creditors' capacity to pursue debtors or to take over debtors' assets. In these cases, the amount of credit offered is less than would be available if the classic ideal prevailed, other things being equal. Value Generates Risk 35 in another way, each of these holders of claims on the project or enterprise operates according to different discounting expectations. Division of risk creates value: more funds are available for the project or enterprise than if debt or equity finance were relied upon exclusively. Equity finance becomes unattractive as the sole source of funds at some point because the owners may find their risks too highly concentrated in the enterprise. With only limited funds, they may wish to spread their risks over a number of activities. A more common reason for taking on debt is to obtain better returns. Higher returns are realized if the return on the enterprise's activity is greater than the return demanded by creditors in the form of interest. Equity holders benefit from any returns in excess of the cost of debt that are eamed on the portion of the investment financed by debt. Using debt to obtain higher returns on equity is called trading on the equity, or leverage (in the United States) or capital gearing (in the United Kingdom). Greater return to equity than to debt is consistent with the greater risk assumed by equityholders than by creditors, and with the underlying relationship between risk and returns: the greater the risk, the greater the returns from bearing the risk. Greater returns are necessary to attract liquidity to risky investments. Debt cannot be relied upon exclusively because creditors generally do not want their claims subject to the same risks as the enterprise. Returns to the enterprise are bound to be variable, while creditors expect steady returns. This mismatch makes it difficult to attract debt beyond certain limits that relate closely to the expected variability of returns to the enterprise. Different types of enterprises attract different levels of debt because of the relationship between risks and returns. For example, the agricultural sector in many highly developed Western countries attracts relatively little debt, generally equal to less than 20 percent of its total assets. In contrast, publicly-owned (in the US sense, which means by large numbers of shareholders, not the government) telephone companies' debts fund more than 50 percent of their total assets. The returns to individual farmers are highly variable, as is their cash flow available to service debt. Phone companies' cash flows, by contrast, are relatively stable. The further division of equity and debt into different classes, each with its own combination of rights, risks, and returns, extends this basic 36 Finance and Financial Markets process of risk partition and redefinition, attracting additional funds and creating additional value. For example, preferred shares offer dividends only after the enterprise satisfies all claims other than those of holders of common stock, who are the owners. Some creditors' interests may be secured by debentures or claims on specific assets such as land or buildings, while other creditors such as those providing short-term trade credit may not have any tangible security for their loans. Risk Assunption in Financial Markets Financial institutions assume certain risks they cannot directly match or intermediate. They take these risks under several conditions. One is that they are adequately compensated for their portfolio of such risks. Another is that the risks assumed are not likely to have a significant negative impact on their overall operations. Forfaiting, which is primarily found in Western Europe, is an example of risk assumption. Forfaiting intermediates payment risks for goods shipped to importers in developing or Eastern bloc countries that have a history of slow or erratic payment for imports. These risks include the possibility of delayed payment or nonpayment due to foreign exchange control problems, default by the importer or on a payment guarantee by the importer's bank, or losses from changes in the rate of exchange between the currency in which the exporter was paid and the currency in which the importer's obligation is expressed. The Western European exporter issues a promissory note for the amount due from the Eastern European importer. A guarantee for the note is sometimes obtained from the importer's Eastern European bank. The note is sold by the exporter to a Western European bank (or other forfaiting intermediary) at a discount. The exporter receives immediate payment from this sale and is no longer subject to payment risk, which is assumed by the buyer of the note. The discount reflects the bank's cost of funds, transaction cost, and risk. The foreign exchange risk assumed by the bank through the forfaiting transaction can usually be covered at least partially by instruments traded in foreign exchange markets, but the other risks have to be carried by the buyer of the exporter's note. The discount is usually higher than the cost of a loan for the same amount, but exporters can often pass at least part of this cost to importers through the prices charged for the goods that are Value Generates Risk 37 exported. Forfaiting creates value for the exporter by relieving him of risk. It also enables the exporter to obtain funds immediately without having to go into debt; in this sense forfaiting substitutes for borrowing. Forfaiting is conducted primarily by specialized subsidiaries of large banks that can offer this service because they are well informed about international trade, operate in foreign exchange markets, compete for the business of exporters, and because the amount of forfaiting transactions is limited. Forfaiting is a competitive tool because multinational commercial banks want to be able to offer their clients a full range of services, either directly or through subsidiaries. As a condition for taking on high-risk forfaiting, they may request that the exporter route other business through them, such as letters of credit and other money transfers. Forfaiting transactions are limited by the relatively small volume of trade with countries with doubtful payment histories. Also, some of this trade is covered by guarantees offered to exporters by government-owned export credit agencies or export-import banks. These guarantees are often subsidized, but commonly cover large transactions such as for aircraft or big construction contracts. Transactions covered by forfaiting tend to be smaller, giving the forfaiting house greater opportunity for risk diversification by importer, by guaranteeing bank and by country. Provident Perpetual Sixes: a Risk Twist Many types of risk can be accommodated by financial arrangements. Life insurance, credit guarantees and corporate stock represent different vehicles for managing risk. However, financial instruments can also help to determine how an organization conducts its business and establishes its objectives. To its founders, owners and clients these dimensions of commercial behavior are tremendously important. An interesting example is the Provident Loan Society cited in the previous chapter. How did the Provident's founders seek to perpetuate their vision or to define their legacy? It is late 1893 in New York City. You are a successful businessman who is weathering the Money Panic that broke in May, following a speculative rush in gold and silver that peaked last December. During the depth of the crisis some banks failed, others suspended payment temporarily, and unemployment increased. A number of people of modest means adversely affected by these events approached you and others in 38 Finance and Financial Markets your social circle for assistance. You have been a member in the Charity Organization Society (COS) for several years, and are disturbed by the difficulties many people have had getting loans to help tide them over the disruptions of the Panic. Would it be possible to establish an institution that could provide small loans to assist such people? Some leaders of the COS, including notables such as James Speyer, George F. Baker and Cornelius Vanderbilt, share your concern.6 A group of them has just returned from Europe, where they reviewed the operations of the Monts de Piete, municipal pawnshops that have existed for several centuries in France, Holland, Germany, Austria, Italy and Spain. At a meeting called to hear their report, you join a committee established to raise funds to establish a similar pawnshop in New York City, to be called the Provident Loan Society. A subcommittee consisting of yourself and two others is given the task of developing a fund-raising strategy. Your target is $40,000, a significant sum when unskilled workers earn less than $1 per day. Your subcommittee searches for an approach that will ensure that the target can be met in a way that contributes to the objectives set by the organizing committee. Relying only on donations and setting up a board of trustees to administer the pawnshop may pose risks. After a few years the board could turn into just an honorary body, and the business might suffer. The pawnshop management might lack incentives to be efficient because it would not be exposed to much financial discipline. Yet to compete against commercial pawnbrokers management would have to be agile and alert. It would be embarrassing for the COS to have to preside over periodic appeals to replenish capital squandered by inefficient staff and inattentive trustees, and it could also tarnish your reputation as a businessman. Setting up a corporation to run the pawnshop would, however, pose disadvantages. Shareholders, exercising their voting rights, could try to serve their own interests rather than those of small borrowers. Some stockholders might, over time, try to divert the pawnshop from its chaiitable objectives in order to obtain dividends or increase the price of the stock. Commercial pawnbrokers might accumulate a sufficient number of 6. Herman E. Kroos and Martin R. Blyn, A History of Financial Intermediaries (New York: Random House, 1971), p. 123. Value Generates Risk 39 shares to gain control of the Provident. Would there be any alternative way of funding that could impose financial discipline on the pawnshop managers without subjecting the Provident to subversion? Coming back to the present, the record shows that the founders of the Provident Loan Society used an innovative instrument to meet their objectives. Contributors were given "certificates of contribution" with four features. First, they had a face value equal to the amount contributed. Second, they carried a nominal 6 percent interest rate. This gave the Provident an earnings target and a responsibility. It probably attracted additional capital from supporters who wanted some opportunity to enjoy a return. It also created a continuing constituency: if donations were used, contributers might eventually forget their link with the Provident. Periodic interest payments maintained a relationship that could be useful if the Provident ever sought more funds. Third, the certificates of contribution did not impose on the Provident any legal obligation to pay interest, to allow for the possibility that the commercial and charitable objectives of the business might conflict. Fourth, the Provident could redeem the certificates by refunding the amount of the contribution. These terms allowed the Provident the opportunity to buy its way around the interest burden or to accommodate changed circumstances if its mission turned out to be poorly conceived. These securities were listed on the New York Stock Exchange, where they were well-regarded and known as Provident Perpetual Sixes. History suggests this instrument served its purpose well.7 In the first three weeks of the Provident's operation, half of the $40,000 contributed by founders was disbursed in loans averaging about $10 each. Capitalization was soon raised to $100,000 by issuing more certificates of contribution. The Provident was efficient enough to accumulate reserves sufficient to redeem these certificates in the 1930s, when loan demand was again high because of the Great Depression and 6 percent was well above prevailing rates of interest. 7. Peter Schwed, op. cit. This source does not discuss how the founders decided to use certificates of contribution to fund the Provident. The account given here is a speculative recreation for the purposes of this chapter. 3 CHARACTERISTICS OF FINANCE What permits finance to create value? The theme of this chapter is that finance has special characteristics that differentiate it from the goods and services produced by the nonfinancial sectors of the economy. The market for finance is basically different from the market for soap or cement.1 Its characteristics determine how finance contributes to development, and how strategies that attempt to use finance to nudge the frontier outward have to be structured to be sustainable. Characteristics that relate most closely to the role of finance at the frontier are that it is by nature social, intangible, fungible or interchangeable, that a loan produces no return for borrowers, and that finance attracts attention and is easily politicized. Finance Is Social Finance often seems to be all numbers, but it is fundamentally social rather than mathematical. Like language, finance is a product of society. Modem finance consists of promises that are accepted. The Latin root of "credit" illustrates this aspect-credere is to believe or entrust. In the same way that language facilitates expression and understanding, finance gives promises power in commerce, over the allocation of goods and services to consumers, and over the uses of land, labor and capital in production. Finance cannot be separated from risk, as explained in the previous chapter.2 The opposite of risk is confidence; finance harmonizes these 1. The special features of financial markets were formally recognized in the modem economic literature only in 1981 with the publication of "Credit Rationing in Markets with Imperfect Information" by Joseph E. Stiglitz and Andrew Weiss in the American Economic Review, Vol. lxxi, June 1981, pp. 393-410. 2. The social implications of risk are treated by archaelogists in Paul Halstead and John O'Shea, eds., Bad Year Economics: Cultural Responses to Risk and Uncertainty 41 42 Finance and Financial Markets opposites. When risk is sufficiently offset by confidence, transactions occur and value is created. Finance therefore cannot exist without confidence. The relationship between value, risk and confidence is triangular, as shown in Figure 3.1. Value is placed at the top of the triangle because its creation rests on both risk and confidence. Because finance is triangular, a change in any one of these variables cannot occur in isolation. Perceptions of increased risk will reduce value unless offset by increased confidence. Declines in confidence reduce value unless risk also decreases. Risk can never be completely eliminated, nor can confidence be fully retained for extended periods of time without continual renewal. Confidence is emotion and perception. It is ephemeral in a dynamic world and is reevaluated incessantly. Financial markets test confidence with each transaction.3 Figure 3.1 The Financial Triangle Value Risk Confidence (Cambridge: Cambridge University Press, 1989), which begins with the observation that, "The world about us is in a constant state of flux," (p.1) to which Henry Petroski adds, "Constant change means that there are many more ways in which something can go wrong." To Engineer is Human: The Role of Failure in Successful Design (New York: St. Martin's Press 1982). p. 2. 3. "Confidence must grow out of performance." See "The Economic Impact of Trust and Confidence," in The 5th Column, Far Eastern Economic Review. 30 May 1985. pp. 78-79. Characteristics of Finance 43 Confidence is the most challenging requirement for financial market development. Confidence is generated within financial markets by the same tools that are used to manage risk, as discussed in the previous chapter. For example, division of finance into debt and equity creates more confidence. The equity holders already have confidence in the enterprise and use of debt creates additional confidence that is sufficient to attract lenders who may not have sufficient confidence to become equity holders. Confidence is very strongly influenced by factors outside finance, such as society's general view of the future, social structure and the arrmount of effort or transaction costs required to achieve and maintain consensus or to effect change. These factors also include respect for agreements entered into voluntarily, the legal structure and the costs of gaining access to it, and similar elements that determine social activity. Confidence Creation through Rural Credit Unions The efforts of Friedrich W. Raiffeisen4 to help the poor through voluntary group action illustrate the extreme demands of confidence. Raiffeisen was a civil servant in the Rhine Province of Prussia. He was mayor of Weyerbusch in 1847, which was a very bad agricultural year in that area. To help ensure a supply of bread and potatoes, the staple food of the poor, Raiffeisen and some wealthy citizens formed a cooperative to obtain supplies from distant areas to operate a bakery and to sell good seeds and other farm supplies. Their efforts reduced the price of bread in Weyerbusch by 50 percent within several months, and led Raiffeisen to consider whether similar organizations might help address long-standing rural problems, including the perception of an inadequate supply of credit at reasonable rates of interest. In 1849 Raiffeisen was appointed mayor of Flammersfeld, an area containing 33 villages. There he launched a second experiment with the support of 60 wealthy citizens. A society of wealthy and of poor citizens was formed to "eliminate the usurious cattle trade."5 The society bought 4. Raiffeisen is pronounced rai as in rise, feis rhymes with pies, and sen as in send. An account of his role in cooperative history is found in J. Carroll Moody and Gilbert C. Fite, The Credit Union Movement: Origins and Development, 1850-1970. (Dubuque, Iowa: Kendall/Hunt Publishing Co., 1984). 5. F.W. Raiffeisen, The Credit Unions. 8th ed. (1966), Konrad Engelmann, trans. Neuwied on the Rhine, Federal Republic of Germany: The Raiffeisen Printing and Publishing Company, 1970 [18661. p. 20. 44 Finance and Financial Markets cattle for resale to the poor members, to be paid for in five annual installments. However, this activity was administratively burdensome, imposing high transaction costs. The founders also concluded that supplying cattle to poor farmers did not significantly relieve their poverty. A system of cash loans was instituted, using funds borrowed by the society. Term loans were made available for farmers investing in improved agricultural technology. To obtain funds for the society, members pledged their entire property, assuming unlimited personal liability to satisfy the society's creditors. This degree of dedication attracted sufficient funds only when the 20 wealthiest members accepted joint liability to borrow a significant amount, equal at the time to about US$1500, from a Rhineland "capitalist." Unlimited liability of members, apparently essential to creating the confidence required to obtain credit at relatively low rates of interest, was an extremely rigorous condition. Many rural people were reluctant to make such a large commitment, risking the loss of their crops, livestock, implements and land, and possibly their reputations. Confidence had to be created among members or prospective members before the confidence of those with funds to lend could be obtained. As mayor of Heddesdorf in 1854 Raiffeisen helped establish the Heddesdorf Welfare Association to assist the poor financially, to educate neglected children, to provide jobs for the unemployed and for ex- convicts, and to establish a public library. These objectives proved too broad for effective action. In 1864 the group revised its statutes and became the Heddesdorf Credit Union. From these experiences the early Raiffeisen rural credit union model evolved. It was based on membership of the wealthy as well as of the poor, on the unlimited and joint liability of members, and on voluntary leadership, usually by wealthier members. Their leadership and that of clergymen helped create confidence, which was bolstered by having the accounts kept by a teacher, tax collector, forester or other highly respected citizen. This model proved replicable by others only in 1862, when the second society was established in a nearby village. One can imagine the lengthy discussions required to convince individuals to accept unlimited liability in a new venture over which they would have limited individual control. It had taken Raiffeisen 15 years of tremendous dedication and of trial and error to develop an institutional means of expressing his desire to Characteristics of Finance 45 help the poor in a manner that generated the confidence necessary to ensure financial credibility. Raiffeisen justified his work in religious terms and stated his objectives in social welfare terms. However, he measured the credit unions' success in a very concrete way, which was that the number of "petty suits, forced auctions, executions [of creditors' rights]...have considerably diminished...where the Unions are active."6 Numbers of credit unions or members, total loans made or total assets, references to solidarity and the merits of collective action were not the center of Raiffeisen's pragmatic evaluation. Raiffeisen also reported, after 37 years of experience, that no members had incurred losses as a result of assuming unlimited liability.7 Rural credit unions had their skeptics, who raised questions of public confidence. In response, the Prussian minister of agriculture appointed a commission of investigation that consisted of two prominent bankers and a professor of economics. In 1875 they visited 26 credit unions and reported very favorably. Relatively rapid formation of rural credit unions followed throughout central Europe. While Raiffeisen devised his rural credit union model, an urban credit union model was being developed for artisans and shopkeepers by Hermann Schulze-Delitzsch.8 Schulze-Delitzsch was more flamboyant and less cautious than Raiffeisen, and he concentrated on financial and economic factors as motivators rather than on religious teachings and social ideals. In its initial years his model spread more quickly than the rural model and also suffered some setbacks as societies were dissolved or became moribund due to bad loans and poor performance. The models developed by Raiffeisen and by Schulze-Delitzsch9 have been reconciled and operate in modified form on all continents. Innovations within credit unions and in financial markets generally have pennitted their evolution as limited liability membership organizations operated democratically under a one-member-one-vote rule, usually 6. Ibid., p. 22. 7. Ibid., p. 46. 8. J. Carroll Moody and Gilbert C. Fite, op. cit. 9. J.O Miller, "Early Savings and Credit Cooperatives on the Basis of Self-Help to Combat Poverty and Dependence in Germany," in Guy Bedard, Gerd Glinter Kl6wer and Martin Harder, eds., The Importance of Savings for Fighting Against Poverty by Self-Help. Vol. II. Berlin: Deutsche Stiftung fiir intemationale Entwicklung (DSE- German Foundation for Intemational Development), 1987. 46 Finance and Financial Markets financed entirely by members, with voluntary leadership, and having objectives consistent with those of cooperatives generally. Raiffeisen's emphasis on the role of relatively well-to-do members has declined with the adoption of limited liability. The World Council of Credit Unions includes more than 70 national associations, and there are 8.2 million members of more than 15,000 credit unions in developing countries.10 Members are primarily from low- and middle-income groups. Collapses of Confidence The importance of confidence in the operation of financial markets is illustrated by events that occur when confidence declines. Financial history is peppered with failures of intermediaries and collapses of stock and commodity prices following bursts of speculative behavior. These crises have often been associated with wars, efforts to build trade with or infrastructure in less developed areas, international loans, and precious commodities such as gold and silver. Business cycles and financial crises have inspired a huge literature. Competing theories explain their causes and prevention. Charles P. Kindlebergerl 1 suggests that the events leading to a crisis begin with an external event that significantly changes profit opportunities in a major economic sector. These events include wars, crop failures, political upheavals, and innovations of the magnitude suggested by the introduction of canals, railroads, and automobiles. If the external shock generates more opportunities than it destroys, businesses respond by increasing production. To support the boom, finance is created. The creator may be the commercial banking system, the central bank or private sources. The private supply of credit can be very dynamic. Firms at each step in the production and marketing chain can become increasingly willing to accept debt rather than immediate cash in payment from their customers, and 10. J. Peter Marion, "Building Successful Financial Systems: The Role of Credit Unions in Financial Sector Development." Madison, Wisconsin: World Council of Credit Unions, September 1987; and 1988 Statistical Report and Directory. Madison, Wisconsin: World Council of Credit Unions, 1989. 11. An entertaining analysis of financial crises is provided by Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises, (New York: Basic Books, 1978). The pattern outlined here is from Chapter 2, "Anatomy of a Typical Crisis." pp. 14-24. Characteristics of Finance 47 individuals may invest in or lend to businesses. A modem example of such dynamism is the use of accounts receivable by large corporations in the US as security for commercial paper, which permits using credit outstanding to customers as a base for borrowing.'2 The boom tends to push production capacity utilization to its limits, raising prices as the demand response is stronger than the supply response. New investment occurs fueling the boom. Up to this point, a normal level of rationality tends to prevail. However, the euphoria of a boom can disconnect investment decisions from the realities of production or sustainable market potential, and certain items become the subject of intense interest by an expanding pool of buyers. Historical examples include precious metals, stock, land, tulip bulbs; recent examples include silver, gold, Australian mining shares, oil, US currency and farmland, works of art and antiques. As suspended rationality becomes widespread, the probability of crisis increases. At this stage, confidence is pervasive and relatively unquestioning. Feelings of euphoria are reflected in speculation. Speculation is difficult to define and even more so when the economy is booming. The definition given in Webster's New Collegiate Dictionary is "to assume a business risk in hope of gain; especially: to buy or sell in expectation of profiting from market fluctuations." But when do vision and entrepreneurship become speculation? At what point can the acceptance of normal business risks be separated from behavior responding to expectations of fluctuations? Another twist is that although speculation in the dictionary's second sense is sometimes popularly regarded as being on the fringes of legitimacy, in fact it can play a stabilizing role by transferring and spreading risk. Kindleberger suggests that speculation consists of the purchase of commodities for resale rather than for use, and the purchase of equity for resale rather than for income. This definition would presumably be tempered by a presumption of excess or unusual activity. For example, wholesalers, brokers and retailers and other intermediaries buy commodities for resale rather than for use in the normal course of business. Speculation might consist of building up stocks far in excess of 12. "Industrial Firms Are Using Receivables to Back Commercial Paper, Preferred," The Wall Street Journal. October 7, 1987. p. 41. 48 Finance and Financial Markets normal levels or a surge of new entrants into an industry. Another qualification is seen in the examples of some corporations that limit or pay no dividends on the assumption that their reinvestment in the firm will provide larger returns to shareholders over the long run through increases in the value of the stock. Buyers of these shares seek capital gains, not dividend income. Speculation would have to be driven by expectations of gains greatly exceeding normal yields on equities. But to return to euphoria. Valuation goes into overdrive as a flood of confidence submerges perceptions of risk and cautious tendencies. Speculation in the object or objects of interest expands as more people engage in it, often supported by credit. Manias or bubbles are created when prices reach great heights. As speculation continues, the suspended rationality that fuels it is challenged. "Insiders" may feel that present trends cannot much longer continue. They take their profits by selling the object of speculation for cash. As more people withdraw from the market, the influence of new entrants is eventually offset. The market hesitates, and prices fail to continue their steep rise. At this point some players may have difficulty meeting their obligations because their positions are financed almost entirely by debt, or it appears that they might have difficulty. Speculation attracts opportunism, and frauds or irregularities may be exposed at this stage. Exposure occurs when new debt is no longer easily obtainable. Many types of fraud require an increasing flow of funds to repay existing obligations in order to attract new victims, or to cover bookkeeping manipulations by individuals or small groups working in otherwise respectable financial institutions. The classic swindle is typified by the operation of Carlo Ponzi in the 1920s. He promised to pay 50 percent interest on 45-day deposits, arbitraging currencies by buying international postal reply coupons in countries where they were cheap and redeeming them in the U.S.13 By 13. International postal reply coupons are sold and redeemed by post offices in the member countries of the Universal Postal Union. Each coupon is redeemable for surface mail postage for a letter of the minimum weight classification (e.g., one ounce in the U.S., 20 grams in certain other countries) being sent abroad. These coupons enable a sender to pay for a reply from a correspondent abroad. This payment innovation overcomes the inconvenience to the sender of sending small coins of his own country to his correspondent abroad (which may be illegal and invites tampering with the post) or of obtaining stamps of the correspondent's country. The Characteristics of Finance 49 paying 50 percent interest to early depositors, Ponzi attracted an expanding crowd of new depositors. Ponzi used the new deposits to pay off earlier depositors in an ever-broadening spiral. Kindleberger reports that Ponzi took in $7.9 million and had $61 worth of stamps on the day of his arrest in Boston.14 "Ponzi schemes" that enrich their organizers and obtain increasing amounts of money to repay old loans at high interest rates, rather than to invest in productive activities, take their name from this infamous operator, although they originated long before Ponzi was born. To return to the cycle of euphoria and crisis: when warning signals occur, confidence erodes and more people try to leave the market and obtain liquidity, driving down prices. As this self-reinforcing movement gathers speed it turns into a stampede. "When the market feels that there may not be enough (liquidity) to go around, the rush to get there first is exacerbated."15 Bubbles burst and manias become crises as people reject the object of speculation causing its price to collapse. Traders may not be able meet their obligations, creditors may find that they cannot recover their loans, and waves of bankruptcy may slow the economy. The extent of the crisis depends upon the pace at which liquidation is attempted, and whether there is liquidity to absorb sellers' demands. In this phase too, people may tend to over-react in the same manner, but in the direction opposite to that which occurs with euphoria and speculation. Kindleberger notes that an event that discourages confidence such as a suicide, business failure or an exposure of questionable behavior can begin the collapse.16 Panic or crash occurs when a crisis reaches major proportions: prices are driven to very low levels greatly disrupting markets and so exhausting liquidity that the settlement of claims breaks down. Much energy is devoted to finding institutional remedies to contain the effects of disappointed euphoria and reversals of unquestioning confidence. Central banks were established by national governments correspondent is spared the problem of redeeming foreign coins. Post offices are spared the inconvenience of postage-due letters. Ponzi's ruse was possible because the minimum surface mail rate varied from country to country and the cost of a coupon was equivalent to the surface letter rate in the country of purchase. Postal authorities have removed arbitrage possibilities by charging more for the coupons than the cost of mailing a letter abroad. In the US in 1987, for example, a coupon cost 80 cents while the overseas letter rate was 37 cents. 14. Op. cit. p. 85. 15. Ibid. p. 224. 16. Ibid. p. 107. 50 Finance and Financial Markets around the world from 1850 to 1975 for this purpose, among others. International institutions, such as the International Monetary Fund, are relative newcomers to this field. Securities regulation and self-regulation by intermediaries seek to address problems of fraud and opportunism. Finance Comes in a Tube.... Walter Wriston, former chairman of Citicorp, observed that money comes in a tube.17 The tube referred to is the cathode ray picture tube in the monitors of the computers and computer stations that portray transactions and constitute the basic medium of trading information for modem financial intermediaries and their clients. The darting symbols on screens illustrate that finance is no more tangible than the promises that create it. Beyond the handshake that affirms a promise in many cultures, the feel of the wind on the face of a child or the warmth of the sunlight on the petals of a rose are more tangible than finance. Informal finance is often invisible. In illiterate or barely literate societies beyond the frontier there is frequently no formal record, written or electronic, of credit or of the share of the returns from a venture to which each participant is entitled. Paper money may change hands in these transactions, but is one step removed from the creation of credit, which produces no tangible record in these circumstances. Traditional credit works purely on promise, trust and consent, often before witnessses having intimate knowledge of the consenting parties. Participants clearly recognize that the relationship between borrower and lender is the basis for the transaction, and that their worth in the eyes of others will to some extent depend on their performance under their shared promise. Millions of RoSCAs around the world work very successfully on this basis. Many more millions of viable informal financial relationships also operate invisibly. Their dimensions are understood by participants, but less well documented by researchers; the economy beyond the frontier remains essentially private. Between paperless finance conducted on the dirt floors of villages at one extreme and through electronic circuits at the other, is the world of documents or paper promises. They include paper money, savings 17. Walter Wriston, "In Search of a Money Standard: We Have One: It Comes in a Tube," The Wall Street Journal. November 12, 1985. p. 28, see also "A New Kind of Free Speech," Forbes. December 14, 1987. p. 264. Characteristics of Finance 51 passbooks, periodic statements of account for checking account holders, bills of exchange drawn by one merchant on another, letters of credit arranged by banks, loan agreements of all types, stock certificates, insurance policies, warehouse receipts or warrants, and an incredible array of other financial instniments. These attest to the variety of finance, the rigorous demands of confidence, and the complex institutions that attempt to create and maintain confidence. The blizzard of paper that trails finance is a tribute to the tremendous energy that financial markets direct to building confidence. Paper promises permit finance to venture beyond the face-to-face relationships of informal finance. The passbook holder can initiate transactions with bank tellers who are total strangers. Checks or drafts can be sent to distant places to secure payment through banks or giro systems. Bills of exchange facilitate commercial relationships between parties remote from each other. Letters of credit finance international trade, and stock certificates in bearer form (not inscribed with the name of the owner) can be traded anonymously. These instruments reduce transaction costs greatly because they are generated, processed and enforced in a depersonalized manner within broad institutionalized frameworks of confidence. Finance is Fungible Fungibility refers to the interchangeability of things that are identical or uniform. The term is sometimes associated with the grain trade, where each kilogram of a specified type and grade of grain is for all practical purposes identical to every other kilo of the same type and grade. Because of fungibility, a farmer who stores his harvest in a commercial elevator and who withdraws it to ship to a buyer will not be concerned if the grain withdrawn did not come from his farm, as long as the type and grade are the same. Finance is fungible because one unit of a country's currency is identical to every other unit of its currency. Fungibility underlies the usefulness of money; lack of fungibility creates the inconveniences of barter. The implications of fungibility are illustrated by the fable of Mrs. Kariuki,18 an 18. J.D. Von Pischke and Dale W Adams, "Fungibility and the Design and Evaluation of Agricultural Credit Projects," American Journal of Agricultural Economics. 62, 4, November 1980; J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 74-83. 52 Finance and Financial Markets African farmer who received a loan from a farm credit agency to purchase three milk cows and other materials for a modem diary operation on her small fann. The $1,200 loan was allocated in the loan agreement as $800 for three in-calf, improved "grade" cows, $200 for fencing, $100 for a 2,000 liter water tank, and $100 for a milking shed. Mrs. Kariuki went into debt because of the attractive terms offered-80 percent financing, five years to repay, 10 percent interest-and because of the range of attractive investment opportunities in her area. Her neighbors are expanding their dairy and tea-growing operations, and several have started transport businesses. Land prices are increasing and many families are improving their homes. Mrs. Kariuki is an attractive borrower because her family's four-hectare farm, owned by her husband, is well-maintained. Also, Mrs. Kariuki owns a plot in a nearby village which she used as loan collateral. She obtained the plot several years earlier when she planned to open a restaurant with a friend. The friend died shortly afterward and the plot remains vacant but has increased in value because of the good economic conditions in the area. She also has $600 in her post office savings account, saved from her income from tea production. Mrs. Kariuki used the borrowed funds to obtain the items specified in the loan agreement. Her loan was disbursed by the farm credit agency against invoices submitted directly by the suppliers from whom Mrs. Kariuki obtained the improved cows and materials. But, the $100 worth of iron sheets and lumber for the milking shed were not used to build a shed, which would be considered extravagant by her neighbors and relatives, but to extend and re-roof the family's house. In addition to the loan proceeds, Mrs. Kariuki invested $300 of her own funds in the dairy project (her 20 percent contribution to complement the 80 percent loan financing). This money was used to pay for transport of loan-financed items to her farm, to hire labor to install the fencing and water tank, and to buy miscellaneous items such as buckets and pipe. Mrs. Kariuki's first investment priority was to establish an improved dairy enterprise because of its expected profitability, steady labor demands and the family's preference for fresh milk. Before the loan was approved, she sold her entire herd of six inferior dairy animals for $800 in cash. She obtained credit to buy new stock ane materials even though she could have Characteristics of Finance 53 financed most of the project from the sale of these cows and the $600 in her savings account. Her other priorities include planting more tea, which requires hired labor, acquisition of more land; and joining her husband and some of his friends in purchasing a taxi so that their community would be linked more dependably to a market town 20 kilometers away. Mrs. Kariuki spent $250 for tea planting and $300 to purchase a small plot from an elderly neighbor after receiving the dairy loan. She also spent $100 on a new coat for her husband, two new school uniforms for her children, and a visit to relatives. Of her $1,400 in cash and in the post office savings bank, $450 remained after these expenditures. Since she wanted to keep $200 on hand in the event of an emergency or special opportunity, she invested the remaining $250 in a share of the taxi being purchased by her husband and his friends. (These transactions occurred during the time of the year when tea is not harvested. The family's routine income and expenditure were balanced during this time and did not figure in Mrs. Kariuki's planning.) Table 3.1 Summary of Mrs. Kariuki's Cash Flow Sources of cash Uses of cash Farm credit agency loan $1,200 Purchase of cattle $800 Sale of cattle 800 Dairy materials 400 Savings account Transport, labor, misc. 300 opening balance 600 Tea planting 250 Land purchase 300 Clothes, family visit 100 Taxi share 250 Savings account closing balance 200 Total sources $2,600 Total Uses $2,600 Mrs. Kariuki's behavior is similiar to that of small borrowers generally in developing countries where economic conditions are improving and 54 Finance and Financial Markets markets are reasonably competitive. Individuals and households in these circumstances have multiple sources of income. They have a tremendous incentive to diversify their activities because their agricultural incomes are erratic due to natural factors, and relatively low because of market conditions and possibly as a result of government policies. 19 Likewise, their erratic and uncertain incomes give them a great incentive to save. The tale shows how difficult it is to identify exactly what a loan finances. Did the loan really enable Mrs. Kariuki to establish an improved dairy activity? Exploration of her behavior leads ultimately to the conclusion that the loan gave Mrs. Kariuki liquidity, an increase in her overall purchasing power. For all practical purposes all sources of funds (the loan, the sale of her unimproved cattle, and her savings) contribute to all uses of funds (loan-financed goods, home improvements, clothes, land acquisition, and so on). This is the essence of fungibility, which makes finance different from vegetable seeds, which can only be eaten, crushed for oil, or produce plants; tractors, which can only provide motive power, or nuts and bolts, which can only hold things together. Even here, however, seeds, tractors and nuts and bolts of uniform specifications are fungible. Fungibility diffuses the impact of finance. A possible exception occurs when a relatively large additional source of funds is matched by a relatively large additional use of funds in situations where alternative investments and altemative sources of finance are severely limited. Except for some large, lumpy industrial projects, this is unusual in developing countries because large injections of funds are not generally available. One reason for this is because the risk of providing such funds tends to be high. It is not so unusual in countries with highly developed financial markets where home buyers can obtain mortgages equal to several years' income for the purchase of a house that is by far their largest asset. The impact of a loan is also obscured because it is rarely possible to know what would occur in the absence of the loan. What would Mrs. Kariuki have done if she had not received the loan from the farm credit 19. Richard L. Meyer and Adelaida P. Alicbusan, "Farm-Household Heterogeneity and Rural Financial Markets: Insights from Thailand," and Peter Kilby, Carl E. Liedholm and Richard L. Meyer, "Working Capital and Nonfarm Rural Enterprises," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 22-35, 266-283. Characteristics of Finance 55 agency? Would she have borrowed elsewhere? Would she have scaled back her activities or attempted to accomplish her investment objectives gradually over an extended period of time? Would she have cut back on certain expenditures, and gone ahead with others on the same scale she did with the loan; and if so, which ones? The time dimension of credit and the fact that the future is unknown make the counterfactual or "what if?" case hypothetical or speculative. Fungibility means that use of finance is often not tightly associated with the purpose for which it is obtained even when borrowers adhere to their loan contracts. This characteristic of finance highlights the role of confidence in financial relationships. Confidence in the project or loan purpose is important, but confidence in the promoter or borrower is even more important. An old banking saying is that the three important elements in lending are knowing the borrower, knowing the project or use of funds, and knowing the collateral, in that order of importance, with collateral running a distant third. Informal markets demonstrate this: friends, kin and others with whom one has dependable relationships are creditworthy; strangers are not. Credit Earns No Return for Borrowers Credit enables. It gives borrowers purchasing power that can be used to obtain assets that are expected to yield a return. This is the simple development model that underlies much foreign aid, government intervention in financial markets, and other efforts to promote loans for small businesses, farmers, women or other groups. The model is valid, but its application is sometimes naive and its progression not fully appreciated. Problems arise when the steps between the promise and the return to the borrower are neglected. In fact, credit is debt; it earns no return for borrowers. A loan is a liability of the borrower, a source of expense in the form of interest and transaction costs. When a borrower receives a loan in the form of cash, the cash also has no earning power until it is invested. If a small businessman who borrows invests in a lathe, the lathe may be used to produce machine parts that can be sold above cost. If a farmer who borrows invests in seeds, they may contribute to a successful harvest that can be sold at a remunerative price. The intermediate steps between credit access and income generation that are often neglected are receipt of the loan and the purchase and utilization 56 Finance and Financial Markets of assets that are capable of yielding a return. Of course, these steps are not entirely ignored in practice. Credit programs and loans from donor agencies, for example, generally have specific purposes often supported by technical assistance designed to make loan use more efficient. Misinterpretation occurs when the retums to the use of funds are attributed to the loan rather than to the activities "financed by the loan" or associated with the borrower's use of funds. Confusion regarding the source of returns and growth can lead to the unbalanced view that credit is responsible for progress. Credit always has an impact, but because of fungibility, not necessarily the impact expected by lenders or project designers. To attribute a specific impact to a loan requires strong evidence that without the loan there would have been no change in the activities of the borrower. Because this evidence is counterfactual, the assumption of no change without the loan cannot be established unambiguously. In fact, things are usually changing, the poor at the frontier have multiple sources of income and access, and viable alternatives often exist. False attribution feeds euphoria for credit, creating enthusiasm for lending and for the presumed loan purpose that far exceeds enthusiasm for ensuring repayment. Loans are poorly structured, relationships between borrowers and lenders are not carefully designed or diligently tended, and sources of repayment are regarded too optimistically. This imbalance leads to failures in the credit market when bad debt losses exceed lenders' interest and fee income. Overstatements of the developmental role of credit tend to result in its excessive use, which leads to destruction of confidence in credit markets. An example is the Third World debt crisis of the mid- 1980s. Fungibility and the simple fact that returns result only from uses of funds, not from sources, generally makes it impossible to identify unequivocally the returns to borrowers from credit or from a credit project. This realization challenges widely-held perceptions of the simple development model. Finance Works to Close Tolerances Like fine pieces of machinery, finance has very close tolerances. Tolerance is an engineering term for the degree of accuracy between the actual dimensions of a part and its design specifications. Plus or minus one Characteristics of Finance 57 one-thousandth of an inch or 0.025 mm, for example, is the tolerance permitted certain parts of modem internal combustion engines. This is a very close tolerance, compared to that required, for example, for a shovel or hammer. In finance, close tolerances are seen in measurements of tXe performance of commercial banks, where a before-tax profit equal to 1 percent of total assets has traditionally been a measure of good performance. Traders calculate yields on government bonds in terms of "basis points" equal to one one-hundreth of a percent. Close tolerances arise because well-functioning financial markets refine valuation to a high degree. Risk arises from very small changes, especially where large amounts are involved. Close tolerances pose a problem when credit is used directly as an instrument of development. In agricultural credit project appraisal, for example, consider the tolerances achievable by different members of the project design team. The agriculturalist may be doing an excellent job by predicting within plus or minus 25 percent the average yield that is obtained from a new crop. The rural sociologist may be doing an excellent job by predicting within plus or minus 50 percent the extent of target group adoption of the project-sponsored innovation in any given year. The economist may be doing well by predicting within plus or minus 10 percent the average price that growers of the new crop will receive for their produce in the free market. The financial analyst faces closer tolerances, which is the reason good analysts have a peculiar point of view that enables them to bring constructive pessimism to bear in any situation. A one or two percentage point change in the bad debt loss rate can make the difference between profit and loss for the farm credit agency lending funds for the project- sponsored innovation. A ten percentage point error in overhead costs may have a huge relative impact on the intermediary's position under the project. Estimates of the projected rate of inflation, where lending rates are not accurately indexed, also have important implications for the ability of the intermediary to enlarge its operations in the direction suggested by the project once project funds are disbursed. Hence, a project can perform relatively well in terms of its agricultural, social and economic specifications, yet be a disaster for the financial institution lending funds to farmers participating in the project. In this respect, credit is a vulnerable 58 Finance and Financial Markets and fragile project component, not the robust leading edge so often depicted. Finance Attracts Attention While many examples given in this book are based on deals that are or could be concluded, it is also instructive to consider those that are not. Some transactions do not occur simply because finance attracts so much attention. This social aspect of finance is illustrated by anthropologist Parker Shipton's reflections on the role of money beyond the frontier in The Gambia:20 Cash in rural Africa is an odd commodity surrounded by ambivalent attitudes. Nothing in The Gambia is more sought after than money, but nothing is more quickly disposed of. Indeed, money is even seen as something to get rid of, something to convert into longer lasting forms. Several features make money an unstable form of wealth in The Gambia: its nearly universal fungibility, its divisibility, and its portability. These features make money contestable. Everyone needs it for something, particularly in the lean season from June to August; and one with money will usually have an almost infinite number of relatives or neighbors with pressing needs. Inflation, of course, is a further reason not to hold onto money. Though few farmers have the means to measure inflation, nearly all are aware of the process. Rural Gambian saving strategies, then, are largely concemed with removing wealth from the form of readily accessable cash, without appearing antisocial. In communities where one has many relatives, as is usual, this is a delicate balancing act, and beside any ethical issues involved, the "squawk factor," the potential for complaints and accusations, must enter every individual savings decision. Ways of dealing with these aspects of money include burying it, putting it in strongboxes or containers that to be opened must be destroyed, and placing cash with trusted moneykeepers who return funds only when previously agreed conditions are met. Shipton cites these types of behavior as evidence of illiquidity preference. But finance also attracts intense attention within readers' more customary points of reference: the valuation process is so powerful and so closely related to economic well-being that it is the subject of public debate and government regulation. Kenneth E. Boulding notes that, "banks and 20. Parker Shipton, "How Gambians Save--and What Their Strategies Imply for International Aid." Policy, Research, and Extemal Affairs Working Papers: Agricultural Policies. WPS 395. Washington, DC: World Bank, April 1990. pp. 16- 17. Characteristics of Finance 59 other financial institutions occupy a certain nodal position of power in the total structure" of the economy.21 Inside the frontier, finance is inevitably subject to government scrutiny and attempts at control. Finance is often cited as the most highly regulated industry in many mixed economies. Because of its visibility, formal finance is a relatively attractive target, especially for governments with limited sources of revenue from other parts of the economy. The two most important prices in many economies are the prices of financial instruments: interest rates and foreign exchange rates. These are important because they affect all other prices. Interest rates, which offer present measures of future values, influence the volume of investment in the production of goods and services. Investment, in turn, is an important determinant of economic growth. Exchange rates are important because they affect the extent to which buyers and sellers can benefit from access to markets in other countries. Access is important because returns can often be increased by buying or selling abroad. Government control of exchange rates can direct these benefits in favor of domestic buyers at the expense of domestic sellers, or the other way around depending on whether government action helps maintain an artificially high or low exchange rate. Attempts to change access to financial markets affect relationships within a society. Intervention in finance is more than purely economic or financial because it responds to and addresses nonmarket issues of privilege, authority and power. Voters and more active participants in politics may reject financial or economic objectives as too narrow or irrelevant. Issues of privilege, authority and power are fundamentally political, and frequently they are the dominant influence on the role that finance plays in stimulating or retarding development. Subsidized Credit is a Political Playground One manifestation of political efforts to control finance is the attempt by governments to push the frontier outward, into areas of the private economy where they have little direct control. The most common means of doing this is by targeting loans or directing credit at below-market rates of interest to borrowers or purposes accorded priority by the government. 21. Kenneth E. Boulding and Thomas Frederick Wilson, eds., Redistribution through the Financial System: The Grants Economics of Money and Credit (New York: Praeger Publishers, 1978), p. viii. 60 Finance and Financial Markets Low interest rates are politically attractive. They respond to perceptions that the supply of credit is inadequate and too expensive for a particularly worthy purpose or for deserving classes of borrowers or potential borrowers. Their politically most important feature, however, is that the value created by concessional rates tends to be highly concentrated, while the costs are hidden and widely diffused. The benefits of subsidized credit are concentrated in a relatively small number of borrowers for three reasons. The first is the finite size of credit programs-governments have only so much money available to lend a subsidized rates. By definition, funds do not move naturally toward government priorities in the volumes and on the terms and conditions that are desired politically. This, of course, motivates intervention to increase flows and reduce rates. The second reason for concentration is that economies in lending favor large loans. A lender's transaction costs do not greatly vary with the size of the loan. Documentation, recordkeeping and other decision-making and administrative procedures tend to be similar across broad ranges of loan size. Within any given program or budget, the smaller the number of loans, the lower the transaction costs to the lender. Lenders may also believe that large borrowers are less likely to default. Lenders, even if government-owned, generally attempt to avoid losses so that their expansion and institutional continuity are not threatened. If losses are inevitable because of program design or economic crisis, the lender with a constituency of large, politically prominent borrowers may fare better than one with a portfolio consisting only of small loans. The third reason is that cheap loans tend to attract applicants who have the political status to exploit the windfall they offer. Over time, borrowers under subsidized programs tend to be better off than those for whom the funds were intended according to the initial justifications provided by program promotors. These three forces combine in case after case to concentrate the benefits of cheap credit following Claudio Gonzalez-Vega's "Iron Law of Interest Rate Restrictions."22 The costs of subsidized credit are hidden and diffused. If the government borrows abroad to fund the program, repayment in foreign 22. Claudio Gonzalez-Vega, "Credit-Rationing Behavior of Agricultural Lenders: The Iron Law of Interest-Rate Restrictions," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 78-95. Characteristics of Finance 61 exchange will come from the country's reserves at some future date, depriving unseen others of the use of these reserves. If the program's operating and bad debt losses are carried by local financial intermediaries, they can cover their losses, in the long run, only by charging their other customers more, returning less to their shareholders, or by subsidy from the government. Subsidies are a cost to taxpayers or to money holders if the subsidy is financed through inflation. In the short run an intermediary's bad debt losses can be hidden by artful accounting and nondisclosure. Financial institutions may be able to keep bad loans on their books for long periods without making provisions for losses or charging them off. This behavior by lenders often coincides with politicians' desire to paint a rosy picture. Both have an incentive to underestimate costs so that a credit program can continue without hard scrutiny especially if external assistance is available to support it. Credit Programs as Tools of Political Power The appeal of credit programs is illustrated by a real situation in one less-developed country in the mid-1980s. For a number of years the country's system of formal agricultural credit had operated under restrictive interest rate controls, suffered debilitating bad debt losses and was not dynamic. Cooperative credit arrangements languished, beset by poor eamings, organizational and implementational problems, and failed to attract widespread support from farmers, other depositors or from international donors. Donors supported several area-specific rural credit arrangements, but these did not appear to be promising candidates for replicability. Commercial banks had made loans to large farmers, most of whom were also businessmen, civil servants, military officers or political leaders. The banks had not made many small loans to members of households whose income was derived primarily from agriculture, because they were not enthusiastic about further costly rural lending within the interest rate ceilings specified by the central bank. To promote rural lending, the central bank imposed agricultural or rural lending quotas on the commercial banks. However, quotas could be met by placing special, noninterest bearing deposits with the central bank in lieu of agricultural lending. (This alternative, or of buying securities issued by a state-owned farm credit institution, is provided in several countries 62 Finance and Financial Markets because small banks and foreign banks serving specialized "wholesale" financial markets in major cities cannot reasonably be expected to make rural "retail" loans.) This "penalty" was less costly than the risks of agricultural lending at controlled interest rates as perceived and experienced by the banks, and the banks made large special deposits. With donor encouragement, foreign specialists were hired to assist the central bank in a review of the country's agricultural finance system. These specialists were experienced agricultural and nationalized commercial bankers from a developing country with a highly regimented farm credit system subject to detailed central bank control. They spent more than a year producing a lengthy report that contained an excellent description of the agricultural situation and of financial instutions and offered several good technical suggestions. The thrust of the specialists' recommendations was essentially to copy their own country's system. The model was proposed uncritically, without acknowledging the shortcomings that were apparent from its operations in their homeland. The report made a case for agricultural credit at rates of interest similar to those offered borrowers in the commercial and industrial sectors, although experience in both countries had demonstrated that rural lending tends to be more costly than credit for urban trade and industry. Their report was accepted in the same relatively uncritical manner in which it was proposed. It offered the central bank a system of comprehensive controls over rural finance, which would expand the central bank's authority and staff. At last the central bank would have the teeth to force commercial bankers to make agricultural loans, and it could prescribe exactly how this should be accomplished through quotas, instructions or guidelines, and reporting requirements. Banks that failed to meet their quotas would be deprived of a portion of their access to foreign exchange, a source of lucrative transactions. The proposals had few attractions for the commercial banks. Commercial banks were considered by some central bankers, government officials, academicians and by many politicians to be at best indifferent to farmers and at worst unpatriotic corporate citizens. The banks, politically isolated, were not brought meaningfully into the process that led to the recommendations of the report. With their exclusion, the financial and administrative transaction costs and risks of the proposals were not well explored. Characteristics of Finance 63 For large farmers the proposals offered prospects of a revival of the cheap credit machine that had concentrated its benefits in large loans. Wealthier farmers, many of them absentee operators, are likely to get most of the credit. They also face the least pressures for loan repayment because the report did not address in any depth changes that would provide incentives to improve repayment performance. Responding to the relatively low returns in agriculture that reflect government policies, many borrowers will take advantage of fungibility to obtain cheap farm credit for investment in nonagricultural activities. The result will undoubtedly be an accumulation of high-cost bad loans in the financial system. Small farmers, who constitute a high proportion of the population, were accommodated politically by form supported by little substance. The proposals held out the prospect that some cheap credit might become available to small farmers, which was otherwise unlikely. For others with easily identifiable interests, the proposals were also largely attractive. For local politicians they offered the promise of new money, more government activity, favors for friends, and opportunities to gain more control over the banks. Office holders could boast that their disappointment with rural lending by the banks and cooperatives resulted in concrete action by the government. For international donors the model provided a framework for assistance for institutional development and for augmenting the supply of loanable funds. The model will probably perform poorly in the adopting country because corruption is greater than in its country of origin, while administrative capacities are less developed. Nevertheless, the model will probably be adopted because it is so attractive politically to those who stand to gain and is unlikely to be resisted by those who will bear the costs. Commercial banks that will bear these costs directly were isolated politically. The mass of the citizenry to whom the costs will be passed on are not organized to resist or to seek modifications in the model. They have little incentive to do so: the cost is not known, its per capita burden will not be felt in a readily identifiable form, it is unlikely to be inconveniently large, and will be spread over many years. The report's recommendations will probably dominate agricultural credit in the adopting country through the end of the century. A more stunning and less subtle political use of credit were the loan melas held in India during the 1980s. The melas were followed with 64 Finance and Financial Markets considerable interest by the Indian press, which noted that these meetings were often held in parts of the country that were not firnly in the camp of the party in power nationally (before the 1989 elections).23 The melas were large, festive one-day gatherings staffed by volunteers from the national majority party and presided over by a high government official who disbursed loans to beneficiaries who were brought to the mela for that purpose. The funds were provided by nationalized banks, frequently over the objection of these banks' staff and officers who are reported to have had little or no discretion in the allocation of these funds. In one case loans were reportedly issued to 60,000 women at a single mela, and in another 10,000 people who actually repaid their loans were reportedly assembled and given small tokens of appreciation by the minister who sponsored the melas. 23. A collection of press clippings, official correspondence and other materials relating to these activities is found in "Loan Melas-for whose benefit?" Bangalore: Karnataka State Janata Party, n.d. [1987?]. Part II THE CONVENTIONAL ASSAULT ON THE FRONTIER Tremendous efforts have gone into forcing the frontier by providing credit through government programs, often supported by foreign assistance. The World Bank reports 1 that more than US$9.5 billion of its funds have been allocated to agricultural credit projects. The Bank has also provided funds for credit components in other types of agricultural projects. Its cumulative lending for industrial projects through development finance companies was US$19.2 billion. An additional US$4.9 billion has been committed to small-scale enterprise development, much of which is credit. Some of the Bank's urban development projects include credit for housing and for urban entrepreneurs. The Bank's activities that facilitate the flow of funds to farmers, businesses and home buyers, plus those of the regional development banks and the bilateral aid programs of OECD countries, easily exceeded US$60 billion by 1990, as measured by conversion into U.S. currency at the time loans and grants were made. The volume of operations at the retail level supported by donors' funds over the last 30 years probably exceeds US$200 billion at the very least. This total includes developing country governments' contributions to credit activities assisted by donors and recycled aid funds.2 1. The World Bank Annual Report 1989, Washington, DC: 1989. pp. 176-177. The Bank ceased reporting cumulative sectoral totals in its 1990 Annual Report. One billion equals 1,000 million. 2. Recycling arises when long term development loans to governments or to financial institutions are used to fund shorter tenn loans to the ultimate beneficiaries of credit projects. A typical agricultural credit project provides "wholesale" funds to a farm credit agency that are repayable to the government or to the donor agency over 15 or more years. They support "retail" loans ("subloans") to farmers that are usually repayable to the farm credit agency in less than ten years. The funds repaid by farmers 65 66 Finance at the Frontier This scale of activity invites review and examination. US$200 billion amounts to about 10 years' of World Bank Group lending at levels prevailing in the late 1980s. US$200 billion amounts to about US$55 for each citizen of developing countries. US$55 is about half the annual per capita income of the world's poorest countries.3 The financial stakes of official credit projects and programs are high: lots of hope and energy are devoted to using credit as a leading strategy for development. The basic assumptions that underlie these flows are those of development assistance generally, which are beyond the scope of this book. However, there are some crucial factors that determine whether credit projects and programs generate good loans. These issues are specific to the design and evaluation of credit projects, and are the subject of this part of the book. Part II deals with the progression of problems that afflict conventional efforts to deliver credit at the frontier. These begin with the concepts and assumptions that frequently animate the desire to expand the frontier, and their common expression in terns of allocation criteria, beginning with the bad seed of credit need. Chapter 4 provides this introductory background. Chapter 5 discusses devices such as use of selective credit controls and establishment of specialized lenders that are frequently used to direct credit toward the frontier. The verdict is once again unfavorable: costly means are employed that are unlikely to be sustainable, and that in the long run may even produce results opposite to those originally intended. Chapter 6 reviews the adverse effects of low interest rates and inattention to results. These are often associated with official efforts to expand the frontier, and they retard financial development. Chapter 7 wraps up this distressing progression by discussing some of the symptoms of the application of misguided concepts, of the use of inappropriate means of implementation, and of harmful policies and practices. that are not immediately repaid to the donor can be used by the farm credit agency to lend to others. 3. Statistics taken from The World Bank Atlas 1988 (Washington, DC: 1988). The Conventional Assault on the Frontier 67 In short, Part II finds that the conceptual framework upon which conventional projects and policies are based is grossly deficient from the perspective of financial development, and thereby tends to produce consistently unsatisfactory results.4 4. An official policy statement by major development assistance institutions in the Federal Republic of Gennany should be consulted by readers who cling to the view that development finance projects generally perform well in rural areas. See R.H. Schmidt and Erhard Kropp, eds., Rural Finance: Guiding Principles. Eschborn: Bundesministerium ffir wirtschaftliche Zusammenarbeit (Federal Ministry for Economic Cooperation), Deutsche Gesellschaft fur Technische Zusammenarbeit (GTZ-German Agency for Technical Cooperation), Deutsche Stiftung fur internationale Entwicklung (DSE-German Foundation for International Development), 1987. pp. 18 ff, 76 ff. 4 CREDIT NEEDS AND RELATED ALLOCATION CRITERIA This chapter critically examines the conceptual basis of many credit projects and of related policies. These are a coherent and easy target because a set of common factors motivates virtually all official efforts to provide credit to farmers, businesses, cooperative members, other individuals, and for "priority" sectors of the economy. Common features include meeting credit need and credit demand, and removing credit constraints. Need, demand, and constraints are tenms that are often used together or interchangeably. Analytical approaches used to address them are similar. Meeting credit needs or credit demand, or easing credit constraints of a strategic sector or a target group, are frequently mentioned in documents used to solicit support for projects offering credit. Project identification and preparation, the first stages in the project cycle,5 often include projections of credit need or credit demand. Credit need, credit demand, and credit constraints combine as a broad criterion for providing funds for credit programs, for credit allocation and for government intervention in finance. Procedures used to allocate credit critically affect the performance of credit programs. Because of the large volume of assistance devoted to credit, and because of the vast potential for the more effective use of human, financial and other resources in low-income countries, credit allocation strategies and criteria deserve careful examination. Credit need, the most frequently cited member of the set, is the most obvious starting point for inquiry. The development test used in this chapter is simple: Does 5. Warren C. Baum, "The Project Cycle," Finance and Development. January 1978; expanded and published as "The Project Cycle," Washington D.C.: The World Bank, 1982. 69 70 The Conventional Assault on the Frontier concern for credit need contribute to good loans and the remunerative use of credit? The following review of credit need begins at the general level, which deals with the rhetoric of development. Subsequent sections discuss efforts to define and quantify credit need, explore related concepts such as credit demand and constraints, and question the relevance of financing gaps. Basic Weaknesses of the Credit Need Criterion The fundamental problem with credit need is that need, as the word is commonly used, has so little to do with finance or with a financial view of human activity. Common usage is the appropriate standard for evaluation because credit need has no rigorous technical definition or implication that transcends common meanings of "need." Need implies something absolute, like the necessities for survival. As an absolute, need ignores the subtleties of risk and confidence and denies the possibility that there may be alternative ways to achieve development objectives. When these dimensions are considered, it is clear that equating credit with need easily overstates the role of credit. Credit Need: The Conman's Pitch If credit is considered a basic necessity for survival or a critical missing link in processes that ought to produce growth, an attitude is cultivated that does not assist the search for good loans or for efficient measures capable of stimulating development. Those giving "needed" credit may be shielded from hard scrutiny. Project designers may portray their efforts as good works, providing something so clearly valuable that close examination is not helpful or necessary, or as offering something without which other activities expected to have high returns cannot be undertaken. Emphasis on credit need may also lead to efforts to discredit those who question the concept. At the extreme, skeptics may be portrayed as having no understanding of the problems of the poor, as unsympathetic to their condition, as ignorant of the dynamics of progress, and as generally incompetent to participate in the dialogue of development. Long before the plunge to this level it is useful to refocus the debate on the central issue, which is how to make good loans. Behind these absolutist defenses, credit need easily becomes a self- serving concept employed by those providing credit, and equally important Credit Needs and Related Allocation Criteria 71 politically, by those applying for credit. Clearly, not all credit projects, designers and loan applicants seek such protection. However, belief in credit need may increase the possibility of misrepresentation and of efforts to deflect examination. This poses a risk to all parties to credit projects, and should be taken seriously because the problem goes beyond being merely a question of terminology. The assumption behind credit need is that without credit very little happens: the technology or behavior desired by development planners or project designers would not be adopted by the target group of project beneficiaries. However, evidence from a number of countries suggests that, even without institutional credit, significant advances occur. Examples include expansion of informal credit in the Philippines in response to new investment opportunities in the Green Revolution,6 the tremendous popularity of savings clubs to facilitate fertilizer purchase by the rural poor in Zimbabwe,7 and experience with small business development in Colombia.8 Circumstantial evidence consists of the tremendous progress made in developing country agriculture over the last 25 years, while far fewer than a third of rural households receive official credit. Is it reasonable to assume that these households alone are responsible for all of the progress? However helpful it may be, credit is not an essential component of development. From the perspective afforded by this realization, the test of a proposed innovation is its rate of adoption under a project promoting its use without credit. Very few project designers put their technical 6. Orlando J. Sacay, Meliza H. Agabin, and Chita Irene E. Tanchoco, Small Farmer Credit Dilemma (Manila: Technical Board for Agricultural Credit, 1985). See especially Chapter 8; Presidential Committee on Agricultural Credit, A Study on the Informal Rural Financial Markets in Three Selected Provinces of the Philippines (Manila: 1981). 7. C.J. Howse, "Agricultural Development without Credit," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 134-137; J.D. Von Pischke and John Rouse, "Selected Successful Experiences with Agricultural Credit and Rural Finance in Africa," Savings and Development. VII, 1, 1983. pp. 21-44; Hans Mittendorf, "Savings Mobilization for Agricultural and Rural Development in Africa," in Denis Kessler and Pierre-Antoine Ullmo, eds., op. cit. pp. 223-224; Michael Behr, "The Savings Development Movement in Zimbabwe," in Guy Bedard, Gerd Guinter Klower, and Martin Harder, eds., op. cit. Vol. H, pp. 91-112. 8. Jaime Carvajal, "Microenterprise and Urban Development." Speech delivered at the Pan American Economic Leadership Conference, Indianapolis, June 1987. (Bogota): The Carvajal Foundation. 72 The Conventional Assault on the Frontier recommendations to this test. This suggests that credit could be used as a response to gaps in project designers' knowledge of the environments they hope to alter or create with new technology. These gaps may be disguised by the assertion that lack of credit is all that hinders progress. Credit Need Defies Analysis Credit need fails analytically. Economics, for example, deals with the impact of investment, not need. Financial analysis can justify an investment, identify its optimal size, and find the best means of funding it. Successful financing plans ensure that funds are available at the best trade - off between cost and other terms, and that repayment capacity exists to service the debt incurred. These professional tools cannot adequately address need, which appears to be a much broader or less well defined view of investment that is not directed toward the capacity to service debt. Credit specialists who work with farmers or businesses to select investment opportunities and provide funds for expansion or for adoption of new technologies are not prepared professionally to quantify need. Their task is to quantify what loan applicants can manage and afford. Credit need is a dangerous concept because it diverts attention to something that is conceptually ambiguous, that defies professional quantification. Government strategies based on satisfying credit needs, if vigorously pursued, destroy the financial institutions upon wnich the burden of lending is placed. This occurs because credit needs are elastic. Credit needs tend to exceed the quantity of funds that can be prudently loaned to those considered in need of credit. This occurs because political objectives are not necessarily related to financial capacities. Derinitions of Credit Need What are credit needs and how are they quantified? A comprehensive statement of credit need lending strategy is given in the All-India Rural Credit Survey,9 the results of which were published in the 1950s. This survey was probably the biggest one-shot effort to examine rural credit use. It provided the basis for construction of one of the world's largest 9. All-India Rural Credit Survey. "Credit Requirements and Creditworthiness," Chapter 16, Vol. I, The Survey Report, Part 1, (Rural Families). Bombay: Reserve Bank of India, 1956 (see pp. 951-957, 974, 1013). Credit Needs and Related Allocation Criteria 73 rural credit systems. 10 More than any other event, the survey marks the start of the modem era of government attempts to use credit on a broad scale for purposes regarded as developmental. Along with the European cooperative model and the US Farmers Home Administration model, the Indian rural credit system, at least at one time, inspired credit project designers around the world. The Survey report defines credit needs variously as: * The amount of credit a rural family actually obtains. * The amount of credit a rural family wants to obtain for either - proper and legitimate productive purposes that would be economic and enable loans to be self-liquidating, or - activities that are not directly productive, such as family consumption. In the latter case, need could be inferred with reference to the maintenance of some accepted or acceptable standard of living and to the ability of the family to repay without sacrificing such a standard of living. • Funds requested in addition to loans actually obtained that, to be provided, would require changes in prevailing lending terms and conditions (interest, tenor,11 security, etc.) to permit profitable use by borrowers. * Arising from "standards of performance and efficiency in production or of living in consumption," related to input requirements for crops and the optimum use of land, or to some minimum acceptable standard of living. This requirement could be demonstrated by differences in husbandry practices and living conditions between strata of society obtaining credit and those not obtaining credit. * The additional credit that could be supplied by a reorganized or ideal credit system offering terms and conditions different from those presently available, in the form of a demand schedule for credit for productive uses. * Changes in investment or differences in levels of investment associated with variables other than the size of farming activities; that is, investment used for purposes other than the purchase of land. 10. Daniel and Alice Thorner, Land and Labour in India (New York: Asia Publishing House, 1962) (see especially chapters XIV and XV). 11. "Tenor" is a technical word meaning the term of a loan, that is, the time between its availability to the borrower and its scheduled repayment to the lender. 74 The Conventional Assault on the Frontier * Credit required for the purchase of land. * Credit use related to actual expenditures by cultivators, or to some fraction or possibly multiple of actual expenditures. * The reported requirements of cultivators for specific purposes. * Comparison "between relative importance of an (expenditure) item in the total reported credit requirements and the relative importance of the expenditure on that item in the actual total expenditure incurred on all items under consideration" for a surveyed household and period. * Indicators of "real efforts that might be made if the reported credit requirements or parts of them could be met on terms that are reasonable, though not necessarily as low as the cultivator reported in reply to the questionnaire used to obtain estimates of credit needs." These definitions include references to levels of production, administratively-determined standard of living targets, and the amount of credit requested or provided or that might be available under ideal conditions. Concern for repayment is not a prominent feature. The promotors of a credit project can define need as they choose and proceed to meet the need they claim they have identified. Falsd confidence or simplistic approaches based on credit need lead to systems of credit allocation that operate with little meaningful quantification, slight regard for risk and confidence, and lagging loan collections. The application of definitions of the type presented in the All-India Rural Credit Survey is attempted at two levels by government agencies and international assistance organizations. The first derives credit need for a sector of the economy or a specific geographical area where a project or a banking office could be located. The second calculates the credit need of a loan applicant. Each is discussed below. Quantifying Sector or Area Credit Needs Quantification of credit needs is generally undertaken in sector or area studies in one of three ways. The first derives credit need from sectoral or area financial flows summarized in input-output tables, the second relates credit need to projected incremental output, and the third infers credit need from a sector's contribution to the economy. Credit Needs and Related Allocation Criteria 75 The Input-Output Method Input-output matrices summarize transactions among all sectors of an economy and have been used to calculate a sector's credit needs. The purchases of a sector from other sectors are aggregated, and that sum or some portion of that sum is defined as the sector's credit need. In one analysis prepared from the most recently available input-output table for a country, agricultural credit need was assumed to equal the amount of agricultural sector purchases from other sectors. These purchases include farm machinery and equipment from the industrial and import (rest of world) sectors, fuel from the energy and import sectors, and haulage from the transport sector, for example. The credit need calculated in this analysis was larger than the amount of formal credit classified by the central bank as loaned to agriculture. The country did not have a large informal financial market, and the amount of informal credit that was devoted to agriculture was probably small. As the input-output table summarized transactions that had already occurred, it was clear that the "need" identified by this exercise was not critical to achieving the flows that were recorded. If input-output matrices were projected for future years, would the entire expected increase in purchases by one sector from other sectors, and even from itself (e.g., farmers' purchases of seeds from other growers), have to be financed by credit in order for these transactions to occur? This is a more useful question because it attempts to identify constraints to growth. The question cannot be answered from input-output data, however, because these do not specify how transactions are financed. Small-farm credit offers the best illustration of problems in identifying credit needs because the access of agriculture to institutional credit is generally limited-self-finance predominates on agriculture's balance sheet in market economies, especially for small farms.12 Many current transactions are financed from farmers' own funds, and these renewable flows normally continue to be available for transactions that would enable their owners to pursue their livelihoods. As private financial tlows, they 12. Organisation for Economic Cooperation and Development, Capital and Finance in Agriculture. Vol. I, General Report. Paris: OECD, 1970; Doreen Warriner, Economics of Peasant Farming. 2nd ed. London: Frank Cass & Co., 1964; US data are available in Agricultural Finance Outlook and Situation, published periodically by the Economic Research Service of the Department of Agriculture. 76 The Conventional Assault on the Frontier should generally reproduce themselves with a surplus and continue to respond to attractive investment opportunities. Therefore, only some undefinable fraction of the entire projected annual increase in transactions would presumably be dependent upon an increase in the supply of credit. The Incremental OutputApproach The key assumption of the incremental output approach is that credit is required to support growth in the same proportion that it is used to fund present levels of activity. Calculation begins with the amount of credit disbursed during a recent period for the sector or area being studied. This amount is multiplied by the quantity one plus a projected percentage increase in the sector's output. The percentage selected depends upon the user. It may be a target growth rate assigned the sector by planners, or a projection of what is considered likely to occur by a forecaster or project designer. Credit need is defined as the difference between the amount of credit disbursed during the recent period and that derived for a future period from the calculation. The incremental output approach fails to go beyond the mathematical relationship between output and credit. It does not deal with the substance of transactions or of the financial calculation it attempts to influence. It does not provide an indication of the quality of the credit in use or expected to be used. For example, long-mn bad debt losses and administrative costs that exceed lenders' spreads suggest that lending cannot be sustained without changes in the credit system. Yet, the incremental output approach would still indicate that more credit should be issued, regardless of the condition of the credit system or of borrowers' incentives to repay loans. This approach assumes that all credit is homogeneous. Short-term loans and longer term loans, for example, are mixed together as credit disbursed, yet their implications for the growth of output during any given forecasting horizon are greatly different. Short-term loans may assist farmers from one harvest to the next using existing technology, while longer term loans may assist technological transformation and greatly change the relative proportions of land, labor, and capital used by the borrower. Examples include agricultural mechanization and irrigation. A more serious problem arises when this method is used to identify credit need for sectors that are favored by the government. Credit issued to these sectors tends to be subject to quotas and targets. These controls or CreditNeeds and Related Allocation Criteria 77 guidelines distort reporting by lenders, giving them an incentive to designate as much lending as possible as contributing to the target or quota. Because favored sectors tend to receive loans on soft terms, borrowers also have an incentive to apply for these loans whenever they find a remunerative use for borrowed funds, regardless of whether these uses are those for which the loans are intended. Fungibility destroys the neat compartments that are suggested by quotas and targets. A creative variant of the incremental output approach found in one project used surveys to quantify borrowing by different types of farmers in the proposed project area. Credit need was defined as the amount of credit that would be used by poor farmners when their incomes rose, under the project, to the level used by representative richer farmers with the same endowments of land and labor at the time of the survey. Capital-output ratios could be misused in a similar manner. The Proportional Output Approach The proportional output approach derives credit need from a sector's contribution to the economy. The size of the economy is customarily measured by gross domestic product (GDP). A proportional output ratio is then calculated using GDP as the denominator, while the output of the sector, the value added to the economy by the sector, is used as the numerator. The total amount of credit outstanding is then multiplied by this ratio to quantify the sector's credit need, that is, the amount of credit that ought to be flowing to the sector.13 Unlike the input-output and incremental output approaches, this measure is generally used to indicate insufficient credit, rather than as a tool for defining an exact amount of credit that ought to be made available. The reason for this conservatism is not clear. The major shortcoming of the proportional output approach is that it ignores risk. While some industries attract credit relatively easily, others do so with difficulty, as was noted in chapter 2. Those that receive relatively little credit, such as agriculture and small scale industry, are the ones for 13. The amount of credit disbursed during a given period may be used instead of the amount of credit outstanding, but the outstanding amount is usually more easily obtainable and more accurate than data on amounts disbursed. This is because commercial lenders measure their risk and project their income from amounts outstanding. 78 The Conventional Assault on the Frontier which special credit programs are often designed. Hence, project designers in these sectors can generally use proportional output comparisons to imply that the sector the project is supposed to benefit appears to be tremendously short of credit. This comparison is especially striking, but still irrelevant, in the poorest countries that have relatively large agricultural sectors. Conspiracy theories citing lazy, uncomprehending or unpatriotic lenders, and allegations of "market failure" (an economic tenn suggesting a sub- optimal market equilibrium) may be offered or inferred. The reasons why a sector has difficulty attracting credit do not have to be dealt with when this measure is used to advocate credit-the figures speak for themselves. Or, do they? The reasons for different levels of credit use generally revolve around risk. While credit outstanding for agriculture typically equals less than 20 percent of agricultural assets, for example, the liabilities of commercial banks (credit they obtain in the form of deposits and by going into debt in other ways) often exceed 90 percent of their total assets. Agriculture is very risky, while deposits in commercial banks are often insured or backed by government. Agricultural lenders' bad debt losses may be relatively large even when agriculture has a debt-to-assets ratio of 20 percent, as was the case in the United States in the mid-1980s. However, the proportional output comparison suggests that more lending is in order because agriculture has such a small share of the national credit pie. Quantifying a Loan Applicant's Credit Need In projects, identification of an individual loan applicant's credit need typically is based on incremental input or investment. In project design, technical, marketing, and other key variables are examined through feasibility studies, field trials, and review of successful experience elsewhere. These data provide the basis for recommending innovations on the farm or by the firm, or investment to expand operations with familiar technology. A survey of facilities for grinding grain into flour, for example, may suggest that additional rice or posho mills could operate viably in a rural area. This determination would be based on consumption and marketing studies to determine demand, and on the quantity of land devoted to grain production, crop yields, consumption of grain by farm animals, storage losses, location and capacity of existing mills, transport costs, and similar factors to determine supply. From this data a program Credit Needs and Related Allocation Criteria 79 could be designed to support the development of additional mills through credit and technical assistance. This sort of data is used to try to ensure that project funds invested could earn a satisfactory return. However, data on technical feasibility, marketing and other non-financial essentials for success are not sufficient for credit project design because they do not indicate whether good loans could be made. The difference between good investments and good loans arises from a number of factors. Some of the more obvious include the following: Do the design data include allowances for risk? Would loan applicants have sufficient equity capital to permit appropriate financing? Would prospective borrowers possess sufficient managerial capacity to obtain the returns envisaged? Would the lender be skillful enough to identify competent borrowers and to obtain timely loan repayment? Could the lender charge a spread high enough to cover costs? Flows Before and After Financing Agricultural project analysis uses farm budgets to formalize technical and financial feasibility information and to project the incremental costs and benefits of the proposed innovation.14 Cost and benefit streams are typically derived "before financing" and "after financing." The before- financing budget shows projected flows from the activity being promoted by the project. The after-financing portion of the budget shows the financing that would be necessary to support the activity initially and the surplus expected from implementation. The financing portion of the budget usually contains relatively large amounts of credit to fund the project- induced investment. A highly simplified example of a farm budget is contained in Table 4.1. It shows that with the project the farmer's seasonal input purchases jump by $800 from $200 to $1000. This investment in seeds, fertilizers and insecticides doubles the volume of production, from 5 tons to 10 tons, which increases the net benefit before financing from $1,000 to $2,200. 14. Farm budgets are described in J. Price Gittinger, Economic Analysis of Agricultural Projects. 2nd ed. (Baltimore and London: The Johns Hopkins University Press, 1982); in Maxwell Brown, Farm Budgets: From Farm Income Analysis to Agricultural Project Analysis (Baltimore and London: The Johns Hopkins University Press, 1979); and in Walter Schaefer-Kehnert, "Methodology of Farm Investment Analysis." Course Note 030/031 Rev. Dec. 1981. Economic Development Institute of the World Bank, Washington, DC. 80 The Conventional Assault on the Frontier This is all made possible, according to the credit need approach, by a loan of $800, which funds all of the incremental input purchases. Table 4.1 Hypothetical Farm Budget Without Project With Project Calculation Produce (tons) 5 10 + Produce consumed on the farnm (tons) 2 2 Marketed produce (tons) 3 8 = Farmngate price per ton ($) 400 400 x Total farm cash receipts ($) 1,200 3,200 = Purchased inputs ($) 200 1,000 Net benefit before financinga ($) 1,000 2,200 = Loan receipts ($) - 800 + Debt service ($)[including a 20% interest charge] - 960 Net benefit after financinga ($) 1,000 2,040 = a "Before financing" refers to the costs and benefits directly related to production. -After financing" includes these costs and benefits and also loan receipts and debt servicing. The majority of farm credit projects deliver medium- or long-term loans for investments in capital goods. In the more elaborate budgets prepared for these operations a relatively large initial investment cost results in a negative net benefit before financing in the first (or early) years of implementation. This is offset by a term loan, which is repaid from the positive flow of funds in later years. Basing Loan Sizes on Investment Costs The design of credit arrangements for project beneficiaries usually starts with the costs of the investment. In the typical case this is measured by the negative funds flow in the initial year or period of the before-financing portion of the budget. Here, project designers usually define credit need arbitrarily as a relatively high percentage of initial costs-hopefully only the cash costs and not the noncash contributions or "sweat equity" of farm Credit Needs and Related Allocation Criteria 81 family labor unless these would otherwise not be forthcoming. Popular figures used to identify credit need based on cost estimates are 75, 80, 90 and 100 percent of estimated incremental costs. Table 4.1 conforns to this convention, showing a loan of $800 to cover incremental input purchases of $800. The procedure for determining credit needs of commercial and industrial activities is similar to that used for agricultural projects. Investment cost tables quantify credit need, although more sophisticated analysis uses traditional financial statements (balance sheets, income statements, and sources and uses of funds statements) because these identify flows that are not obvious from cost tables and more effectively communicate financial performance and condition. Problems of Financing High Proportions of Investment Costs with Debt Relating credit needs to costs is systematic, but the underlying assumption that most investment costs must be funded by debt bears examination. The conclusion that little equity investment will be forthcoming from the borrower or beneficiary is usually based on the observation that at relatively low levels of economic activity there is little surplus. And, where markets facing small firms are highly competitive, there is also little surplus. However, the surplus produced by an activity and the liquidity that supports the activity are not the same. Although money income not immediately spent is both liquid and "saved," surplus and liquidity are not necessarily closely related. 15 Low levels of surplus do not necessarily accompany low levels of liquidity. Because of risk and the lack of convenient access to formal financial institutions, large amounts of cash are often held in the countryside. Evidence for this includes the success of efforts to mobilize rural savings, the liquidity of rural bank branches, and the amounts of currency redeemed in rural centers when a currency issue is demonetized and replaced by another. 15. J.D. Von Pischke, "Toward an Operational Approach to Savings for Rural Developers," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp, 414-420. 82 The Conventional Assault on the Frontier The way an investment is financed affects the owner's commitment to ensuring its success.16 Defining credit needs as a high proportion of investment costs leads to high proportions of debt financing. High debt service burdens result, and debtors may conclude that they are working for their creditor rather than for themselves. This realization weakens the incentive to ensure the success of the investment, and to repay the loan. 17 This is most likely to occur when the borrower encounters difficulties that diminish cash flow-precisely the time that extraordinary efforts are required to overcome problems. As Shakespeare tells us through Polonius, "Borrowing dulls the edge of husbandry." Thanks to legal and financial innovations since the 17th century, recent experience demonstrates that only excessive borrowing does so. Another faulty assumption is that the most satisfactory method for determining the size of a loan is in relation to investment cost. While there may be no reason for a loan to exceed cost, using cost alone as the major determinant of loan size poses dangers. This is because cost has little to do with the prospects for loan repayment. Future cash flows, not original cost, are the source of loan repayment. Future cash flows are obviously uncertain, and the common flaw in relating loan size to investment cost is that it ignores risk. In agriculture, the most risky of all major industries, this oversight has overwhelmingly important implications. These extend to other rural economic activities that depend on agricultural incomes. Need is a bankrupt approach to credit allocation because its definition and quantification do not address the core developmental issues of finance. These issues, explored in earlier chapters, are the determinants of value, risk, and confidence. They come together in the basic credit question of how to make good loans that are remunerative to lenders. Similar problems arise when loans are allocated in response to credit constraints, credit demand, and financing gaps. Credit Constraints Are Ambiguous Analysis based on credit need deals unsuccessfully with a problem that is also reflected in concern for financial constraints. In a general sense, 16. Louis L. Allen, Starting and Succeeding in Your Own Small Business, (New York: Grosset and Dunlap, 1968). 17. Stiglitz and Weiss, op. cit., provide an economic analysis of this type of behavior. CreditNeeds and Related Allocation Criteria 83 finance is a universal constraint. By definition finance is scarce, and scarcity gives it value. The point of interest to developers is that finance may be a binding constraint that discourages the behavior they wish to promote. Finance is a binding constraint when all other ingredients for successful investment are present except finance, and when they can be activated by finance. Finance is often cited as a missing link or described as a catalyst for development. Portrayal of finance as a missing link is abstract and may represent a special case. While finance is a catalyst for development, it is also a catalyst for poor investment, political patronage, corruption, and other types of opportunism. A more plausible interpretation is that finance is one of a limited and identifiable set of constraints that can be supplied simultaneously through a project expected to create a surplus in a way that is consistent with government priorities. social considerations, and voluntary participation. Shortage of finance, specifically credit, is a virtually universal assumption underlying credit projects and components, and is often cited in documents soliciting support for projects. A publication of the International Fund for Agricultural Development (IFAD), for example, notes that credit is considered an important part of many projects: "...the obvious assumption is that the credit-supported components are important for the success of the project and that credit is vital to implement these components."18 In spite of the considerable volume of funds provided to ease financial constraints, no rigorous methodology has evolved to quantify the extent or demonstrate the nature of financial constraints in the economy at the frontier. Estimates of financial constraints are generally derived using the incremental input approach, assuming a low level of equity contribution by the borrower. Binding financial constraints are not necessarily antidevelopmental. If they stand in the way of bad investment, they are socially beneficial. Some loans do not result in positive retums, some attempts at innovation fail, and some projects have to be reoriented to achieve disbursement targets. Efforts to remove these constraints will result only in losses if they do not contain systems for discriminating against proposals likely to lead to bad 18. International Fund for Agricultural Development, The Role of Rural Credit Projects in Reaching the Poor. IFAD Special Studies Series, Vol. 1. Oxford: Tycooly Publishing, 1985. p. 17. 84 The Conventional Assault on the Frontier investments and bad loans. For the financial system to make good loans and allocate funds for high-return investments, it must reject poor proposals, unfit applicants, and low-return investments. Investment Patterns and the Role of Credit A useful perspective on constraints is provided from observation of how development generally occurs in the frontier economy: progress customarily results from small, incremental actions over time rather than through a "big push." An incremental approach permits the investor's management skills, risk-bearing capacity, and organizational efforts to inch forward along with the investor's financial situation. This process deals with shifting constraints and requires creative responses to keep progress in balance. Success is not the result of a single transaction, but of a continuing activity. One of the difficulties facing developers is that there is no typology or model that indicates the relative importance of credit in removing constraints. There is little interpretation of experience that identifies the strengths and weaknesses of the incremental and of the "big push" strategies in different situations. The absence of these data or lessons may stem, in part, from the belief that credit is always essential, or that supplying it is so greatly superior to other alternatives that these alternatives hardly merit investigation. Where could construction of a model or typology of credit constraints begin? For industrial loans, the relative size and indivisibility of proposed investments probably offers a good starting point. Economies of scale may require investments of a certain magnitude that may be considerably beyond the present financing capacity of prospective investors. This would make credit relatively important, while also making investment risk high if the prospective investors lack experience in managing operations of the scale and complexity implied by the size of the investment. In commerce at the frontier, credit constraints may be less important once a size of operation is reached that provides the merchant a reasonable living. Expansion through stocking more lines and a deeper inventory probably can be undertaken incrementally, and facilities may be rented rather than purchased where finance is scarce. In agriculture it appears that finance could be a serious constraint to farmers with the arrival of major irrigation following the construction of a Credit Needs and Related Allocation Criteria 85 large dam. Farmers in newly irrigated areas face new, greatly expanded production possibilities almost overnight. Accumulations from their previous activities are probably insufficient to finance the additional inputs required to produce output sufficient to justify the investment made in major irrigation works. While over time farmers would no doubt respond to the new opportunities, enabling capable, trustworthy operators to do so quickly through credit provision would seem to be relatively attractive. In each of these hypothetical industrial, commercial and agricultural situations, though, attractive prospects for the use of funds do not justify credit programs. Technical feasibility, marketing and other nonfinancial essentials help ensure that funds invested could earn a satisfactory return, but are not sufficient for credit project design because they do not address risk and confidence, and therefore cannot indicate whether good loans could be made. Many Agricultural Innovations Are Not Capital-Intensive In contrast to the financial situation created by the arrival of major irrigation, incremental changes in husbandry practices for annual crops have relatively small financial implications. For example, substantial gains in crop yields are often achievable through changes in husbandry practices, such as date of sowing, plant spacing, or soil preparation that require no purchased inputs. Other types of investment, such as fences constructed from local materials available on the farm or from commons near the farm, use family labor during slack periods in the agricultural production cycle and do not require cash. Adoption of improved seeds and fertilizers also often occurs in small steps. While improved inputs may be the key to production increases, risk tempers the pace of their adoption. Most farmers at the frontier experiment on a modest scale. Their experiments may occur over several seasons, or until a relatively poor crop year provides the information they seek concerning risk, which is reflected in the performance of the innovation in unfavorable circumstances. This strategy gives farmers time to rearrange their affairs, and diminishes the importance of credit to their ability or willingness to innovate. Gains from small changes may finance investment in larger changes, or off-farm activities may be relied upon to provide funds for an investment. 86 The Conventional Assault on the Frontier Even for relatively large, indivisible investments such as cattle, lack of finance is not necessarily an important constraint and credit may not be an appropriate means of promoting the adoption of improved breeds. In Kenya, for example, small fanners exhibited great interest in grade cattle in the late 1960s and 1970s. Most farmers buying improved dairy stock used their own savings. However, some farmers obtained loans from official sources under donor-supported projects. About 20 percent of the animals transferred with project loans died from disease and other causes. In many instances animals obtained on credit failed to produce sufficient cash flow to meet loan installments. A number of borrowers abandoned dairying and either failed to repay their loans or repaid from other sources of income. Other farmers who did not purchase grade cattle also adopted dairying as a cash crop, but over a much longer period using artificial insemination (Al) to upgrade their small, unimproved herds. Al herds are slow to develop because calvings occur once a year, half of the calves are males and have little economic value, and some AI heifers die before breeding. A typical progression, starting from a one-cow herd owned by a frontier farmer, would start with several inseminations a month or two apart. Several are often required because the farmer may not be able to tell precisely when the cow can be bred, and the inseminator may not be sufficiently skilled to ensure fertilization. Nine months later an improved cross-bred heifer is born, but dies within a few months because the farmer is not experienced in controlling the diseases that affect improved breeds. The unimproved cow continues to produce a little milk for nine months after giving birth. Then insemination is tried again, and about two years after the first Al calving a second Al calf is born. This is a bull calf, and is of little value for herd build-up or for sale. A year later a heifer AI calf is bom. Only when that heifer calves, about 30 months after its birth, is there an enhanced supply of milk reflecting the superior characteristics of improved breeding. This example shows that it may take five years to achieve through Al what can be achieved in a matter of weeks or months with a loan used to buy improved in-calf heifers.19 However, adoption through AI subjects farmers to relatively small increments of risk and has no massive financial 19. The process may be accelerated by purchase of a second local breed heifer for Al breeding. CreditNeeds and Related Allocation Criteria 87 implications for fanners or farm credit systems. In addition, AI can be made available to every household with a cow, an old person or child who can take the cow to the insemination center or to a stop along the inseminator's daily route, and a small amount of cash for the insemination. To generate good loans, by contrast, requires a highly selective screening of applicants. Procedures used to encourage applicants also tend to be selective. The logistics of providing an effective AI delivery system including semen supply and storage, inseminator training, and transport or positioning of staff, are not necessarily simple. But they are eminently susceptible to measurement and management, permitting mastery in less time than that required to construct an effective credit system. Credit Constraints Summary To summarize, there is no rigorous means of identifying or quantifying credit constraints on the small farm or in the small firm where the activities of the owner or household are mixed with the commercial aspects of the operation. Farm budgets and investment cost tables fail to quantify liquidity before the loan, and loan applicants may be reluctant to divulge this information. There is also no accurate way to identify the entrepreneurial responses that target groups of beneficiaries might undertake, in the absence of a loan, to gain access to improved technologies. There is not even a typology capable of yielding qualitative indications of the extent to which credit is useful or appropriate for typical investment situations. The widespread existence of binding financial constraints to sustainable innovation remains an intuitively appealing but empirically unverified possibility. When the possibility is invoked to obtain support for a credit scheme, skepticism is the sage and prudent response. Credit Demand Credit demand is also a deficient concept for credit project design. In economic theory, credit demand is equated with credit supply at the market-clearing rate of interest. However, credit demand is not homogeneous or transparent, but consists of true demand and false 88 The Conventional Assault on the Frontier demand.20 True demand is the sum of loan applications backed by bankable projects. Important characteristics of bankable projects are generally an experienced entrepreneur as a borrower, a liquidity cushion in the form of equity financing that protects the interest of the lender, projected cash flow that will cover reasonably expected claims in a timely manner, a loan purpose related to a technology and an activity, commodity or industry that is likely to perform satisfactorily, and measures to contain the effects of the risks that are most threatening to the success of the project. False demand is the difference between applications for bankable projects and total loan applications received. False demand consists of proposals for unbankable investments. Unbankable investments may be bad investments that are not remunerative. They may be good investments that are poorly structured financially, so that creditors would profit while suppliers of equity lose, or vice versa. They may also be good investments backed by investors who are inexperienced or not regarded as dependable by lenders. An important role of development lenders is to separate good proposals from bad. The concept of credit demand is difficult to apply where developmental experimentation at the frontier requires exploration of many doubtful investment proposals. Separating the good from the bad is difficult at the frontier because of risk and other information problems. Areas beyond the frontier are uncharted waters for those within it. Information-gathering requires transaction costs and bad debt losses from experimental lending. A special problem besets state-owned lenders established to promote investment at the frontier. They find it difficult to be objective in rejecting bad proposals because of the expectations and pressures to lend created by the nature of their ownership.21 Their objectivity may be further compromised if external funding agencies' enthusiasm for disbursement crowds out prudent credit decisionmaking. 20. Sayre P. Schatz, "Government Lending to African Businessmen: Inept Incentive," Journal of Modern African Studies. 6, 4, December 1968, pp. 519-529; Economics, Politics and Administration in Government Lending: The Regional Loans Boards of Nigeria (Ibadan: Oxford University Press, 1970). 21. Jean Causse, "Necessity of and Constraints on the Use of Savings in the Community in which they are Collected," in Denis Kessler and Pierre-Antoine Ullmo, eds., op. cit. pp. 168-169. CreditNeeds and Related Allocation Criteria 89 Credit demand is distorted by cheap credit policies. Credit demand is theoretically infinite when credit carries a negative real rate of interest. This occurs when the rate of inflation is higher than the interest rate, which is frequently the case for credit issued by official lenders to favored sectors and when rates of inflation are high.22 The theoretical possibility of infinite demand is not realized because transaction costs are imposed by lenders on loan applicants seeking negatively priced funds. However, the prospect of cheap funds creates an incentive to generate false demand. Applicants who can minimize transaction costs by virtue of the size of their resources or through political influence see a special opportunity in cheap credit. Their applications may not represent the best investment opportunities in a sector or the best structured proposals, and their status may discourage objective decisionmaking by lenders. Positive real interest rates give borrowers an incentive to be efficient; negative rates do not. Incentive comes in part from risk that is reduced when a portion of the loan is in effect a grant created by a decrease in the value of money used to repay the loan. This effect increases false demand: investments that might be successful when incentives are in place may be unsuccessful in their absence. Economists' models of loan demand often exclude transaction costs while assuming that markets are perfectly competitive in the economic sense, so that every participant could lend or borrow any amount at the same rate. In this theoretical framework there is no financial constraint, which would be unusual in any financial market. Assuming away transaction costs also assumes away the institutions that facilitate transactions in these markets. Risk is also often assumed away, ignoring the major characteristic of finance. In economic terms, risk (uncertainty) means that financial capital has more than one price and that product differentiation based on information is common and rational. These problems make credit demand difficult to analyze, except possibly in planned economies where "credit demand" is determined and administered centrally through formulas and planning criteria. 22. Inter-American Development Bank, "Summary of the Evaluation of Global Agricultural Credit Programs," GN-1493. Washington, DC: February 1984. pp. 8, 11, 21 and 23. 90 The Conventional Assault on the Frontier Filling Financing Gaps Financing gaps are the volume of funds a borrower seeks from sources other than those that are already available. Financing gaps, also called resource gaps, are cousins of credit needs. They are the product of a planning and budgeting approach that is legitimate for those owning or operating an enterprise or activity. Firms require resources for the realization of their objectives. Resources are by definition limited, and a function of management is to push back these limits to improve the firm's performance. Targets are set to focus organizational energy, expressed in budgets or projections of funds required for fulfilment of a plan. Quantifying and filling resource gaps are part of fund-raising strategies. But they are not adequate for formulating viable lending strategies because debt is only one element of finance, and because the position of the lender is different from the role of the manager or the owners of an enterprise. To the lender, resource gaps are ubiquitous: in the normal course of business all sorts of proposals, applications, and propositions are received. This flow of requests is essential to the successful operation of credit markets. Lenders in a dynamic credit market are unwilling, and often unable, to satisfy every request for credit. Rationing according to credit standards is necessary to ensure that loans are allocated to borrowers who are most likely to service their debts.23 Because of risk, rejection of loan applications is a legitimate function of lenders and of credit markets. A rational lender's motivation for issuing credit is to profit by absorbing unexploited borrowing capacity, not to fill resource gaps. The efforts of a lender striving to fill resource gaps are easily dissipated in unremunerative lending. Resource gaps are never a sufficient condition for issuing credit. They create opportunities for lenders to seek remunerative transactions, but do not generate loan repayments. Resource gaps may offer insights into what would occur in the absence of a loan. But, they tend to be analytically inconclusive because alternative sources of finance 23. Rationing in credit markets is different from the nonprice rationing associated with equilibrium analysis in economics because it is a rational response to risk. The lender is not sacrificing or being denied an advantage that would otherwise be attractive or produce greater returns from lending. The supply of loanable funds within the margin may remain interest-elastic even after becoming completely inelastic to those at the margin. The use of nonprice criteria is essential in credit allocation because of the information problem-there is never complete certainty about the outcome of a credit transaction because it extends through time. CreditNeeds and Related Allocation Criteria 91 are frequently available. Gaps that cannot be filled force loan applicants to alter their expectations, targets, and objectives. This reorientation may be constructive and developmental when it results in selection of better investments and when it contributes to better loan portfolios held by a competitive financial sector. 5 COMMON STRATEGIC FLAWS IN EFFORTS TO CHANNEL CREDIT TO THE FRONTIER Credit need and other deficient concepts used to advocate more credit, which were discussed in chapter 4, are not the only causes of unsuccessful efforts to force the frontier outward. Strategies commonly used by governments and development assistance agencies to achieve their objectives at the frontier are also flawed. This chapter examines direct efforts to move the frontier faster than it would naturally expand through the actions of competitive intermediaries. Direct attempts to hasten credit expansion in selected sectors or regions are found in virtually all countries. They include special credit programns, lending targets and quotas that respond to perceptions of credit need, social equity or financing gaps, and specialized financial institutions established to serve clients or sectors marked for favorable treatment by government and by external donors. The objectives of special programs, targets and quotas are often regarded as highly laudable, enabling their sponsors to obtain political support for their design and implementation. However, the desirability of objectives is not sufficient justification for implementation-ends do not justify means. Justification for the use of government funds requires examination of costs and benefits, and a search for the best alternative means of achieving the chosen objectives. This requires a broad perspective on government efforts to force the frontier, which is consistent with the political, economic, and financial bases for intervention discussed in chapter 3. Flaws in traditional strategies to force the frontier discussed in this chapter include overemphasizing credit, use of lending targets and quotas, an emphasis on institutions rather than on instruments, and neglect of transaction costs and incentives. The extent to which these flaws increase 93 94 The Conventional Assault on the Frontier costs is a question of degree. Minor strategic flaws diligently imposed may have larger costs than major ones not seriously pursued, for example. But what types of cost do these common flaws entail? Overemphasizing Credit Emphasis on loans and on disbursements follows naturally from concern for credit needs and related loan allocation criteria discussed in chapter 4. Because these common allocation criteria fail to identify the potential for good loans, their application through credit programs, targets and quotas is likely to be less than satisfactory. Emphasizing credit as a development strategy is often based on an argument made by Hugh T. Patrick that "supply-leading" finance stimulates growth by creating financial institutions in advance of the demand for their services.1 Supply-leading institutions could transfer funds from traditional to modem sectors, create new horizons for entrepreneurs and produce favorable allocation and incentive effects. Patrick hypothesized that financial services that could have a relatively large developmental impact are relatively inexpensive to provide. While Patrick stated his argument in terms of developing intermediation and financial markets in general, its most notable application has been one- sided, directed at the expansion of loan disbursement. Loan disbursement is easy, and responds to the political definition of the problem beyond the frontier, which is a shortage of credit at low rates of interest. However, there are three weaknesses in a primary emphasis on credit: it does not necessarily produce good loans and therefore is ultimately unsustainable, it ignores savings mobilization and therefore retards intermediation, and it disregards alternative means of stimulating investment and therefore tends to be both inefficient and inequitable. Disbursement Does Not Necessarily Produce Good Loans The first problem with emphasis on credit is that disbursement has to be followed by loan repayment for credit operations to be sustainable. In almost all cases an expansion of credit begins with disbursements, as this 1. Hugh T. Patrick, "Financial Development and Economic Growth in Underdeveloped Countries," Economic Development and Cultural Change. 14, 2, January 1966. Excerpted in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 50-57. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 95 is the first transaction in a loan.2 Concentration on the disbursement side of the credit equation ignores the larger issues discussed in chapters 2 and 3. These include creation of confidence between borrower and lender, measurement and management of risk, and accounting and procedural infrastructure for loan administration. When these do not receive the same enthusiasm devoted to disbursement, credit programs tend to self-destruct as arrears mount and bad-debt losses take their toll. "Savings Mobilization: The Forgotten Half of Rural Finance"3 The second flaw in emphasis on credit is that credit is only one financial service: linking credit with saving has many advantages for all parties concerned. Most importantly, the number of deposit accounts normally exceeds the number of loan accounts on the books of the financial sector, especially at the retail level. More people can be served by providing savings facilities than by offering credit.4 Robert C. Vogel lists economic arguments for emphasizing savings mobilization.5 For example, savings mobilization can lead to a more equitable distribution of income by giving the poor access to financial assets with returns that are higher, after considering transaction costs, than those available from savings held in the form of tangible assets such as 2. An exception occured in the 1970s when the Agricultural Development Bank of Pakistan assigned mobile officers to groups of villages. Their first task was loan recovery, and access to additional credit was used as an incentive to repay loan arrears. Collections increased markedly, and the arrears recovered that otherwise presumably would have been bad debt losses more than offset the cost of employing the mobile officers. Mobile officers were originally an innovation of the National Bank of Pakistan. See A. Jamil Nishtar, "The Mobile Supervised Agricultural Credit System for Small Farmers." Karachi: National Bank of Pakistan, August 1972. 3. See the article by Robert C. Vogel bearing this title in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 248-265. 4. People's Banks in Rwanda, for example, had 107,309 depositors and 7,875 loans outstanding in 1985. See Aloys Rukebesha, "People's Banks in Rwanda" and an accompanying case study by Guy B6dard, in Guy B6dard, Gerd Giinter Kl6wer, and Martin Harder, eds., op. cit. pp. 163-177 and 61-79, respectively. Data cited is from p. 176. In Kenya in the 1970s the number of primary cooperative society members borrowing under the Cooperative Production Credit Scheme rarely exceeded half the active membership, all of whom had Cooperative Savings Scheme accounts. See J.D. Von Pischke amd John Rouse, "Selected Successful Experiences in Agricultural Credit and Rural Finance in Africa," Savings and Development. 7, 1, 1983. p. 26; J.D. Von Pischke, "A Penny Saved: Kenya's Cooperative Savings Scheme," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op.cit., p. 305. 5. Ibid. 96 The Conventional Assault on the Frontier livestock or jewelry or in cash. For this to occur, attractive interest rates and relatively low transaction costs are required. Savings mobilization improves resource allocation by drawing funds away from less attractive investment opportunities and allocating them to more productive investments. Lending rates are often artificially low under govemment credit programs, which tends to discourage saving and to favor investments with low retums. Artifically low rates also deter lenders from mobilizing savings, because they cannot lend these funds profitably. Offering attractive rates on savings and basing lending rates on the intermediary's costs promotes efficient investment. Intermediaries will become more perceptive allocators because greater interaction with clients gives them information on investment opportunities and credit risk. Savings mobilization contributes to good credit and to good financial intermediation. As Vogel notes:6 When financial institutions deal only with clients as borrowers, they forgo useful informqtion about the savings behavior of these clients that could help to refine estimations of their creditworthiness. Furthermore, borrowers are more likely to repay promptly and lenders to take responsibility for loan recovery when they know that resources come from neighbors rather than from some distant government agency or international donor. A related question is the effectiveness of contracts in general. Where contract enforcement is generally weak, financial intermediation is constrained: the quality of the promises that are the basis of financial value is compromised. Better contract enforcement may occur where existing relationships, such as between neighbors, underlie finance. Where loan contracts cannot be enforced, credit easily converts to grants. These information and incentive problems are reflected in shortcomings of state-owned institutions that operate only as lenders to farmers or small businesses.7 They tend to allocate credit by political criteria, to be only superficially in touch with the economies and communities they are supposed to serve, to make loans that are either too large or too small to 6. Ibid. p. 252 7. J.D. Von Pischke, Peter J. Heffeman and Dale W Adams, "The Political Economy of Specialized Farm Credit Institutions in Low-Income Countries." Staff Working Paper No. 446. Washington, DC: World Bank, 1981. Case studies from nine countries illustrate these effects. Excerpted as "The Pitfalls of Specialized Farm Credit Institutions in Low-income Countries, " in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 175-182. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 97 generate good repayment by borrowers, to become unprofitable because their interest rates are too low and they accumulate bad debt losses, and to use failure as a rationale for continued support and expansion of their activities. These effects tend to arise regardless of the organizational form and location of these specialized lenders. Savings mobilization is an effective antidote to these problems because it adds value to relationships between intermediaries and clients. The prospect of having access to credit, based on a deposit relationship, is a powerful incentive to depositors. Institutions competing for deposits also have positive incentives to be efficient, to keep their financial housekeeping in good order, and to innovate to retain and attract funds. Depositors constitute a logical market for credit, too, making the interests of intermediaries and clients coincide. In short, savings mobilization is the half-not of development assistance and of direct intervention in financial markets. If half the effort that has been spent on throwing credit at the frontier had been devoted to stimulating voluntary savings mobilization, the financial landscape in much of the Third World would probably be more attractive today. (And if the other half had been devoted to managing risk in credit relationships, as discussed in chapter 12, this financial landscape would be a lush garden.) Infrastructure and Policy Improvements Are Often More Developmental Than Credit There are many barriers to development that cannot be removed by providing loans. For example, rural poverty may be caused by deficient production technologies, low prices received for farm output, and an absence of attractive investment opportunities. The reasons for these problems may include lack of agricultural research, government regulations that restrict the promotion of improved technologies by private firms and traders, corrupt and inefficient cooperatives, high transport costs due to poor roads, and price controls favoring urban consumers or exporters of agricultural products. Where these problems persist, it is very difficult to use credit effectively as an instrument of development policy except for very narrow purposes. Even if credit is coupled with efforts to build roads, develop improved technologies, or improve cooperative performance, for example, disbursement may not lead to good loans. The reason for this is that credit 98 The Conventional Assault on the Frontier usually goes out at a faster pace than infrastructure is created, than technologies are adapted and adopted, and than institutions are reformed. In any event, resort to credit as a primary means of attacking the problem of rural poverty means that relatively few farmers or small scale businesses will be involved. This occurs because credit allocation requires standards of creditworthiness, making credit selective. If underlying problems responsible for rural poverty are attacked directly, a larger number of people benefit than if emphasis is primarily on providing credit. A road, for example, can be used by those who are untrustworthy or who consume too much alcohol, as well as those who are creditworthy. And, even the drunkard and the liar have a potential to contribute to development in their more responsible moments. Improvements in agricultural technology, marketing and input supply arrangements, and movement toward economically rational prices likewise benefit large numbers of producers, not just the minority who receive official credit. Too much faith in credit as a developmental tool can lead to neglect of other opportunities that may take longer to realize but have a broader and more equitable impact. (These possibilities are dealt with more broadly in chapter 13.) Equity Finance Supports Good Credit Use Another unfortunate aspect of the overemphasis on credit is that it ignores the importance of equity finance. The role of equity finance was briefly stated in chapter 2, and is touched upon in various places later in this book. But to elaborate a little on the role of equity: First, equity is a commitment, demonstrating the owner's good faith. Second, equity provides an incentive to the owner to make the firm or activity succeed. The positive aspect of this incentive is that profit belongs to the owner, constituting a return on the owner's investment. The negative aspect is that losses consume equity, diminishing the owner's wealth. Third, equity provides a cushion to creditors. The cash flow dimension of this cushion was explained in chapter 2. And if the lender requires security, equity makes it possible for the value of the security to exceed the amount of the loan. This excess provides a cushion in the event the security has to be realized to repay the debt. Overemphasis on credit results in underemphasis on equity. This leads to unreaslistic expectations regarding credit and insufficient attention to Common Strategic Flaws in Efforts to Channel Credit to the Frontier 99 mobilizing, creating and rewarding ownership capital. More attention to ownership capital would logically include greater government encouragement of profits through favorable tax and other legislation. A related governmental role is definition and protection of property rights to give owners greater clarity and confidence. Finally, measures to develop stock markets by favorable legislation and by entrepreneurial efforts by brokers and other intermediaries can also have desirable developmental effects.8 Medium-sized and large firms would have greater access to equity from sources other than their founders and founders' families and friends. Development of equity and of equity markets should improve the quality of corporate finance and of credit markets by providing alternative and mutually reinforcing ways of creating value. Externally Imposed Lending Targets and Credit Quotas Governments use lending targets and credit quotas to push lenders through the frontier at a faster pace than they would otherwise undertake. These controls, usually administered by central banks, often require that a certain percentage of commercial banks' loans outstanding must be to politically favored sectors such as agriculture, artisans or rural industry. The specified share is usually less than 20 percent. Another common quota requires each branch of a bank, or branches in rural areas, to attain a specified loan-to-deposit ratio. Under this control, each branch must have loans outstanding in an amount equal to at least a specified fraction of deposit balances it collects. Requirements usually range from 30 to 50 percent, and presumably promote investment in the local area. Without the quota, many branches would lend less locally and place a larger portion of their deposit balances at the disposal of their head offices for lending to borrowers in other parts of the country, or for investmnent in financial markets. Banks not meeting the targeted level of lending may be fined, forced to buy securities issued by an agricultural finance agency, or forced to keep noninterest bearing reserves with the central bank that equal the extent of their deficiency under the quota. 8. Antoine W. van Agtmael, Emerging Securities Markets (London, Euromoney Publications, 1984); The World Bank, World Development Report 1985. New York: Oxford University Press, 1985. 100 The Conventional Assault on the Frontier Quantitative controls in the form of targets and quotas have a number of shortcomings. The most important is that they do not necessarily generate good loans, and they tend to weaken controlled lenders. The following sections point out that lending targets and portfolio quotas do not address the problems that make lenders reluctant to advance the frontier voluntarily, that they are usually designed without reference to the cost of their implementation, that their implementation generally distorts statistics, and that they do not make good economic sense. Quantitative Controls as a Quick Fix Controls give governments some allocative power over the funds depositors entrust to banks. Informal explanations given for imposing controls usually cite bank behavior that is regarded as unresponsive to development or govemed by outdated colonial traditions. Bankers may be portrayed as lazy, as oligopolists who do not compete, or as an elite or possibly an ethnic minority that is selfish, unpatriotic, or out of touch. Formal explanations may cite a desire to increase production of certain products or to assist specific producer groups. If these perceptions were true, are quotas and targets the best means of changing bankers' behavior? Insight may be provided by the imposition of quotas and targets in countries where major banks are nationalized and hence presumably already responsive to political priorities and social considerations. Nationalization and controls are sometimes defended as giving government control of the "commanding heights" of the economy. A dimension less often mentioned is referred to in American slang as "deep pockets." Because banks obviously have money, they may be attractive political targets. Quotas and targets do not address the problems that inhibit lenders from moving the frontier. Designers of quantitative controls apparently regard these as either impossible to change, inconsequential or as something that can be overcome by the experience gained from having to comply with their quotas or targets. A common factor inhibiting exploration of the frontier is interest rate controls, imposed by the same authorities who establish targets and quotas. The maximum rates permitted usually do not enable commercial lenders to obtain spreads sufficient to cover the costs of risk and of administering small loans at the frontier, and quotas and targets Common Strategic Flaws in Efforts to Channel Credit to the Frontier 101 simply compound the damage caused by directives or pressures that keep interest rates artificially low. Other inhibiting factors include the quality of physical, social, and administrative infrastructure beyond the frontier which makes financial intermediation costly. Imposing controls is usually much easier and politically more attractive than correcting the inhibiting factors, and the costs of controls may appear to fall entirely on the banks in the form of diminished profits. The Costs of Controls Are Rarely Measured Costs accompany controls, but are rarely measured by those responsible for their design or enforcement. Compliance tends to move banks into areas they purposely avoided as unremunerative. So, it is probably more difficult to make good loans under quotas and targets than it is in the areas where banks have already developed expertise. To the extent this applies, controls and quotas cause banks to lose money or to employ their funds less profitably. Hence, banks' financial positions are generally weakened by compliance. Another cost is that directing credit to specific borrowers or categories of borrowers tends to deprive others of credit. If those who are deprived are more productive than the favored borrowers obtaining targeted credit, a cost is imposed on the economy. This cost equals the difference between the incremental value of production of favored borrowers and the incremental value of production that could have been realized by those who are deprived of credit if they had credit, plus the incremental transaction costs of designing and implementing the targets and quotas. Quantitative controls impose transaction costs. Banks must demonstrate the extent to which they comply. This requires reporting systems and thr costs of inspection by authorities. Additional recordkeeping must be adopted when quota categories do not match bankers' information systems oriented toward risk and portfolio quality, not toward political or social objectives. For example, farmers may buy light trucks to transport inputs and produce. Banks making loans for light trucks would normally record them as vehicle loans, because the vehicles are pledged as collateral. Quantitative controls give lenders an incentive to categorize their activities in a way that shows they meet quotas. If an absentee farm landlord or a wealthy businessman with a number of interests including 102 The Conventional Assault on the Frontier one small business buys a light truck, the lender may be able to report the loan as agricultural or as a small business loan, for example, for purposes of complying with lending targets and quotas. Because of this effect, quantitative controls tend to make liars out of lenders and make compliance statistics useless. What portion of reported "agricultural credit" really has much to do directly with agriculture? These effects are important if transparency, straightforward dealing, and accurate representation contribute to development. Generating meaningless numbers and enforcing questionable controls requires central bankers to compile statistics and investigate noncompliance and reporting irregularities. Ineffective controls put more people at risk in discharging their duties without engaging in corrupt practices. Collusion and subversion may arise if central bankers understand that money is fungible and that targets and quotas are useful politically but destructive financially and economically. Central and commercial bankers may work together tacitly or openly to devise liberal definitions of loans that qualify as meeting targets and quotas. This type of activity makes central bank relations more complex and confidence more difficult to achieve, and imposes transaction costs on all concemed. Distortions of data and behavior are exaggerated when quantitative controls are accompanied by concessional loan terms. Prospective borrowers, for example, have an incentive to obtain funds on the most favorable conditions possible, and directed credit is often concessional. Hence, the borrower's stated purpose in borrowing may not correspond to the actual use of funds. Irrigation loans have occasionally financed the construction of swimming pools on ranches, and tractors may be used primarily for road transport rather than for farm work. When borrowers misrepresent their intentions, it is more difficult to develop the confidence on which finance is based. Edward J. Kane summarizes the effects of these factors in agricultural credit as follows:9 Subterfuge in political purpose tends also to promote subterfuge and corruption in bank operations. No matter how many formal bureaucratic safeguards are established to earmark funds for agricultural purposes or for 9. Edward J. Kane, "Political Economy of Subsidizing Agricultural Credit in Developing Countries," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 166-182. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 103 small farmers in particular, career incentives within the bank and opportunities for personal enrichment invariably predispose loan officers toward allowing funds to flow to uses that are only apparently agricultural and to wealthy persons whose connections with farm operations may be tenuous. An additional casualty of the numbers-fudging game arises from the opportunity cost it imposes. Managerial and clerical energy is consumed by the maintenance of systems of deceit. The time and talent required could be more usefully devoted to the generation of good loans and in loan administration, especially to supervision of client relationships. For example the risks of lending at the frontier imply that borrowers will frequently encounter difficulties. Lenders may be able to help these borrowers by spending more time looking for solutions to their problems. This type of concern and cooperation can improve relationships with these clients as well as contributing to portfolio quality. Development would be better served by confronting these problems rather than by filing fanciful reports to satisfy planners, donors, and compliance supervisors policing targets and quotas. Quantitative Controls Are Economically Suspect The economic argument for quantitative controls rests on "market failure." Market failure occurs, for example, when lenders' perceptions of the profitability of certain types of loans are wrong, and when lenders' profitability from certain transactions does not reflect the benefits of these transactions to society. When markets fail, worthwhile transactions are not undertaken because lenders wrongly assume they are not remunerative, or because they would not in fact be remunerative to bankers. Under these conditions, lending is inefficient because opportunities to make good loans are rejected. Economists may advocate quantitative controls to make credit allocation more efficient. Omotunde E.G. Johnson cites two reasons why lenders' perceptions may be deficient.10 One is that lenders underestimate creditworthiness because of insufficient information. A lack of competitiveness or high costs of obtaining information may discourage lenders from pushing the 10. Omotunde E.G. Johnson, "Credit Controls as Instruments of Development Policy in the Light of Economic Theory," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 323-329. 104 The Conventional Assault on the Frontier frontier. As a result, they overestimate risk and the administrative costs of lending to certain sectors. A second is that certain types of lending may produce "positive externalities," effects such as the reduction of poverty or pollution that are highly beneficial for society but which do not benefit lenders directly. Lenders do not have a monetary incentive to make such loans. WHY QUANTITATIVE CONTROLS ARE NOT EFFICIENT RESPONSES TO MARKET FAILURE. However, quantitative controls tend to allocate credit inefficiently while failing to achieve their objectives of redistribution of income and wealth. For example, allocation may occur through inflation when the central bank provides rediscounting facilities to support lending to favored sectors. Rediscounting is a form of central bank lending to commercial banks, in this case against commercial banks' loans to favored sectors. It gives commercial banks greater liquidity, which permits them to expand their overall lending. This increases the money supply without necessarily increasing the supply of goods and services. Inflation results. The declining value of money tends to shift purchasing power to net borrowers and away from net lenders throughout the economy. Favored sectors obtain relatively more resources, others obtain relatively less. In this sense, quantitative controls tax nonfavored economic sectors, reducing their efficiency. Reallocation also occurs through reduction in the net incomes of banks and their nonfavored clients. Banks' income declines because lending under targets and quotas is less profitable than alternative uses of these funds in the absence of controls. Lower returns to intermediaries may reduce the supply of credit and lead to lower interest rates offered to depositors. Nonfavored clients' income is also decreased because they obtain relatively less credit. This decrease is especially concentrated among relatively less attractive clients outside the sectors favored by targets and controls. Banks react to decreased earnings and greater risk from lending under controls by attempting to increase earnings and reduce risk in other parts of their portfolios. This crowds out the less attractive nonfavored borrowers and provides relatively more credit to nonfavored borrowers who are relatively attractive because of their size or relationships with lenders. More credit to small farmers, for example, could result in Common Strategic Flaws in Efforts to Channel Credit to the Frontier 105 relatively less credit to small businesses. These nonfavored clients presumably then seek funds elsewhere, which tends to bid up interest rates. This decreases the incomes of these borrowers and increases the income of nonbank lenders, such as informal moneylenders and suppliers of trade credit. In certain developing countries with small markets and a narrow range of economic activities, banks may not be able to adjust easily to the decrease in earnings on one part of their portfolios because few alternatives exist or because changes in one direction in one part of the economy directly affect most other parts in the same direction. In this situation banks may choose to lend relatively little, keeping low loan-to-deposit ratios; and may discourage deposit growth through unattractive interest rates and low levels of service to depositors. Controls may be especially damaging in these economies by restricting banks' flexibility even further. EFFIcIENT ALTERNATIVE ACTIONS TO CORRECT ALLEGED MARKET FAILURE. Johnson proposes two theoretically economically efficient alternatives to quantitative controls. Where lenders underestimate the attractiveness of would-be borrowers, he proposes that government establish specialized intermediaries. Specialization would provide a comparative advantage in obtaining information to evaluate the creditworthiness of borrowers favored by government but not attractive to existing lenders. Johnson says these institutions should not need subsidy because their activities would be privately profitable as well as socially beneficial. They should be able to borrow from commercial banks or through bond issues at market rates and re-lend to favored sectors at higher rates. Where prospective borrowers' credit use would benefit society greatly, but have only meager benefits for bankers, Johnson advocates government subsidies to the banks. These subsidies would have to be funded by "society," which is justified economically because "society" benefits from the positive externalities of such lending. These theoretical solutions suggest just how difficult it is for economic planners and governments to intervene effectively in financial markets. Specialized financial institutions have a poor record, and appear to be much more costly in the long run than imagined by their sponsors. Subsidies, likewise, may be difficult to control or to target. Subsidies are politicized and attract special interest groups that favor their continuation; they are not 106 The Conventional Assault on the Frontier subject to the adjustments and self-correcting tendencies of competitive markets. Neglected Transaction Costs For firms and individuals at the frontier, the transaction costs of obtaining access to formal financial services easily exceed the interest paid on loans or the interest received on deposit balances. Interest rates held artificially low by government policy, presumably intended to benefit those at and beyond the frontier, paradoxically tend to increase loan applicants' and depositors' transaction costs. Loan Applicants' Transaction Costs Loan applicants' transaction costs tend to rise because low interest rates generate a false demand for capital. Borrowers inside the frontier will try to lower their costs of borrowing by obtaining concessional credit, and applicants beyond the frontier may be attracted in large numbers by advertised rates greatly below those they pay in the informal market. Lenders facing an onslaught of questionable applicants attempt to control costs by reducing the number of applicants. In commercial situations, lenders discourage unattractive applicants by raising interest rates or by imposing other conditions, such as minimum loan sizes that exceed the repayment capacity of small farmers or businesses, or by requiring that a deposit account be maintained for a period of time before a loan application is accepted. In many government-sponsored efforts to advance the frontier, however, these options are not available to lenders. Interest rates are held low, and program design specifies other loan terms and conditions. Standardization is expected to ensure that all target group members receive equal treatment, and that lenders do not subvert program objectives or exploit the target population. In this situation, the most effective way of discouraging applications is to impose transaction costs. This is accomplished by demanding lots of documentation to support an application; by restricting service, which requires applicants to queue; and by soliciting bribes. The ultimate weapon against a loan applicant is of course "losing" the file containing the application and accompanying documents, which occurs occasionally when lenders find the going extremely rough. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 107 Expanding transaction costs tend to make borrowers' cost of funds roughly equal to the cost of alternative funds that they could obtain elsewhere.11 This effect is rarely considered in the design of credit projects and other interventions to force the frontier. This omission is especially regrettable when coupled with The Iron Law of Interest Rate Restrictions, which specifies that as government-regulated interest rate ceilings become more restrictive, the share of credit issued to large borrowers increases while that to small borrowers decreases.12 These effects combine to increase the costs to most borrowers and to exclude a disproportionate share of applicants at the frontier. Neglecting transaction costs when designing financial market interventions occurs naturally when emphasis is on meeting credit needs or responding to similar perceptions of a shortage of finance, when the importance of credit is overemphasized, and when loan disbursement receives inordinate attention and the other elements required to produce good loans are not seriously addressed. Depositors' Transaction Costs When the market for deposits is not competitive and innovative, deposit-takers have little incentive to be sensitive to transaction costs imposed on depositors. Depositors may have little choice of intermediary or there may be little that distinguishes the services of one intermediary from those offered by others. In this case, the depositor may simply bank at the nearest deposit-taking office. The transaction costs imposed on depositors are similar to those imposed on borrowers by intermediaries not anxious to seek new clients at the frontier. The first consists of queueing, which is often compounded by the use of tellers and cashiers rather than unit tellers. The teller-and-cashier system separates the clerical and the cash-handling functions. For example, the depositor waits in one long line to present a withdrawal request to the teller, or for the teller to prepare the form. While the customer is kept waiting in a second line in front of the cashier's window, this form moves across several desks where it is checked, recorded and 11. World Bank, World Development Report 1987 (New York: Oxford University Press, 1987), p. 76. 12. Ibid. p. 118. 108 The Conventional Assault on the Frontier eventually forwarded to the cashier, who pays out cash and obtains a receipt of acceptance from the customer. Unit tellers, by contrast, handle all aspects of routine transactions on a one-stop basis. The teller-and-cashier system permits better control against fraud, while the unit teller system requires greater managerial attention to staff training and integrity in order to serve clients more quickly. Other transaction costs arise from minimum balance and minimum transaction requirements, which may be relatively high. In certain countries, for example, these may exceed the daily agricultural wage, which discourages small depositors and minimizes the deposit-taker's bookkeeping and other overhead costs. Deposits and transactions may also be subject to fees for deposit of checks drawn on other banks or from other parts of the country, for example, and ledger fees may be levied when a record card is set up or filled in. Money transfers through money orders, cashiers checks or bank drafts may also be relatively expensive. High transaction costs for depositors are likely when financial institutions do not depend upon deposits as important sources of funds. This may occur when institutions receive funds from the central bank or from development assistance agencies. The cost of processing numerous small deposits, especially in noncompetitive markets, easily exceeds the costs of central bank or donor funds, which are often exceptionally low. There may also be more personal rewards to bankers from dealing with donors, such as travel, training and entertainment, than in serving hordes of noisy, impatient depositors crowded into poorly ventilated banking offices on a hot day. Overlooked Incentives Intervention influences incentives.13 Incentives are important in confidence-building, in obtaining compliance with targets and quotas, and in controlling transaction costs. Overemphasizing credit, imposing binding lending targets and portfolio quotas, and indifference to transaction costs are possible only when incentives that motivate individuals and institutions are disregarded in the design of intervention. 13. Edward J. Kane, "Good Intentions and Unintended Evil," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 316-322. Common Strategic Flaws in Efforts to Channel Credit to the Frontier 109 Disregard for incentives results in failure to address the role of confidence in financial relationships. Confidence is built only when both parties to a transaction or relationship have incentives to consider the interests of the other party or to behave as if they did. Where incentives are disregarded, for example, the merits of linking saving and credit in retail financial institutions are not realized. Specialized institutions are established that do not command confidence, that are perceived as alien and transitory by the local community. Lack of confidence in a financial institution that provides subsidized credit produces complex effects. The first is that individuals have an incentive to obtain as much of the cheap credit as possible, especially where repayment obligations are likely to be lightly enforced. Heavy use of debt that is casually administered leads to accumulation of arrears. While it may appear that the community's interest is to keep the cheap credit machine operating well so that it can provide a steady flow of subsidy, this possibility is foreclosed by private decisions by defaulters, whose failure to repay debilitates the institution. By not repaying they obtain a subsidy equal to 100 percent of their loan, while repaying and reapplying for credit involves transaction costs and receipt of a subsidy of much less than 100 percent. In effect, the community as individual borrowers has an incentive to destroy the institution through nonrepayment of loans, rather than to preserve it as an intermediary to which savings can be entrusted and from which future loans are likely to be available if certain rules of conduct are followed. Incentives are rarely well examined when quotas and targets are established to force lenders to act in ways that are otherwise not in their own best interest. Rediscounting at preferential interest rates for credit issued to favored sectors or borrowers is often offered, but the spread between the retail lending rate and the rediscount rate is often not designed to ensure that the lender will gain from the activities supported by rediscounting. Hence, misreporting of compliance develops into an art form. Retail lenders appear to meet quotas and targets while expanding credit more rapidly to sectors not especially favored by government. Lenders' incentives to create transaction costs and to pass them to loan applicants and clients stem from the failure to focus competitive forces on the frontier. Lenders shielded from competition may hire superfluous staff because a larger payroll symbolizes greater power. They may shift 110 The Conventional Assault on the Frontier transaction costs to clients or potential clients to discourage loan applications and would-be depositors. Competitive lenders and deposit-takers would attempt to cut costs in order to gain customers by offering convenient services at attractive prices. Transaction costs would be reduced. Competitive intermediaries would tend to respond to market-driven incentives by linking credit, saving and money transfer services, reducing documentation requirements, and building their own information systems to facilitate loan decisionmaking. Emphasis on Institutions Rather Than Instruments Institutions as referred to in the following discussion are formal organizations registered or chartered according to law. An instrument can be defined as written evidence of a legal claim. 14 A check is a financial instrument in this sense, for example. Instrument is defined more widely here as a financial product or service. In this sense a checking account is an instrument, as are savings accounts, letters of credit, forfaiting arrangements and credit union signature loans. Emphasis on Institutions Governments' efforts to force the frontier are often implemented by establishing institutions especially for this purpose. Specialized agricultural credit institutions, cooperative credit societies, small enterprise development funds, special credit programs and similar intermediaries are commonly found in mixed economies. Those that work in one country are often copied in other countries. Those that do not work very well are also often replicated abroad by governments and donors, as discussed in other chapters. Institutions are important because they can increase efficiency and arbitrate the conflicting claims of different interest groups. "Institution- building" is a task to which much effort is rightly devoted. This term is often used in development assistance to refer to helping a particular government department, state corporation or cooperative to improve its management and operations by developing procedures and information systems, hiring and training qualified staff, obtaining equipment such as 14. "Instrument: any written document that gives formal expression to a legal agreement or act." Jerry M. Rosenberg, The Investor's Dictionary, (New York: John Wiley & Sons, 1986). Common Strategic Flaws in Efforts to Channel Credit to the Frontier 111 computers and vehicles, and erecting new buildings. These contributions are indeed useful when they are efficient and succeed, even if they do not directly develop society's great institutions, such as markets, property and human rights, systems of justice and education, and the framework for political decisionmaking. Experience with credit and development finance projects suggests that institutional development is stubbornly difficult, especially when incentives are not carefully analyzed. Efforts to support an institution may be counterproductive if its activities are poorly conceived or if its mission cannot possibly be accomplished. Efforts to build such institutions lead to injections of good money after bad and have a high opportunity cost: the energy they absorb otherwise could have been directed toward tasks that could be successfully undertaken or that could be quickly abandoned if they prove unviable. Potentially excessive attention to institutions in development projects is the result of several influences. The first is that governments create institutions for political purposes, and they are important sources of patronage in terms of promising services to citizens and providing jobs to the faithful. Second, development assistance agencies require a certain environment for the use of their funds. Project lending, by definition, sponsors activities that have a separate identity, activities that generally are not just part of the routine functions of the state, or that would not be conducted on the same scale or with the same complexity without external assistance. Assistance agencies often prefer to work with "autonomous" or semi- autonomous state agencies that are perceived as having the flexibility required for creative tasks and that can use budgeting, procurement, and accounting procedures preferred by external assistance agencies. A third source of potentially excessive attention arises from institutional mystique and outreach. Cooperators want to establish cooperatives because they view cooperatives as a morally superior form of economic organization. University professors believe that instruction in their particular disciplines could be useful in another country. Strong believers in a popular form of government believe that its adoption would benefit the people of other countries. This institution-building context, backed by development assistance funds, produces highly motivated secular missionaries whose objectives go beyond the skills they want to transfer. 112 The Conventional Assault on the Frontier Their efforts are tremendously powerful when they are entrepreneurial and adaptive, extending to others the benefits of their expertise. But when they are narrow and imposed, they may be of only limited success, possibly wasteful, or ultimately destructive. If financial sector institution-building as generally conceived and practiced is a high risk investment for both donor and recipient, what developmental alternative can be offered? One alternative is to focus on transactions undertaken by institutions, which requires attention to financial instruments. Emphasis on Instruments Defining instruments as financial products directs attention to transactions, to how these products are sold. Institutions are delivery mechanisms for transactions-through transactions they meet and relate to their clients. Instruments defined as financial services are vehicles for transactions. Financial markets function through transactions. When transactions fail to attract clients or are structured so that relationships cannot be sustained, institutions will not be viable, become irrelevant, and are unlikely to fulfill a developmental role. The segments of financial markets dealing in these transactions will languish. By contrast, innovative instruments that successfully stimulate and facilitate transactions are developmental. This perspective suggests that efforts to stimulate financial development and to design credit projects should begin with transactions. The first task is to identify the types of transactions that are or could be useful to the people and for the purpose the project designer expects to serve. When the transaction objective becomes clear and the transaction is fully formulated, institutional form and content follow. The benefits that could flow from a transactions approach can be illustrated by an example, given below, of failure to comprehend the nature and implications of the transactions required to implement a project. The results were loans that were probably unremunerative to the lender, burdensome to borrowers, and that failed to realize their potential developmental impact. A YOUNG ANALYST GOES ABROAD. One of the writer's early experiences with development projects was as a member of a team that appraised a small Comunon Strategic Flaws in Efforts to Channel Credit to the Frontier 113 farm credit project. The financial institution that would implement the project was having housekeeping difficulties: tremendously large cash balances were held in a local bank. These balances were large because the institution took about three months to reconcile the numerous bank accounts it kept for its own convenience and to accommodate donors' requirements that separate accounts be maintained for each project, and because disbursement of a loan commitment could take up to six months. Even with this cash cushion, lending was suspended from time to time because it appeared that liquidity might be depleted. Arrears accumulated on loans due for repayment by farmers, and collections of certain large loans were delayed for months or years because the government's loan guarantee program was inefficient. Suspense accounts were generously used for transactions that were not properly handled. External audits by a multinational firm appeared less than thorough, and the auditor's opinion did not seem to square with the facts. Annual reports were published greatly in arrears because of accounting problems and governmental review procedures. Trends in the financial statements, such as they were, suggested that financial reorganization might be necessary during the expected disbursement period of the project the team was instructed to design. Two development assistance agencies had provided specialists to review the situation, and their report awaited us. Our team spent considerable time negotiating with the institution's management, the report's authors and ministry of agriculture officials to agree on a plan for institutional development. Objectives were to upgrade accounting performance, to train staff, to obtain more equity capital by persuading the government to convert to equity a loan it had made to the institution, and to expand lending. We left the borrowing country confident that progress would be made. These discussions occurred after five years of a donor's support for the institution. Fifteen years later, after about 20 years of involvement, an official of the development assistance agency sketched a rehabilitation plan for the institution. The problems enumerated were generally the same as those the author investigated in the early 1970s. They had endured throughout the intervening period, which had been punctuated by suspensions of lending by the institution because of accounting and other internal problems. 114 The Conventional Assault on the Frontier Concentration on the institution appeared logical to the author's team and identified problems that inhibited good lending and effective financial management. The author analyzed the institution's finances, which corresponded with his training and the way in which the institution's problems were defined by all involved. Institution dealt with institution. A TRANSACToN Focus: DEFERENT QUESnONS, DlFERENT ANSWERS. A transaction focus might have yielded a useful and sustained contribution to development. A clue that the team might have picked up was that the lender's accounting problems provided an incentive to minimize the number of transactions. This would hopefully permit the backlog of entries to be worked down. However, the institution, the government and the donor wanted to expand lending. The institution's traditions and the interaction of these forces resulted in loan repayment schedules requiring farmers to make annual installments on medium- and long-term loans. Loan terms: The project provided credit primarily for small-scale dairying. Income from dairying occurs daily as cows are milked and as milk not consumed on the farm is sold. Could small dairy farmers be expected to accumulate enough cash throughout the year to make a single payment? Convenience to the borrower favors loans repayable in frequent installments. Could the farm credit institution modify the instrument by offering incentives for the prepayment of annual installments, in small amounts throughout the year? Clearly not, if transactions were to be minimized. Yet, annual installments would probably deter conscientious small farmers from participating in the project, reinforcing the tendency for loans to flow to relatively better-off operators. A significant proportion of borrowers had incomes from cash crops marketed through cooperatives and parastatal agencies, while others worked for the government as teachers, civil servants, police and members of the armed forces. Loan recoveries from these borrowers might have been made through deductions from cash crop delivery proceeds or from the monthly paychecks of those who worked for the govemment or for other employers willing to cooperate by splitting wage or salary payments, part to the lender and part to the borrower. Linking savings with credit: Investigation would have shown that savings account facilities were not readily available in rural areas. Therefore, poor repayment could be expected from those without relatively Common Strategic Flaws in Efforts to Channel Credit to the Frontier 115 large incomes from cash crops or off-farm employment, because of the formidable size of the annual installment. Loan collection problems would raise the lender's administrative costs and complicate its cash flow projections. A transaction focus might have led the team to consider promoting savings facilities as a means of assisting farmers. Savings facilities could be offered by the credit institution (which would have to have good financial housekeeping to sustain confidence) or by banks and rural cooperatives. Prioritization of assistance efforts: A transaction focus could also have pointed to several other alternatives. One would be no disbursements of donor funds until housekeeping problems were solved, which might have required 18 months. Institutions have to record credit transactions properly to manage portfolios effectively. However, alternatives requiring suspension or reduction in disbursements go against the grain of the I"resource transfer" thrust of development assistance. In addition, it is not unusual for a donor that seeks to develop strong intermediaries through project terms and conditions based on high performance standards to be thwarted by another donor in a hurry to move money with fewer and softer terms and conditions. Cost analysis: Analysis concentrated primarily on the institution's overall revenues and expenses, but not the costs of each transaction. Examining costs per transaction would have permitted calculation of the overall costs and benefits of the project to the institution. This calculation is not usually made, and unremunerative lending may result as a consequence. Exploration of alternatives: Attention to transactions and their costs might have led to support for altematives to credit, including artificial insemination for the development of dairying, and leasing or integration arrangements to achieve wider distribution of improved dairy cattle. These altematives could have contributed to institution-building, but not simply within the credit agency and the ministry of agriculture. 6 POLICY AND PRACTICE THAT REDUCE VALUE AT THE FRONTIER Intervention based on deficient concepts such as credit need and flawed strategies such as an overemphasis on credit can eventually reach the frontier, but only at high cost as indicated in the previous two chapters. However, the problem of inappropriate actions does not stop here. Further damage to prospects for financial development are imposed by the common policy of keeping interest rates artificially low and the common practice of failure by the sponsors of intervention to keep in touch with the overall performance and implications of the programs they spawn. These traditional features of intervention are the subject of this chapter. Repressed interest rates tend to keep formal credit entirely away from activities that actually expand the frontier in a sustainable manner. This often reinforces concern for credit needs and recourse to directed credit. Artificially low rates of interest are government-administered rates that fail to compensate lenders for their costs, that are inconsistent with vigorous deposit mobilization, and that are below the relevant opportunity cost of capital. Low interest rates reduce value because they keep term structures short, ignore risk and fail to give incentives for refinement of valuation processes. The practice of inadequate reporting and accountability of credit programs results in poor information, which reduces value by inhibiting the management and refinement of valuation processes. It also makes the costs of government programs extremely difficult to control, and errors difficult to correct. This chapter begins by discussing arguments commonly advanced in favor of low interest rates in general and for specific purposes. The second part of the chapter explores information questions and problems, and their 117 118 The Conventional Assault on the Frontier relationship with efforts to advance the frontier. Illustrations are cited from the Philippines and from enthusiasm for crop insurance by United Nations agencies and bilateral donors. Artificially Low Interest Rates There is a strong and widespread belief that governments should do everything possible to keep interest rates low at the frontier. Its acceptance is demonstrated by credit projects around the world that attempt to expand the frontier by issuing loans carrying interest rates that approximate those commercial banks charge their best customers, who are of course well within the frontier. Dale W Adams cites and refutes eight of the most common arguments for low interest rates that are applied to rural finance, as follows:1 • The usury argument against high rates of interest is often based on religious and ethical values,2 which are not open to refutation on their own terms. Other statements of the argument link high rates of interest with exploitation by moneylenders. In fact, net returns to moneylending are rarely measured, but the handful of surveys that have been conducted indicate that, although their interest rates are high, moneylenders' earnings are much lower than suggested by the usury argument. (This point is developed in chapter 8.) * Their defenders argue that low rates have been used in developed countries, especially by the US Farm Security Administration and its successor, the Farmers Home Administration. These agencies are often cited because of their visibility and familiarity. They have trained rural credit officials from developing countries, and the United States Agency for International Development (AID) has used technicians from these agencies to work with credit institutions in developing countries.3 AID has also pushed for higher rates under projects and through research, making American examples especially interesting. 1. Dale W Adams, "Are the Arguments for Cheap Agricultural Credit Sound?" in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 65-77. 2. Benjamin N. Nelson, The Idea of Usury: From Tribal Brotherhood to Universal Otherhood. 2nd ed. (Chicago: University of Chicago Press, 1969). 3. E.B. Rice, History of AID Programs in Agricultural Credit. Vol. XVII, AID Spring Review of Small Farmer Credit. Washington, DC: Agency for International Development, Department of State, June 1973. pp. 12-20. Policy and Practice that Reduce Value at the Frontier 119 During the 1930s American farmers paid between 2 and 7 percent on government loans, which appear to be regarded by some as traditional and appropriate rates even though market rates have remained consistently above these levels for the last 30 years. Adams points out that deflation during that period made the real (i.e., inflatior/deflation adjusted) rates of interest quite high.4 U.S. agricultural prices declined by 20 percent or more in 1930, 1931, 1932 and 1938. Nominal interest rates of 2 to 7 percent translated into real rates, measured in terms of the purchasing power of farm incomes, were frequently greater than 20 percent in these years. So, high positive real rates were charged, while in many developing countries rates are negative because low nominal rates are exceeded by relatively high rates of inflation. • Development assistance agencies often provide cheapfunds to poor countries. Some argue that these concessions should be passed on to farmers, or that similar concessions should be offered to stimulate on-farm development. Adams notes that this argument ignores the opportunity cost of funds, the foreign exchange risk on many foreign assistance loans, and the costs of lending at the frontier. Cheap credit easily results in losses to the banks or credit agencies offering it. C Concernfor lender solvency has led to pressure for continued low interest rates where financial institutions' assets have relatively long maturities and low fixed interest rates. Increases in nominal rates reduce these assets' market value, eroding the capital of these unfortunate intermediaries. However, this is not necessarily reflected in financial statements in many countries, because assets are valued at original cost, not market value. Losses would not occur unless loans were not repaid, or sold for less than the amount outstanding. Adams notes that this effect is not material for short-term lenders because short maturities limit repricing risk. He also observes that 4. The formula for deriving real rates is r = [(1 + i)/(1 + p)] - 1, where r is the real rate of interest, i is the nomninal rate, and p is the rate of inflation. For an application, see Joao Sayad, "Rural Credit and Positive Real Rates of Interest: Brazil's Experience with Rapid Inflation," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. p. 147. 120 The Conventional Assault on the Frontier many medium- and long-term lenders are government owned, and could be subsidized to offset losses; and that raising interest rates on existing contracts by government decree is consistent with accepted practice in many countries.5 The strongest argument for high lending rates is that they can assist institutional viability by helping to cover the relatively high costs of frontier lending. Low interest rates are often advocated as a means of inducing borrowers to behave in a manner desired by planners, by adopting new technologies and raising production. However, are low or negative rates essential to promote desirable investments? Experience with fertilizer promotion, for example, shows that new adopters are unlikely to be attracted unless the investment in fertilizer yields a return of at least 100 percent in a normal season. A 300 percent return is often associated with rapid adoption. Given these threshholds for adoption, the difference between an interest rate of 50 percent per annum pales beside a return of 200 percent per season. Many small farmers use relatively little debt. Their interest expenses are small relative to their overall financial flows, and not an important element in their investment calculations. Others who do use credit are generally more concerned about cash flow, about availability of and access to credit rather than about interest cost, which amounts to a relatively small fraction of the amount of credit received. Many remunerative investments are divisible, such as improved seeds and fertilizer, and can be adopted in a series of small steps. 5. See, for example, Appendix A, "Farmers' and Fishermen's Usurious Debts Resettlement Order," in David C. Cole and Yung Chul Park, Financial Development in Korea, 1945-1978, (Cambridge: Council on East Asian Studies, Harvard University, 1983). Ex-post government amendments to private contracts are not unique to developing countries. In 1933 the United States government abrogated the "gold clause" on its own obligations and on private contracts. The gold clause required settlement of an obligation in gold or in currency having a value equal to a specified weight of gold. It was designed to protect lenders against depreciation of a currency relative to gold. The declaration voiding the gold clause was associated with the devaluation of the dollar against gold, from $20.67 per ounce to $35 per ounce. For a description of the action and its implications, see Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960. Princeton, New Jersey: Princeton University Press, 1968. pp. 468 ff in first Princeton paperback edition, 1971. Policy and Practice that Reduce Value at the Frontier 121 Their acquisition is not difficult. Also, loans are not effective means of controlling behavior. Fungibility and the Iron Law of Interest Rates intervene when cheap credit is used to attempt to translate planners' objectives into farmers' activities. Cheap credit is often advocated as an income transfer device to help the poor, who cannot afford expensive credit because the returns they can obtain from investing are low. Returns may be low because government policies reduce their incomes. For example, agricultural price controls keep food cheap or marketing arrangements for export crops permit the government to extract large margins between export and farmgate prices. Credit may be proposed to offset these effects. However, it is tremendously difficult to spread cheap credit widely over the poor, and compensation is proportional to loan size: large borrowers get a large subsidy, small borrowers a small subsidy, and nonborrowers no subsidy. This subsidy is regressive, benefiting primarily the relatively better-off who receive the larger loans. Low lending rates also make it difficult for the poor to obtain access to deposit services on attractive terms because deposit rates normally have to be kept below lending rates for intermediation to be sustainable, and lenders may have insufficient income to support aggressive expansion of their operations. In fact, low rates often undermine lender viability. e Some observers believe that high interest rates contribute to inflation by raising costs. Adams points out that this view reverses the causation between inflation and interest rates, and that it confuses the one-time impact of interest rate increases on price indexes with the continuing influence of interest rates on economic behavior. High interest rates help to retard or decrease inflation, as demonstrated by experience in Taiwan6 and in Korea,7 while rapid expansion of cheap credit to favored sectors is inflationary, as 6. Reed J. Irvine and Robert F. Emory, "Interest Rates as an Anti-Inflationary Instrument in Taiwan," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 393-397. 7. David C. Cole and Yung Chul Park, op. cit. See especially chapter 8, "Price- Stabilization Problems and Policies." 122 The Conventional Assault on the Frontier demonstrated in Brazil.8 Higher interest rates enable financial markets to mobilize more savings, permitting government to reduce deficit spending. By making saving more attractive, higher interest rates induce households to spend less on consumption, reducing upward pressure on prices. Also, higher rates should have the largest corrective impact on large borrowers, while opening financial markets to new borrowers at the frontier and stimulating their production. Cheap credit is often regarded as a "second best" alternative. It is reasonably easy to provide cheap credit, while it may be difficult politically to adjust the structure of the economy to promote equity and stimulate efficiency directly. The equity argument includes the position that the poor should not have to borrow at high rates while the rich borrow at low rates, as well as concern for the effect that credit access has on the distribution of income and assets in the economy. The second best argument is weak on equity grounds because cheap credit reaches relatively few, who tend to be better-off. It is not generally relevant to donor-supported projects because project design documents normally show that relatively small retail loans are expected to produce relatively large returns. Interest is a small part of borrowers' total costs, and is also small in comparison with projected increases in their incomes. On efficiency grounds, cheap credit is unlikely to stimulate producers to use more inputs to produce a good that has an artificially low price. Subsidizing input prices is an economically more efficient way of offsetting the effects of low produce price policies. Fungibility also confounds efforts to draw a direct relationship between credit impact and the purpose for which it is disbursed. 8. Joao Sayad, "The Impact of Rural Credit on Production and Income Distribution in Brazil," in J.D. Von Pischke, Dale W Adams and Gordon Donald, eds., op. cit. pp. 379-386; Paulo F.C. de Araujo y Richard L. Meyer, "Dos Decadas de Credito Agrfcola Subsidiado en Brasil," in Dale W Adams, Claudio Gonzalez Vega y J.D. Von Pischke, eds., Credito Agrtcola y Desarrollo Rural: La Nueva Visi6n. Columbus, Ohio: Ohio State University, 1987. pp. 192-205. Policy and Practice that Reduce Value at the Frontier 123 Why Low Interest Rates Reduce Value at the Frontier Arguments for low rates disregard the fact that the benefits associated with a single cheap loan are unobtainable in financial markets as a whole. Individuals receiving cheap credit reap a benefit but impose a cost on other individuals and on society. These benefits can be stated at two levels. The first is simply the basic observation that economizing, getting more for less, is generally attractive to consumers. At the second level, discounting formulas show that it is possible to borrow more, presumably producing a greater impact, at lower rates than at higher rates, given certain assumptions: for a single loan, low interest rates create more value than high interest rates. This is most easily demonstrated by an example assuming that debt service capacity is constant, in this case $100, regardless of the interest rate. The discounting formula, v = 1/(1 + i)n, indicates that the present value v of 1 received at the end of period n diminishes as interest rate i increases. For example, the present value of 1 received at the end of one year (i.e., n = 1) at a 5 percent per annum rate of interest is 0.952 (or 1/1.05). At a 20 percent interest rate, the present value is only 0.833 (or 1/1.2). In other words, an acceptable promise to pay $100 one year in the future could be traded for a loan of $95.20 at an interest rate of 5 percent, but for a loan of only $83.30 at an interest rate of 20 percent. When the calculation is made for a number years, the value-creating impact of low rates is more dramatic: the value of 1 received at the end of the tenth year is 0.614 at a 5 percent rate, but only 0.162 at 20 percent. This effect can also be demonstrated by compounding: compounding at a low rate produces less future value than compounding at a high rate. Or, given a target value in the future, the amount of money that would have to be committed now in order to compound to the target level varies inversely with the interest rate. Review of the arguments refuted by Adams indicates the limited relevance of the observation that low interest rates create more value according to the discounting formula. Cheap credit has distributional and incentive effects that overwhelm the application of the formula. The most interesting questions at the frontier are not whether any credit that is obtained is cheap, but who has access to financial services, and what does it cost to provide and obtain these services. Cheap credit retards expansion 124 The Conventional Assault on the Frontier of the frontier by limiting the number of borrowers, discouraging savers, and inhibiting intermediation. Low rates limit the number of borrowers, concentrating loans well within the frontier. Because of this tendency, lenders devote less energy to developing business at the frontier, which remains stubbornly fixed. Governments often respond by providing even larger amounts of cheap loanable funds and by imposing more controls, but these measures are unlikely to be sustainable. Funds will eventually become limited, controls will be increasingly subverted over time or their costs of enforcement will rise, and the hoped-for production or welfare results are unlikely to be achieved. Low rates discourage savers by reducing the attractiveness of intermediated financial assets. Savers are more likely to keep their savings in cash, to invest them in tangible assets or to engage in speculation. These altematives tend to be less efficient economically; without financial intermediation resources are less easily directed to high return investments. This effect tends to be self-perpetuating: low returns keep saving low. Low rates inhibit intermediation. They deprive intermediaries of deposits from the community as a source of loanable funds. Intermediaries may have extensive access to other sources of funds, such as from governments or development assistance agencies. However, dependence on these sources deprives interrnediaries of information about savings behavior that is valuable for credit decisions and for welding links of confidence. Without such information, lenders have difficulties building strong loan portfolios. Low rates also inhibit intermediation by concentrating loans in relatively few hands, rather than expanding access to financial services that should occur broadly with development. Low-Interest Rates Accompany Credit Targets Interest rates on targeted credit are often kept low as part of selective credit controls that attempt to direct credit to "priority" activities. Maxwell J. Fry provides devastating economic arguments against this unholy alliance, listing six internal inconsistencies in selective low interest policies.9 These combine and summarize the observations of Johnson concerning the preverse effects of credit targets and quotas cited in the 9. Maxwell J. Fry, op.cit. Policy and Practice that Reduce Value at the Frontier 125 previous chapter with several of the points made by Adams about low interest rates. First, the use of low interest rates to support activities favored by govemment encourages investments in lower-yielding activities that otherwise have difficulty attracting finance in spite of their alleged high social retums. Fry states that the record of economic planning provides no clear evidence that planners are able to identify investments with high social but low financial retums. Second, Fry notes that long-term credit is often the target of interest rate controls. As a result, long-term rates are often below short-term rates, which tends to keep term structures short, reducing the supply of credit, and third, unduly encouraging investment in capital-intensive technology. Fourth, low interest rates on targeted credit are often below deposit rates, and flows from cheap credit sources to attractive deposits thwarts the objective of selective credit policies. This leads to the fifth inconsistency, which is that savings are discouraged because low rates on loans tend in the long run to reduce the returns on deposits. Sixth, Fry notes that low rates on selected loans tend to give the wrong signals to lenders, who have an incentive to lend first at rates they can select, and last at low rates determined for them, which reduces to supply of credit to sectors favored by the govenmment. Fry concludes that interest rate controls, as part of selective credit policies, seem to be "an ideal recipe for reducing both the quantity and the quality of productive investment."10 Political Economy and Interest Rates The discussion of low interest rates is not complete if it is limited to equity, economic efficiency and creation of value at the frontier. Govemments may have less-than-charitable reasons, such as budgetary and patronage considerations for keeping credit cheap. The budgetary dimension arises because governments are major borrowers in their domestic financial markets. Govemments want to keep the cost of funds low so that interest payments do not eat into budgets, crowding out more attractive expenditures. 10. Ibid. pp. 414. 126 The Conventional Assault on the Frontier Patronage considerations are more complex. Political use of credit is most attractive to politicians when they can make funds available at rates below or equal to commercial rates prevailing among large formal borrowers and lenders in the economy. Harry W. Blair observes that, "low interest rates just seem to be good for everyone who matters-at least in the short run, and the short run is the time frame that those in positions of power tend to be most worried about. But the long run costs of these policies may be high."11 Kane illustrates the dynamics of credit priced low by government regulation:12 The true purpose of real-world systems of economic regulation is seldom to promote greater economic efficiency in the long run. Lobbying activity seeks primarily to employ government power to redistribute current income and wealth from politically weak to politically powerful sectors... .Legislative processes help politicians to disguise and legitimize beggar-my-neighbor political activity by special interests ....By delegating the detailed operations of regulatory schemes to a semi-autonomous financial agency, elected officials erect still another layer of cosmetic shielding. Regulatory bureaus insulate sponsoring coalitions and their agent politician from being blamed for the unpopular long-run consequences of specific regulatory decisions. Although subsidized loan programs may achieve a good portion of their intended distribution effects in the short run, they impose unintended costs that tend to increase the longer the program stays in operation. First, they tend to require a growing diversion of resources to monitoring... .Second, they tend to deprive a program's intended beneficiaries from access to program funds. Third, they tend to produce a more corrupt society in general and a more corrupt bureaucracy in particular. Kane's vividly politicized world illustrates tendencies that appear when nonmarket devices are used to obtain economic power. When subsidized rates are only slightly below market rates, these tendencies develop to a small degree; highly subsidized rates invite rapid and extensive subterfuge. Unlike the case for market rates of interest, arguments for subsidized credit have no built-in limits-the lower the rate, the better the credit program. These effects may not be fully realized because of competition for 11. Harry W. Blair, "Agricultural Credit, Political Economy, and Patronage," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. p. 186. 12. Edward J. Kane, "Political Economy of Subsidizing Agricultural Credit in Developing Countries," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 172-173, 176. Policy and Practice that Reduce Value at the Frontier 127 patronage, but highly subsidized rates can clearly develop, and negative real rates coupled with poor loan recovery can turn a credit scheme into a great give-away. Blair suggests that governments have three policy choices when considering the removal of rural interest rate subsidies. 13 These concern primarily large farmers, because they receive the bulk of the subsidy. One is to provide another form of benefit to big farmers to maintain their political loyalty. The second is to build an alternative political constituency to compensate for the loss of large farmer support. The third is to suffer the potential loss of their support. Blair sees no easy choices among these options, and notes that large farmers may already have captured just about all that government is able to offer. He believes that market interest rates, giving broader access to financial services that expand the frontier, might be obtained by using broadly based, participatory local institutions to distribute credit. In the long run, "nondominant" groups such as the poor could presumably be included more easily in the outreach of these types of institutions than in the activities of large, centralized financial intermediaries. Institutions that might satisfy Blair's description could include community credit unions, other cooperatives, village banks and RoSCAs. Inadequate Reporting and Insufficient Accountability Careful readers may have wondered why a book on finance contains so few numbers. Surely the billions of development dollars that have assaulted the frontier have left a trail? In fact, data gathering is a formidable challenge for any student of development finance who consults government and aid agency documents and seeks to go beyond reporting disbursements, levels of investment supported by credit, physical counts of wells dug, hectares planted, and loans made, or an individual success or failure here or there. And most of the success stories that do appear are poorly documented from a financial point of view: it is difficult to evaluate portfolio quality and the extent to which lending is remunerative. The case for good reporting and accountability in development finance is simply that it enables borrowers, lenders and intermediaries to create more value at the frontier. The incessant valuation that occurs in financial 13. Op. cit. 128 The Conventional Assault on the Frontier markets is refined only by experience and information. Without data, valuation is more difficult, errors in valuation-including failed attempts at innovation-are more costly, and sustainability is harder to achieve. Reporting and accountability are especialy important because finance works to close tolerances. Small variations spell the difference between success and failure. Why then, is development finance not brimming with cases, cost studies and widely discussed and carefully reviewed nonns and ranges for key variables such as interest spreads, costs per borrower and per depositor, and net returns to lenders? It may be simply that no one likes to report poor perfonmance, but the probable causes are more complex. Why Is Frontier Financing Data Usually Scarce? The political use of credit at the frontier leads to biases in the reporting of results. Kane's thesis, that results are disguised to protect those benefiting from patronage, implies that reporting would concentrate on disbursements, which yield immediate political advantage, and reveal less about repayment and subsequent operating results. Blair's perspective, that support-seeking is important to patronage strategies, suggests that results would be reported selectively to attract or maintain the support of beneficiaries and suppliers of funds. There is little direct evidence that these effects govern reporting of government programs to push the frontier, although it was noted in chapter 5 that the imposition of targets, quotas and controls-the expressions of patronage-is seldom accompanied by detailed analysis. However, circumstantial evidence reported below appears to support conclusions consistent with Kane and Blair's insights. Financial Reporting by Frontier Institutions Presentations of financial data by cooperatives and specialized lenders at the frontier often conceal more than they reveal. This reflects financial housekeeping problems, government accounting standards and a low priority accorded to disclosure. Poor presentation is also a feature of many other firms' financial reporting in developing countries, but why would government-owned or -supported institutions that assume a leading role in development, and have access to external assistance, not be in the forefront of disclosure and promptness in financial reporting? Policy and Practice that Reduce Value at the Frontier 129 Although governments have auditors and procedures for parliamentary reviews of the accounts and performance of government corporations, financial presentations are often complex, delayed and assembled according to accounting standards and procedures that make interpretation difficult. Prescribed formats may be altered frequently or exhibit excruciating detail to satisfy statutory requirements rather than to provide summaries that communicate results clearly and quickly to parliamentarians, military officers or other citizens not trained in finance. The shares of cooperatives and most government corporations are not traded, and this may result in a relative unconcern for performance and for value as defined in chapter 1. Use of Financial Data by Development Assistance Agencies Development assistance agencies also display a selective approach to financial reporting at the frontier. Reporting financial results appears to be less important than disbursing loans to farmers and small businesses, although diligent efforts are made to ensure proper reporting of the purposes for which project funds are disbursed. Development assistance agencies do not routinely compile quarterly or annual overall summaries of the operations of the frontier financial institutions they support. Definitions, measures of results and reporting standards vary widely. Hence, these agencies' managers and staff are unlikely to have an integrated view of the financial conditions of institutions included in their portfolio of development finance activites. However, their files usually contain voluminous data on each of these institutions. Data in these files are generally treated as confidential government information or confidential bank-to-bank information and are not available to the public. Lack of an overall view based on detailed financial data reflects official orientations and objectives. Disbursement is important, as reflected in use of the term "resource transfer" to describe development assistance rather than other terms more clearly oriented toward investment performance and risk. Development assistance agencies are seldom exposed to project- or institution-specific risks, and project analysis may not be finely tuned to risk. Development loans are usually made to governments, and donors' risk is general country risk. Accordingly, country economic performance is 130 The Conventional Assault on the Frontier closely monitored by batteries of economists to evaluate and identify opportunities for further assistance. Efforts to deal with risk at the farm level in credit pmjects are generally restricted to mechanical manipulations of cost and benefit flows to test expected economic rates of return. Little sensitivity analysis is done to refine financing plans. Neither economic nor financial analysis is directed toward the substance of risk, the things most likely to go wrong. Most development finance institutions lending to industrial and commercial firms do no financial risk analysis beyond calculating key financial ratios. Projections are rarely adjusted to show the possible impact of adverse events on loan repayment. In many cases standard assumptions concerning factory capacity utilization rates are employed, e.g., 60 percent in the first year of production, 70 to 80 percent in the second, and 100 percent in the third, with no sacrifices of profitability per unit of output to achieve increased sales. Norms such as these have lives of their own, even though 100 percent of planned output is often not achieved and when it is achieved it generally requires more than three years. (In developed countries, overall industrial capacity utilization rates above 85 percent are usually associated with inflation and are therefore regarded as danger signals.) However, the best of these development finance institutions in developing countries deal with risk qualitatively. They devote considerable energy to identifying those industries likely to prosper and those likely to decline, to engineering design and other technical questions, and to selecting ventures backed and managed by dependable and promising individuals and groups. One reason why the debate over so many aspects of development finance strategy, policy, and impact seems difficult and interminable is that development of data is tortuous. Project analysis is oriented toward the impact of these funds on ultimate borrowers. The impact of credit projects on the institutions that disburse project funds at the frontier is often not measured. When measurement occurs, it is usually confined to cost-benefit tables using simplified assumptions concerning bad debt losses and other key impact variables. Hence, credit project design normally contains no rigorous in-built check to ensure that lending operations at the frontier will be remunerative. During project implementation the usual focus is on the credit institution's Policy and Practice that Reduce Value at the Frontier 131 overall financial condition, which coincides with one aspect of institution- building. But reporting is often patchy and data submitted may not be closely reviewed by development assistance agency officials except at the clerical level. Deeper investigation and reporting is usually ad hoc. An example is policy papers published by donors, such as those compiled on rural credit and development finance companies by the World Bank in the 1970s. Other major efforts were the Spring Review of Small Farmer Credit conducted by AID in the early 1970s and reports from a series of Food and Agriculture Organization (FAO) regional seminars leading up to a world conference on agricultural credit in 1976. Data are also generated by commissions appointed in various countries to review agricultural finance, the performance of financial institutions, or financial policy and policy alternatives. The All-India Rural Credit Survey and similar Indian government enquiries are among the most accessible and well-known examples. Finally, academic economists' research into finance, often for official sponsors, has yielded most of the enlightened insights that have fueled debates on financial policy at the frontier. Innovation and Efficiency from Information: Two Cases In spite of the information problem that surrounds official efforts to expand the frontier, there are some examples where accurate, meaningful information has been diligently sought and where this information has changed behavior in developmental ways. The information gathering, analysis and dissemination process helps to refine the definition of issues and provides a basis for designing activities that are likely to have a developmental impact, or that achieve a desired impact at a lower cost than would be possible without information. Of course, information is also costly, but its costs usually amount to a relatively small fraction of the funds committed to efforts to expand the frontier. An example from the Philippines suggests how information can create an informed body of opinion and facilitate innovative project design. Crop insurance offers another example of how information stopped donor profligacy, but not until damage had been done. These two examples, discussed in detail in the remainder of this chapter, are offered to show the pay-off from good information and to illustrate the costs of unconcern for information or its disregard. 132 The Conventional Assault on the Frontier Facts on Finance at the Frontier in the Philippines A stunning exception to the generally poor data base on finance at the frontier is found in the Philippines. In 1975 a Presidential Commission on Agricultural Credit (PCAC) was established, along with a secretariat called the Technical Board for Agricultural Credit (TBAC). PCAC was a relatively independent interagency body responsible to the president of the Philippines for agricultural credit policy. In 1987 PCAC and TBAC were reconstituted into an Agricultural Credit Policy Council (ACPC) with somewhat expanded functions. A major impetus to the founding of PCACJTBAC was the mounting arrears under Masagana-99 (M-99), a national program designed to stimulate rice production that issued seasonal loans to more than a half- million farmers at its peak. The size and objectives of M-99 attracted attention and it was felt that this, and the multiplicity of credit programs and agencies, probably required coordination and impact measurement. INSTITUTIONALIZING INFORMATION SYSTEMS. The Philippines has several institutional features that are reflected in the formation and role of PCAC/TBAC. One is a lively, decentralized fonnal institutional structure in rural finance consisting of cooperatives, private development banks, savings and loan associations, and many essentially private rural banks. Active trade associations for each type of intermediary bring issues to the attention of government officials and the press. Another is relatively open administrative processes. The Central Bank, for example, publishes detailed annual summaries of the conditions of rural banks and the other institutions it supervises. A third is an administrative tradition that permits an agency to operate independently. PCAC, chaired by the governor of the Central Bank, included key ministers, presidents of government-owned banks and the director-general of the National Economic and Development Authority. The functions of PCAC were to advise government-owned financial institutions concerning agricultural credit, to establish priorities in credit allocation, to review credit program proposals and operations, to coordinate credit activities among institutions and at different stages in agricultural production, processing and marketing, and to oversee the use of government funds by nongovemnment agricultural lenders. Policy and Practice that Reduce Value at the Frontier 133 The TBAC Board, chaired by a Central Bank deputy governor, included key deputy ministers, bank vice presidents and others of similar rank. During most of its existence, TBAC's staff numbered about 35, organized into three sections: planning and research; monitoring, review and coordination; and administrative services. Most of the staff were professionals with master's degrees who designed surveys and analyzed data collected by students and others hired as field enumerators to interview farmers and gather statistics from bankers. TBAC/PCAC ACHEVEMENTS. Generating and interpreting data were TBAC's primary purpose, which enabled it to evaluate credit policies and study proposals for new projects, concepts and institutional changes. TBAC staff responded to requests from board members, but many of its tasks were initiated internally by staff to develop interesting lines of inquiry and explore issues arising from their activities. Research on individual banks was confidential, but data on groups of banks were frequently made public. The TBAC secretariat was flexible and responsive under young, dynamic leadership that was kept in place long enough to obtain and exercise mastery over the work program and issues. Views of the board and the staff did not always coincide, but conflicts were a healthy part of the information and informing process. The staff's primary fora were the quarterly or more frequent meetings of PCAC. TBAC mounted major studies and undertook minor research tasks, organized seminars, kept in constant contact with government and banking officials having a stake in rural finance, initiated a statistical series on agricultural credit, developed good relations with local academic researchers in prominent universities, and established an intemational presence by participating in credit conferences abroad. TBAC produced a steady flow of documents, many of which were published as papers, seminar proceedings, and books. Concrete results claimed by PCAC and TBAC from 1976 through 1980 included design of loan arrears collection campaigns, introduction of restructuring guidelines for distressed borrowers, design of a rural bank rehabilitation scheme, expansion of rediscounting facilities to private development banks, miscellaneous innovations through amendments to the 134 The Conventional Assault on the Frontier General Banking Act, simplifications in loan terms and conditions, and lengthening the term structure of agricultural loans.14 Its activities contributed importantly to the most innovative rural finance project ever supported by the World Bank through the mid-1980s. A noteworthy feature was pricing project funds to local lenders at adjustable rates consistent with their costs of obtaining retail deposits from the public. This was to ensure that extemal funds did not displace deposits as sources of funds for participating intermediaries, making the credit program more robust by providing prospects for continuity with or without external support. Another feature associated with TBAC's activities and those of its successor, ACPC, was noted by many donor agency officials and researchers from abroad. A relatively large number of people in Philippine government, academic, agricultural, policy analysis and financial circles are extremely well informed about the operations and condition of the country's rural financial system. Those having a need to know have a command of the facts. The information base is healthy and walks around on many pairs of legs rather than reclining on dusty shelves. This brilliant information infrastructure did not save the Philippine rural credit system from tremendous difficulties. Serious problems were associated with Masagana-99 and began before the founding of PCAC/rBAC. Others related to activities initiated during a period when democratic processes were repressed and political patronage through the financial system became rampant. However, opportunities for recovery and institution-building in the broad sense are clearly much greater because of the activities of PCACITBAC and its successor agency.15 This Philippine innovation creates value because it refines the valuation process and facilitates risk management. 14. PCACtTBAC, The First Five Years: 1976-1980. Manila: PCAC, n.d. 15. For example, ACPC has issued a series of policy briefs of approximately four pages each that receive wide circulation. One dated January 12, 1989, is titled "The ACPC does not favorably endorse Senate Bill No. 743 and views it is unnecessary." Tlhe bill it attacks offers "An Omnibus Code to Rationalize and Promote Small Enterprises, Establish a Credit and Guarantees Corporation, Provide Funds Therefore And, for Other Purposes." PCAC holds that the Bill is inconsistent with the Government's policy and privatization and minimum intervention, and notes that the supply of credit is not the most critical constraint to small enteprise development. Policy and Practice that Reduce Value at the Frontier 135 Good Information Aborted Premature Promotion ofAgricultural Insurance Efforts to introduce all-risk agricultural insurance in developing countries during the late 1970s and early 1980s are a striking example of attempts to move the frontier of fonnal financial markets. The rise and fall of promotion of all-risk agricultural insurance illustrates the danger of acting on insufficient information, and how good information can limit losses from failed innovations. Agricultural insurance consists primarily of crop insurance, livestock insurance and crop credit insurance. Crop and livestock insurance directly protect a farmer against loss by paying an indemnity when crop failure or accidental animal deaths occur. Crop credit insurance maintains an indebted farmer's access to credit in the event of crop failure by reimbursing the lender the amount due from the farmer. All-risk or multi-peril insurance covers losses from all events other than farmer negligence or purposeful destruction, while specific-risk coverage is restricted to specified causes of loss such as fire, hail, or flooding. INSTITUTIONAL SUPPORT FOR DEVELOPMENT OF AGRICULTURAL INSURANCE. Specific- risk crop insurance, especially for hail and fire damage to grain, was developed by private insurance companies in Europe and North America in the late 1800s, but the product was not well-established until the 1920s when the risks to insurers were more clearly understood. In the late 1930s the League of Nations commissioned a study on crop insurance, 16 and the United States and Japan established state-owned crop insurance corporations offering all-risk coverage. These served as models for developing country programs in the 1970s. Several donors and international agencies promoted all-risk coverage, especially to small farmers. The Special Insurance Programme of the United Nations Conference on Trade and Development (UNCTAD) arranged regional crop insurance conferences supported by funds from the United Nations Development Programme (UNDP), prepared promotional materials17 and advocated subsidies for crop insurance.18 16. M. Louis Tardy, Report on Systems of Agricultural Credit and Insurance (Geneva: League of Nations, 1938). 17. An important example is Jose Ripoll, "Contribution of Agricultural Insurance toward Economic Development," paper delivered at the UNCTAD/UNDP Seminar on 136 The Conventional Assault on the Frontier UNCTAD's interest derived from the Programme of Action on the Establishment of a New Intemational Economic Order adopted by the UN General Assembly in 1974. UNCTAD helped establish national insurance markets in developing countries to reduce the use of foreign exchange to purchase coverage from insurers in developed countries. Objectives were "to increase the volume of premiums written [in local markets] and to limit the number of insurance companies sharing these premiums." 19 These goals were promoted by revising insurance legislation, restricting underwriting to locally-owned or -chartered insurers, making coverage compulsory, and nationalizing insurers or reinsurers (which insure insurance companies for a portion of their risks). The Food and Agriculture Organization of the United Nations was another source of initiative. FAO had an agricultural insurance specialist on its staff for many years, who wrote in 1975 that, "No sustained and steady development of the agricultural economy of the developing countries is possible without some form of crop insurance to underwrite the risks of crop failure."20 FAO had organized conferences and prepared country studies on agricultural insurance since 1953.21 The United States Agency for Intemational Development funded pilot projects in Latin America and related studies with technical input from the US Federal Crop Insurance Corporation. The Japanese government offered technical assistance and access to Japanese experience. Several Agricultural Insurance, Colombo, Sri Lanka, 1-5 September 1979. Geneva: UNCTAD/INS/33 GE.79-54061. 18. United Nations Conference on Trade and Development, "Invisibles: Insurance-Crop insurance for developing countries." Study by the UNCTAD secretariat for the Trade and Development Board, Committee on Invisibles and Financing related to Trade, Ninth session, second part, Geneva, 29 September 1980, Item 7 on the provisional agenda. TD/B/C.3/163, 5 May 1980. 19. United Nations Conference on Trade and Development, "Third world insurance at the end of the 1970s." TDlB/C.3/169/Add.lIRev.l. New York: United Nations, 1981. 20. P.K. Ray, "The Role of Crop Insurance in the Agricultural Economy of the Developing Countries," Monthly Bulletin of Agricultural Economics and Statistics. May 1975. Repeated in Ray's seminal work, Agricultural Insurance: Theory and Practice and Application to Developing Countries. 2nd ed. (Oxford: Pergamon Press, 1981), p. 309. 21. For an historical account see Paul R. Crawford, Crop Insurance in Developing Countries. Unpublished masters dissertation, University of Wisconsin-Madison, 1977. Chapter 1. Policy and Practice that Reduce Value at the Frontier 137 others, including France, Israel, Sri Lanka, and Sweden, expressed interest as well. ECONOMIC BENEFITS OF AGRICULTURAL INSURANCE. This institutional thrust was bolstered by economists who believed that all-risk insurance could deliver economic and social benefits. Among the most notable of these was V.M. Dandekar, who maintained that: Crop insurance is part of the institutional infrastructure essential for development of agriculture which is basically insecure. Importance of agricultural credit is now universally understood. Without protection from the insecurity of agriculture, the entire structure of agricultural credit is in danger of total collapse, burying under it the cultivator in perpetual indebtedness 22 Advocacy grew partly out of the study of risk in agriculture that captivated many development economists in the mid-1970s. The major theoretical argument is that agricultural investment would increase if growers' risks were diminished.23 This would permit greater specialization in insured crops and stimulate productivity. Insuring priority crops-cash crops, export crops or food crops-could rearrange national cropping patterns, making them more responsive to govemment objectives. Insured farmers would obtain credit more easily and in greater amounts because insurance provides a cushion to lenders. Risk management through insurance could be more than merely financial, because insurance makes risks more transparent (by generating data and experience) and by technical assistance to farmers from or in association with insurers. Bumps in the farm economy due to adverse natural events could be smoothed out, benefiting bankers, input suppliers and providers of other services in rural communities where the rhythm of economic life is determined by the fortunes of agriculture. Insurance was viewed as economically superior to disaster relief because it is easily targeted and the costs of indemnities would be determined in advance according to insurance contracts. Farmers would 22. V.M. Dandekar, "Crop Insurance in India," Economic and Political Weekly. June 1976. Review of Agriculture, p. A-80. 23. The definitive work on all aspects of agricultural insurance, which arose in conjunction with international interest in promoting it in developing countries, is Peter Hazell, Carlos Pomareda and Alberto Valdes, eds., Crop Insurance for Agricultural Development: Issues and Experience. Baltimore and London: The Johns Hopkins University Press, 1986. 138 The Conventional Assault on the Frontier contribute to the cost directly through premium payments, and payments of claims would come from the insurer's reserves rather than from hard- pressed government budgets. Reinsurance could support broad coverage over the farm population. DATA PROBLEMS IN DESIGNING AGRICULTURAL INSURANCE PROGRAMS. Development assistance agencies promoted agricultural insurance programs in a number of developing countries in spite of theory and practice that indicated that the conditions required for these programs' success are extremely rigorous. The FAO specialist noted that problems included a lack of basic data, heterogeneous agricultural practices contributing to wide dispersions in yield levels, small and geographically scattered risks that would make administration difficult, poor land tenure and land record systems, the limited ability of some farmers, lack of staff trained in insurance, poor infrastructure inhibiting field administration, and limited financial resources to support introduction of agricultural insurance.24 DESIGN wr1Tour DATA. Many writers, including some in the UNCTAD secretariat, expressed caution. But promotors gave little attention at the outset to the question of how insurable agricultural risks could be covered in a financially viable manner. Data from developing countries that had crop insurance were not fully analyzed.25 Deficiencies were often blamed on characteristics peculiar to the country concerned, rather than to flaws in insurance design, or were said to be readily correctable. Primary problems included difficulties in collecting premiums from reluctant farmers, achieving sufficient volume without making coverage compulsory, and eaming the income and obtaining the subsidies to break even financially. The vulnerability of agricultural insurance to politicization was not widely discussed. Success stories from developing countries were limited to insurance for the highly organized sugar industry on Mauritius, that introduced coverage in 1947, and for European growers of tobacco in Zimbabwe. Coffee 24. See P.K. Ray, op. cit. pp. 309-330, for a summary of materials that were published earlier as articles. 25. An example is "Crop Insurance," published in Bangkok in 1984 by the Asian Reinsurance Corporation, an intergovernmental organization formed with UNCTAD assistance. It fails to include any information about loss ratios in its country summaries. Loss ratios show the relationship between premium income and claims paid. Policy and Practice that Reduce Value at the Frontier 139 insurance in Puerto Rico, available since 1946, was sometimes also cited by advocates. Programs suffering serious problems, such as well- documented experience in Sri Lanka since 1958, and less well-documented operations in Mexico since 1954 and in Kenya since 1942, were not contemplated in depth, nor were unhappy experiences that had been corrected in the United States26 and France.27 How farmers actually manage risks, the magnitude of these risks, and the factors that determine farmers' willingness to pay for insurance were not entirely clear.28 One option for addressing these problems would have been to inaugurate a battery of studies to build up information bases on variability in yields and on farmers' responses, for example. Studies of this type require data for a number of years to permit statistically sound rate making (i.e., determining the size of the premium required to cover payment of claims). Could development wait for this tedious bean counting (literally) to be completed? The most creative effort to address these problems was launched by AID in the form of support for pilot schemes in Bolivia, Ecuador, and Panama. Project documents were optimistic, envisaging a Latin American reinsurance pool to spread risks. Insurance technicians and academic researchers were assigned to these efforts, and operations were closely monitored. After two years it was reasonably clear that farmers were generally unwilling to pay and governments were generally unwilling to charge the premiums required to make these programs viable financially. In other words, farmers in the pilot areas had other, more economical ways of managing risk, and politicians viewed insurance as patronage rather than in commercial terms. These pilot results confirmed experience in other developing countries. 26. See Bruce L. Gardner and Randall A. Kramer, "Experience with Crop Insurance Programs in the United States," in Peter Hazell, Carlos Pomareda and Alberto Valdes, eds., op. cit. pp. 195-222. Subsequent experience in the US shows that some reforms unravelled. See "Farmers Play Uncle Sam for Uncle Sap: Taxpayers are the big losers in the federal crop-insurance plan that is badly conceived, badly run and made moot by free bailouts," U.S. News & World Report, August 8, 1988. pp. 27-28. 27. See Le Monde, "Le rapport de la Cour des comptes sur l'indemnisation des calamites agricoles met en evidence de nombreux abus," ["The Controller General's Report on Claims Paid for Agricultural Losses Reveals Numerous Irregularities," trans. ed.] and "La confiance ne paie pas," ["Confidence Doesn't Pay"], 13 juillet 1979. p. 29. 28. R.H. Schmidt and Erhard Kropp, eds., op. cit. p. 89. 140 The Conventional Assault on the Frontier EFFECTS OF INFORMATION AWARENESS. The activities of AID, UNCTAD, and FAO led to better and more widely spread information. Data were brought together from a number of countries, officials became more widely aware of each other's experiences, and researchers got involved with agricultural insurance issues. The result was a large body of data and theory identifying characteristics of agricultural insurance programs, their costs, and the conditions required for their financial viability. Only a small part of this data was generated directly by promotion of agricultural insurance. Most of the material that was gathered already existed, but was not readily available and had not been synthesized into meaningful summaries with analyses readily adaptable for policy making and project design. These results could, of course have been obtained relatively cheaply through an investigative research project without spending a penny on promotion, pilot programs, or new institutions. These data indicate that the economic argument for agricultural insurance is not realized in practice. A review of almost 50 years of federal crop insurance in the United States, for example, concluded that, "it is still difficult to find experimental results that will permit inferences about the effects of crop insurance introduced on a permanent basis in an area where it previously did not exist."29 Furthermore, "with few exceptions, farmers in both developed and developing countries have been unwilling to pay the full cost of all-risk crop insurance,"30 which explains why less than 15 percent of land under permanent and arable crops in the United Sates is insured.31 And, the case for subsidy is suspect: "the social benefits of compulsory crop insurance in Mexico are negative, even before the cost of the subsidy is taken into account.",32 Finally, "there is no existing multi-peril crop insurance system anywhere in the world that could be recommended as a model to other 29. Bruce L. Gardner and Randall A. Kramer, op. cit. p. 218. 30. Pater Hazell, Carlos, Pomareda and Alberto Vald6s, "Introduction," in Peter Hazell, Carlos Pomareda and Alberto Vald6s, eds., op. cit. p. 7. 31. Coverage of federal crop insurance in recent years has ranged from 9 percent of land planted to major crops and fruits and vegetables in 1983 to 14 percent in 1985. See United States Department of Agriculture, Agricultural Statistics 1986. Washington, DC: United States Government Printing Office, 1986. Tables 559 and 597. 32. This conclusion of a study by analysts of crop insurance in Mexico is reported by Peter Hazell, Carlos Pomareda and Alberto Valdes, "Introduction," in Peter Hazell, Carlos Pomarada and Alberto Valdes, eds., op. cit. p. 8. Policy and Practice that Reduce Value at the Frontier 141 countries."33 Although "developed countries are able to afford programs that produce no measurable positive results (and some very negative ones).. .severely strained national budgets make these programs doubly questionable for developing countries. They do not productively use state resources and in many cases prove to be counterproductive."34 On the design and administrative side, accurate rate making requires a data base that seldom exists in developing countries. Claims adjustment- determining the amount of indemnities to be paid for individual farmers' claims-was more demanding than assumed by promoters. Loss ratios (measuring the relationship between premiums received and indemnities paid) for many existing programs were quite high, requiring substantial subsidies. Government subsidies were cited equal to 25 percent of claims paid in the US, 50 percent in Brazil and 80 percent in Mexico.35 Promoters simply failed to factor existing data into project design. Initial enthusiasm for insurance was not matched by energetic enquiry into what developing countries could afford. Realizations from the old and new data that accumulated led to virtual discontinuation of AID support for agricultural insurance. FAO and UNCTAD activities in this area were scaled back simultaneously. Good information resulted in decisions permitting the better use of resources. While promoters turned their backs on unpromising results, their blind advocacy produced an antidevelopmental impact that is less easily left behind. The surge of international enthusiasm backed by aid left several countries with agricultural insurance programs that continue to absorb government funds. Political attractiveness and bureaucratic inertia keep them alive-it is hard to kill a program that has access to government funds, a constituency, and that claims to be doing good.36 33. R.A.J. Roberts, W.M. Gudger and D. Gilboa, AGS Bulletin on Crop Insurance. Draft. Rome: FAO, 1987. p. 4. 34. Ibid., p. 1. 35. Pater Hazell, Carlos Pomareda and Alberto Vald6s, "Introduction," in Peter Hazell, Carlos Pomareda and Alberto Valdes, eds., op. cit. p. 8. 36. William M. Gudger and Luis Avalos, "Planning for the Efficient Operation of Crop Credit Insurance Schemes," in Peter Hazell, Carlos Pomareda and Alberto Valdes, eds., op. cit. pp. 278-280. 7 SIGNS OF POOR FITS AT THE FRONTIER Markets are avenues of self expression and mutual accommodation. They reward harmonization of the interests of buyers and of sellers. Financial market innovations that produce good fits between intermediaries and clients create value and are sustainable. They reduce transaction costs, produce good loans and profitable intermediation, promote mutually beneficial activities voluntarily undertaken, and provide incentives for responsible behavior. Signs of poor fits deserve attention. They offer scope for corrective action, for refinements in the valuation process that lower costs by reducing behavior that retards financial market development. Common signs of poor fits in development finance are the subject of this chapter. They include irrelevant lending criteria, unnaturally high transaction costs, intensive and extensive credit rationing, substitution and diversion of funds, poor loan collections, unprofitable intermediation, irrelevant reporting, and inappropriate funding. Irrelevant Lending Criteria Relevant criteria contribute to remunerative lending and good loans: irrelevant criteria do not. Irrelevant lending criteria indicate a poor fit, that credit is assigned an inappropriate role. Incomplete or poorly applied but relevant criteria are basically consistent with good lending and can be refined with experience and time. Irrelevant criteria tend to have lives of their own in development assistance and government policy, however, and are more insidious in their potentially antidevelopmental impact. Irrelevant criteria have two unfortunate effects on loan quality. One is that they impose unnecessary diversionary transaction costs on decision 143 144 The Conventional Assault on the Frontier processes by consuming time, energy and resources that should be devoted to dealing with variables that produce good loans. Diversionary criteria complicate and slow decisionmaking without directly undermining loan portfolio quality. A more serious destructive effect occurs when irrelevant criteria bias decisionmaking in ways that increase the incidence of bad loans and unremunerative lending. Familiar Examples of Irrelevant Lending Criteria Some examples of irrelevant lending criteria were cited in previous chapters. "Credit needs" and related concepts, explored in chapter 4, impose diversionary effects when they produce meaningless numbers, and destructive effects by focusing on need and related concerns rather than on the source of loan repayment. Loan targeting can also be irrelevant. If developers want to assist micro-enterprises owned by women, for example, preoccupation with disbursing credit to this target group can divert attention from the fundamental question of whether a credit institution can interact effectively with micro-enterprises. A second question is whether or how micro- enterprises owned by women have characteristics arising from their ownership that are likely to enhance or diminish loan quality. If the fundamental question is not examined, a women's micro-enterprise credit project poses a destructive risk, regardless of the energy devoted to exploring the gender dimensions of credit relationships and entrepreneurship. 1 Is The Economic Rate of Return a Relevant Lending Criterion? The best and the brightest red herring in credit projects is the economic rate of return (ERR). The ERR is calculated using actual prices that are adjusted to compensate for factors that distort them from an economic point of view. These factors include monopoly, taxes and subsidies, and quantitative trade restrictions, all of which intervene to make prices unrepresentative of economic or true scarcity values. The ERR is supposed to show the return an investment yields for "the economy." Intermediaries lending project funds for development are often required to include ERR 1. Chapter 10 discusses a stunningly successful bank that lends primarily for micro-enterprises operated by women. Signs of Poor Fits at the Frontier 145 estimates in analyses of industrial loan proposals and in farm budgets used for agricultural credit decisionmaking. The relationship between loans that make good economic sense and those that make good financial sense is unclear. Loan repayment is made possible by cash flows in the currency in which the loan is payable, while ERRs are not based on any currency but on analytical assumptions. Two cases, explained below, reflect the divergence between financial strength and the ERR. One is the combination of a low projected ERR and prospects for good financial performance, while the second is poor financial performance but a high expected ERR. Low PROJECTED ERR AND GOOD FINANCIAL PROSPECTS. When importing is cheaper than producing locally, governments sometimes erect tariff and nontariff barriers to reduce imports and encourage local production. Firms that are highly protected by these barriers may be successful financially while imposing high costs economically, and consequently have low ERRs. However, they tend to be attractive loan applicants because they are protected by govermment from import competition. However, setting up and operating a business is risky, to which is added the risk that protection may someday be removed, while importing involves relatively little risk. To promote economic efficiency, donors often require intermediaries retailing project funds to calculate ERRs for each investment or borrower financed. However, poor economic analysis results when intermediaries sense that it is irrelevant to making good loans, when it stands in the way of engaging attractive clients, and when donors do not enforce ERR reporting requirements or analytical standards. ERRs frequently impose diversionary costs on intermediaries and fail to deal effectively with risk. (In fact they may even fail to deal fully with economic costs. An Inter- American Development Bank study2 noted that financial intermediaries' costs of allocating, administering and recovering loans is rarely included in these analyses, which focus exclusively on the activities of subborrowers.) HIGH PROJECTED ERR BUT POOR FINANCIAL PROSPECTS. A destructive effect occurs when enthusiasm for investments with high projected ERRs diverts attention from their financial characteristics. When the ERR is the major criterion for investment attractiveness, and when credit need is assumed to 2. Inter-American Development Bank. Op. cit. pp. 18, 28. 146 The Conventional Assault on the Frontier equal a high portion of project cost, project design may lock retail intermediaries into unremunerative lending. Borrowers may have difficulty achieving commercial success when elements of success are less carefully studied than ERR calculations in project design. Faltering commercial performance, compounded by relatively high debt service burdens, produces poor loan repayment. This situation is captured by "Murgatroyd's Inversion," the observation by a World Banker that the greater the sophistication in the economic analyses constructed by industrial development banks in Africa, the greater the probability of serious portfolio problems. Perceiving project performance or returns to a portfolio as a function of average ERR levels is misleading for the reasons suggested above, and also because several large failures can devastate a portfolio confined by the close tolerances of finance. ERRs ARE IRRELEVANT TO CREDIT ALLOCATION. Properly calculated economic rates of return may be useful guides for economic planning, but they offer no guidance on how investments should be financed. Attempts to clothe credit with favorable ERRs indulge the imagination. Even if projected ERRs for credit-supported investments are carefully calculated and diligently reported, and even if credit is used as specified in the loan contract, fungibility confounds the usefulness of the ERR. The borrower may have other funds that in the absence of the loan would be devoted to activities associated with the project. When the loan is received, these alternative funds can be devoted to activities with low ERRs. Also, the intermediary may use funds for purposes with low ERRs that would have been invested in high ERR activities in the absence of extemal assistance to such activities. Under certain circumstances, fungibility may force project funds into the least remunerative activities available. This tendency is strongest when project-supported activities are the best available, when projects fail to innovate in ways that would not otherwise have been exploited, and when market fragmentation is low, permitting funds to flow more easily to altemative uses. Market fragmentation is low when households borrow, as they have numerous activities. Signs of Poor Fits at the Frontier 147 Unnaturally High Transaction Costs Financial intermediation at the frontier is costly, especially for formal institutions. The frontier is often spread over large geographical areas, involves relatively small transactions and balances, and requires relatively large amounts of noninterest-earning cash to serve depositors and borrowers. Obligations to formal institutions may not be accorded high priority at the frontier, especially when institutions are not responsive to clients. These factors create relatively high transaction costs. The challenge for financial market development is to cover transaction costs and to reduce them. They are diminished by improved management of existing intermediaries and by innovations in intermediation. An advancing frontier reduces transaction costs for people who are brought within it. While transaction costs at the frontier are naturally high, those associated with credit programs, targets and quotas are probably unnaturally high, demonstrating a poor fit. Intermediaries have little incentive to relate costs to productivity in nonmarket situations, and cost control may be poor. Program design may add costs unnecessarily because credit project operating costs are not always fully estimated in project design. The problem to be addressed in project design, therefore, is costs that are higher than they would be in a competitive situation and how these costs are distributed among depositors, intermediaries and borrowers. Unfortunately, little data are available to show the extent of unnaturally high costs, and comparisons are difficult because many factors influence these costs. However, transaction costs are material. Borrowers' Transaction Costs The first major attempt to quantify small farmer credit transaction costs appears to have been undertaken by Mirza Shahjahan.3 His pioneering theme was developed in a survey article by Dale W Adams and G.I. Nehman, who identified three types of such costs: noninterest charges by lenders; loan application procedures that require the applicant to deal with agents outside the banking system, such as agricultural extension staff, 3. Agricultural Finance in East Pakistan. Dacca: Asiatic Press, 1968. 148 The Conventional Assault on the Frontier local officials and cosigners; and travel expenses and time spent promoting and following up the application.4 Adams and Nehman noted that new applicants often have to make between five and seven trips to the lending institution before receiving their first fonnal loan. Based on Shahjahan's data and on the observation that formal lenders reject many applicants who have not borrowed before, they concluded that the overall costs of formal borrowing made informal credit more attractive to many small farmer applicants. From Shahjahan's data, Adams and Nehman estimated that interest payments amounted to less than half of the borrowing costs of 2,500 sampled borrowers from the Agricultural Development Bank of Pakistan; for a six-month loan, noninterest costs amounted to 91 percent of the amount borrowed, a level that strains plausibility if it is assumed that borrowers know their costs and expect to repay their loans. A 1981 study of the transaction costs of borrowers from the Bangladesh Krishi Bank, successor to the Agricultural Development Bank of Pakistan, reported material but somewhat lower costs. Zia U. Ahmed surveyed 61 borrowers in 12 villages served by the Raipura branch, and calculated average transaction costs equal to 22 percent of loan size, with a standard error of about 2 percent.5 Nehman surveyed 150 farmers in Sao Paulo State, Brazil, in 1971. He found that, ignoring inflation, noninterest costs on formal loans constituted from 14 to 71 percent of borrowing costs. The smaller the loan and the shorter its term or tenor, the higher the transaction cost relative to the amount borrowed. Adams and Nehman cited data compiled by V.M. Villamil Ortiz for a sample of 63 Colombian farmers, most of whom farmed less than 10 hectares. For formal loans, Villamil found that interest rates averaging 13 percent amounted to only 30 percent of total borrowing costs, which in turn amounted to 42 percent of amounts borrowed. Lenders' Transaction Costs The World Bank's 1975 agricultural credit sector policy paper suggests that the annual administrative costs for efficient medium- and long-term 4. D.W Adams and G.I. Nelman, "Borrowing Costs and the Demand for Rural Credit," Journal of Development Studies. 15, 2, January 1979. 5. Zia U. Ahmed, "Effective Costs of Rural Loans in Bangladesh," World Development. 17, 3, 1989. pp. 360-361. Signs of Poor Fits at the Frontier 149 agricultural lenders would amount to between 7 and 10 percent of the size of the loan portfolio. Estimates of administrative costs as a percent of new loans made ranged from 3 percent for a lender in Mexico to 50 percent for a lender in Uganda.6 Katrine Anderson Saito and Delano P. Villanueva estimated that lenders' annual administrative costs in the Philippines ranged from 3 to 4 percent of amounts outstanding to small scale agriculture and industry.7 In a new small farmer credit program in the Yemen Arab Republic in the mid - 1970s, Mohammad Rashrash Mustafa reported that administrative costs equalled about 18 percent of amounts loaned for seasonal agricultural inputs.8 In Malawi, estimated seasonal credit administration costs equalled between 7 and 8 percent of amounts loaned from 1970 through 1973 in the Central Region Lakeshore Development Project, and in the Lilongwe Land Development Project fell from 331 percent to 4 percent of the average loan size between 1968 and 1973 as the number of borrowers expanded from 656 to 21,469 and as average loan size rose from about US$10 equivalent to about US$26 equivalent.9 An important and pioneering evaluation of agricultural projects by the Inter-American Development Bank (IDB) reviewed transaction costs and their origins. 10 In one case cited, the costs associated with loan generation and administration amounted to 14 percent of the volume of lending, and 82 percent of this cost was personnel cost. In a second case cited, these percentages were 8.2 percent and 76 percent, respectively. The study found that the level of these costs is directly related to the administrative procedures and staffing practices employed by lenders. Where a credit project involves many lending criteria, terns and conditions, costs tend to be higher than for simpler projects. IDB concluded that on-site visits to 6. Agricultural Credit. Washington, DC: World Bank, 1975. pp. 44-45, Annex 13. 7. Katrine Anderson Saito and Delano P. Villanueva, "Transaction Costs of Credit to the Small-Scale Sector in the Philippines," Economic Development and Cultural Change. 29, 3, April 1981. pp. 634-635. 8. Mohammad Rashrash Mustafa, "Agricultural Credit Fund Activities in Tihama: April 75 - October 77, Final Report." Yemen Arab Republic, Tihama Development Project, November 1977. pp. 31-32. 9. J.D. Von Pischke, World Bank office memorandum to T.C. Creyke, December 7, 1973, "Malawi-Lilongwe Land Development Project: Smallholder Credit Arrangements and Proposals for the Development of Smallholder Credit." 10. Op. cit. pp. 14 ff. 150 The Conventional Assault on the Frontier farms and extensive legal reviews of guarantees and other loan documents contributed to high costs, as does overstaffing. In one project, 90 percent of the loan applications required between three and four-and-one-half months to process, while in the most efficient office studied the turn- around time for an application was about three weeks. Processing time did not vary with loan size in one project, while in others it tended to be longer for larger loans. The IDB study indicates that cumbersome procedures create unnecessarily high costs, often without producing good loans, and that the overall costs of lending expressed as a proportion of amounts loaned can easily exceed interest rates charged by agricultural credit institutions. Carlos E. Cuevas and Douglas H. Graham studied the administrative costs of a private commercial bank and an agricultural development bank in Honduras.11 Their results suggest that credit program design and institutional organization significantly influence transaction costs. The commercial bank's administrative expenses amounted to about 2.5 percent of amounts loaned, while the agricultural bank's were equal to 8.4 percent. The commercial bank's major costs were associated with deposit mobilization, while the development bank's were related to lending. The commercial bank was decentralized, and most lending costs were incurred by branches. The development bank was centralized, partly because of reporting requirements associated with loan targeting by donors, and its head office lending costs exceeded those incurred by branches. The commercial bank was more cautious, as reflected in higher proportions of lending costs arising from staff, loan evaluation, and loan recovery costs. About 7 percent of the development bank's lending costs were from loan supervision, against only 4 percent for the commercial bank. With respect to agricultural lending by the commercial bank, Cuevas and Graham estimated that the average administrative cost of each loan under a donor-supported project was equal to 7.8 percent of the amount of the loan, while for other agricultural loans the figure was 3.1 percent. Also, loans under the donor-supported project averaged more than twice the size of other agricultural loans, which should have reduced transaction 11. Carlos E. Cuevas and Douglas H. Graham, "Agricultural Lending Costs in Honduras," in Dale W Adams, Douglas H. Graham and J.D. Von Pischke, eds., op. cit. pp. 96-103. Signs of Poor Fits at the Frontier 151 costs assuming that loan appraisal and administration costs do not vary greatly with loan size. The Cuevas and Graham study does not compare the clients, credit portfolios, loan terms, and profitability of the commercial and agricultural banks, making it difficult to judge institutional appropriateness or efficiency. However, the data illustrate vividly that costs vary between institutions, and, for agricultural loans, between donor-funded lending and other lending. Intensive and Extensive Credit Rationing Well-functioning financial markets value promises efficiently. Loan sizes are appropriate, tailored to borrowers' prospects, adjusted for risk, and finance some portion of the borrowers' costs but not profit. Efficient loan sizes fit borrowers' repayment capacity and stimulate enterprise. Loan sizes that are inappropriate reflect a poor fit between the objectives of lender and borrower, and tend to result in bad loans and unremunerative lending. Poor loan sizing is illustrated by intensive credit rationing, which allocates too much credit to too few borrowers, and extensive credit rationing, which issues too little credit to too many borrowers. The explanations that follow assume moderate to high degrees of rationing of small farm credit. Intensive Credit Rationing Intensive credit rationing occurs when a relatively small target group receives relatively large loans. These loans are issued for purposes that greatly change borrowers' productive activities. Local cows are replaced by exotic breeds; bullocks are discarded for tractors; rainfed land is irrigated; traditional crop varieties and husbandry practices are abandoned to adopt modem varieties or different crops dependent upon purchased inputs. Intensive credit rationing is often found in agricultural credit projects because it promises great increases in borrowers' incomes as a result of technical innovation. Intensively rationed credit is supply-leading, and responds to the perception that finance is a binding constraint. Borrowers could not reasonably be expected to repay the loan from their pre-loan cash flows, so loan repayment must come from incremental cash flow generated by the loan-supported investment. Credit allocation under these 152 The Conventional Assault on the Frontier circumstances tends to be quite selective, and elaborate access mechanisms using farm budgets are frequently employed by lenders. Intensively rationed credit in effect performs the function of equity capital, absorbing the impact of risk. Adversity diminishes borrowers' debt servicing capacity and may be reasonably anticipated in agriculture and in adoption of new technologies. By imposing relatively large debt service burdens and by being designed to change technology significantly, intensive credit rationing can push finance beyond a borrower's managerial and risk-bearing capabilities, especially during the critical initial period of adaptation to change. The new activity may not generate sufficient cash flow to repay the loan that facilitated its adoption. Borrowers may have relatively little of their own resources committed to the loan-supported investment, which tends to reduce their commitment to its successful performance. Intensively rationed credit may also undermine project objectives. Relatively large loans may tempt poor borrowers to divert a portion for purposes not envisaged by the lender, especially if the borrower is not entirely comfortable with the leap in risk and managerial demands and labor requirements of agreed loan use. Diverted funds not used productively reduce repayment capacity. Lenders have fewer resources to recycle to new borrowers as arrears accumulate, delaying or denying access, and increasing pressures for concentrating loans on well-known large borrowers who already use advanced technology. Extensive Credit Rationing Credit is rationed extensively to relatively large numbers of farmers in broad target groups. For example, all members in good standing of a cooperative may have access to seed and fertilizer loans. All commercial growers of wheat having land titles may be eligible for production loans. Extensive credit rationing is most often found in seasonal loan programs for agricultural inputs. It is motivated by considerations of access as well as of production, and access mechanisms are simple. Broad access to a credit program implies relatively small loans. Loan limits are usually specified as rules of thumb, such as standard amounts per hectare. Small amounts issued to each borrower satisfy the production orientation of planners and inspire broad political appeal. Signs of Poor Fits at the Frontier 153 In promoting broad access to credit through simple procedures, lenders offer credit to some who do not use it wisely, or who have little intention of repaying, or who are so exposed to risk or so close to subsistence that even small cash repayment obligations are formidable. Some who borrowed with the expectation that their agricultural incomes would be increased may be disappointed. Investments, even in seasonal inputs, may have indivisibilities-improved seeds without fertilizers may perform worse than traditional varieties, for example. Borrowers may not use packages of inputs as prescribed because of risk aversion or a desire to convert part of the package to cash for use elsewhere. Lenders find it difficult to supervise large numbers of borrowers, or to ensure that they have adequate information on loan-supported technologies. Extensively rationed credit does not necessarily stimulate adoption of new technologies, and loans may be too small to produce commitment to their productive use or repayment. As extensively rationed credit operations accumulate arrears, lenders may try to maintain wide access by reducing average loan size, creating even more incentives for default. Inflation may reduce loan size in purchasing power terms, with the same effect. Repayment Capacity as a Guide to Financial Development Figure 7.1 portrays intensive and extensive credit rationing as departures from an optimum allocation of a given supply of credit based on repayment capacity. At the intersection, 0, of the axes in figure 7.1, the repayment capacity of individual borrowers and of all borrowers at the point of time portrayed is equal to the debt service payments they have contracted and are expected to be able to make to lenders. Intensive rationing departs from this optimum by lending too much to too few, while extensive rationing lends too little to too many. The alternative possibilities suggested by the remaining quadrants in figure 7.1 include too much credit issued to too many borrowers, in which case widespread overindebtedness may be a major social problem and a cause of financial market difficulties as massive rescheduling, write-offs and foreclosures may be forthcoming. Too little credit for too few borrowers, on the other hand, provides opportunites for financial intermediation and development by increasing the supply of loanable funds 154 The Conventional Assault on the Frontier and by innovative changes in the structure of the financial system and in the instruments it trades. The possibilities suggested by figure 7.1 expand the point that finance works to close tolerances. The initial statement of this fact in chapter 3 used illustrations from a credit project and for a lending institution, while figure 7.1 portrays the situation of individual borrowers and lenders and for the entire financial system. In only one of the four quadrants, that in which too little credit flows to too few borrowers, does departure from the optimum, where debt service equals the ability to service debt, not endanger the strength of the financial system. In three of four directions, being off course can put lenders on the rocks. Figure 7.1 Credit Rationing and Borrowers Repayment Capacity too much credit per borrower (overindebtedness Intensive Credit constitutes a Rationing major social problem) totworow boroer (oprtuiis - 7ZZZ/ rl 00 -n (opportunitiesoeidebedes for financial Extensive Credit development) Rationing df-/f zXf (,