Agricultural Credit and Rural Savings

Agriculture is both more capital-intensive and more labor-intensive than the manufacturing sector in developing economies. The capital required per unit of output is twice or more as high in agriculture as it is in industry, on average. This basic fact is confirmed by the data in the capital matrices of input-output tables. Labor also is more intensively used per unit of output

4. Jacob Yaron, Successful Rural Finance Institutions, World Bank Discussion Paper No. 150, The World Bank, Washington, DC, USA, 1992, p. 3.

5. See the survey evidence on this point cited in Claudio Gonzalez-Vega, 'Servicios Financieros Rurales: Experiencias del Pasado, Enfoques del Presente', presented at the international seminar, El Reto de América Latina para el Siglo XXI: Servicios Financieros en el Area Rural, La Paz, Bolivia, November, 1998.

6. Brigitte Klein, Richard Meyer, Alfred Hannig, Jill Burnett and Michael Fiebig, Better Practices in Agricultural Lending, Agricultural Finance Revisited No. 3, FAO and GTZ, Rome, December 1999, p. 68.

7. Scheme for Agricultural Credit Development, Report of the Eighth Technical Consultation, FAO, the African Rural and Agricultural Credit Association, and the Central Bank of Nigeria, Abuja, Nigeria, March 8-10, 1999, p. 17.

in agriculture, as confirmed by the high share of the economically active population that depends on agriculture, relative to the sector's contribution to national product.

Logically this circumstance means that in agriculture either capital or labor must have a lower return than in industry, or that both of those factors do. In practice, it means both: wages as well as average rates of return to investments tend to be lower in agriculture than in other sectors. The lower wages can be explained in most cases by the relative abundance of labor and its difficulty of moving, in the short run, to remunerative non-agricultural occupations, since many of them have higher skill requirements. The lower returns to capital cannot be explained by its abundance in the sector. Investment capital is scarce in agriculture.

According to the traditional view that economic growth must be based on industrialization (see Chapter 1), agriculture simply lacks profitable opportunities for investment. Empirical evidence strongly suggests that this cannot be the whole story, however. Many farmers who borrow capital do so on the informal financial market, where they pay very high interest rates. If the productivity of capital were low throughout the sector, then all of those borrowers would have defaulted and informal lenders would have disappeared from the agricultural sector. In fact, in all countries' agricultural sectors there are numerous examples of entrepreneurs and product lines that have successfully expanded output through investments financed by borrowing. The low returns to capital may characterize mainly lending by formal financial institutions.

A plausible explanation for the apparently low average return to capital in the sector is that investment funds do not flow readily to the most productive uses, both because of the way credit institutions have been managed and because of the structure of markets. Funds injected into agriculture by public agencies have not necessarily gone to the uses with the highest returns. Private capital markets are segmented in rural areas and are imperfect in other ways. An econometric study of credit in Philippine agriculture found strong evidence of market segmentation, based on occupations. In practice the segmentation facilitates screening of borrowers and enforcement of contracts since, for example, some traders tend to be linked to farmers who are large rice producers.8 While this kind of arrangement may be efficient for those particular lenders and borrowers, it poses problems for the development of the sector:

A rice trader is better equipped to evaluate the creditworthiness of rice farmers than corn farmers at a lower cost due to his occupational specialization. However, with the growing need for crop diversification because of environmental and risk concerns, it may become difficult for such specialized informal lenders to adequately service diversified farms It would also be difficult to introduce a formal credit institution into this type of segmented market. . . . Formal institutions would have to solve these borrower screening and contract enforcement problems in order to effectively compete with specialized lenders. . . . The well documented failure of the Philippines rural banking system in the early eighties was due in part to its inability to develop appropriate financial technologies to meet this challenge.9

Many of the reasons for the limited development of private financial intermediation in the sector are well known: imperfect information

8. G. Nagarajan, R. L. Meyer and L. J. Hushak, 'Segmentation in informal credit markets: the case of the Philippines', Agricultural Economics, 12(2), August, 1995, p. 180.

9. Ibid. Other studies have documented the segmentation of rural financial markets. For cases in Africa, see 'Informal Financial Markets and Financial Intermediation in Four African Countries', Findings: Africa Region, No. 79, The World Bank, Washington, DC, January, 1997. This last reference summarizes work by Ernest Aryeetey, Hemamala Hettige, Machiko Nissanke and William Steel in Financial Market Fragmentation and Reforms in Sub-Saharan Africa, Discussion Paper No. 356, The World Bank, Washington, DC, USA, 1996.

about borrowers and projects, as illustrated by the Philippines example, lack of adequate collateral (landholdings without full title, for example), asymmetric information on the part of borrowers and lenders about crop yield expectations and variability and repayment capacity, covariant yield risk10 and price risk, and so forth. A consensus also is emerging that inappropriate policies for the rural financial sector are another reason for its low state of development. Exploration of this problem and ways to improve those policies is a main theme of this chapter.

It is indisputable that the generally low level of human capital formation in the rural sector is also an explanation for its low returns to investment capital: the two forms of capital are complementary. Nevertheless, there have been many successful experiences with reforms in rural finance in recent years, in all regions of the world, that have addressed the weaknesses of existing formal systems of rural financial intermediation. These experiences suggest that it is possible, through appropriate policies and programs, to improve the allocation of capital in rural areas, yielding the results of higher returns to capital and higher incomes for its users.

Investment capital takes the forms of equity and debt. In addition, in agriculture human capital can be converted into physical capital by on-farm effort, as in building irrigation channels and fences by hand. However, many forms of productive capital cannot be created in an artesanal way, and rural families in developing countries typically do not have much financial equity (savings deposits) that can be put into major investments, although they may have a capacity to save. Nor is corporate farming, based on share capital, very prevalent in developing agriculture. In fact, in all sectors in almost all economies, including in the more industrial countries, equity capital plays a much less important role than borrowing in the financing of investments. As noted by Joseph Stiglitz, 'in most countries equity is a trivial source of new finance'.11 Hence, more efficient and sustainable lending mechanisms can contribute in a central way to agricultural development.

Institutions and mechanisms for mobilizing financial savings also are essential for the financing of agricultural and rural development. They contribute to the sustainability of rural financial intermediation and provide needed financial services to the rural population. The capacity of low-income rural households to save has often been underestimated and used as a justification for the approach of channeling credit to farmers, rather than that of building viable rural financial institutions. As commented by Robert Vogel, as early as 1979-1981 a successful USAID-supported project in Peru demonstrated the rural savings potential:

This project [BANCOOP] shows that savings can be mobilized in rural areas of low-income countries when the proper incentives are present. .. . There is a myth . .. that most of the rural population has no savings. If this were true, the rural poor would have become extinct long ago with the onset of the first emergency, and small farmers would have starved while waiting for the next harvest if they failed to save some of the previous harvest. The rural poor, more than anyone else, must have a liquid reserve to meet emergencies. Credit, usually from informal sources, can sometimes supplement this liquid reserve, but credit is available only to those who have actual or potential savings. Even the moneylender will not lend to someone with no accumulated or potential surplus, and friends and relatives, as well as

10. The large variability of crop yields increases the probability that an individual agricultural borrower will default or request a loan rescheduling, but for banks an even greater concern is that the yields of all crops and all farms in a given area tend to fluctuate together because of weather variations. This is covariant behavior of yields.

11. Joseph Stiglitz, 'The Role of the Financial System in Development', paper presented to the Fourth Annual World Bank Conference on Development in Latin America and the Caribbean, titled Banks and Capital Markets: Sound Financial Systems for the 21st Century, San Salvador, El Salvador, June 28-30, 1998, p. 3.

savings and credit societies, usually require the ability to reciprocate .. .12

Marguerite Robinson has observed that Indonesian banks' massive savings mobilization from 1986 onward has destroyed the myths that mobilizing rural savings is difficult in developing countries.13 She points out that institutional savings provide numerous benefits to households, including the following:

• Liquidity. Rapid access to at least some financial savings is considered essential by many households in monetized or partially monetized economies.. . . people save for emergencies and for investment opportunities, which may arise at any time . . .

• Returns on deposits. Positive real returns on deposits are typically not available at low risk outside financial institutions. .. .

• Savings for consumption. Households with uneven income streams (from agriculture, fishing and enterprises with seasonal variations) can save for consumption during low-income periods. .. . Households also tend to save for other kinds of investment, such as children's education, house construction, and electrification. . . .

• Savings for social and religious purposes and for consumer durables. . . .

• Savings for retirement, ill health, or disability.

• Savings to build credit ratings and as collateral.. . .

Many of the benefits gained from institutional savings by households are also applicable to enterprises [which] tend to have a high demand for liquidity Deposits mobilized in conjunction with commercial credit programs enable ... financial institutions [to become sustainable]. As of December 31, 1991, BRI's14 KUPEDES program had 1.8 million loans outstanding that were fully financed by ... bank deposits from 8.6 million savings accounts KUPEDES supplies an increasing amount of the large demand for local credit at commercial interest rates.15

In addition to increasing the pool of loanable funds and directly benefitting rural households, savings mobilization by rural financial institutions generates other beneficial effects. Vogel has summarized some of them in the following way:

Income Redistribution

Policies that improve savings opportunities can do far more to redistribute income toward

Another experience that revealed the latent potential to mobilize savings in rural areas occurred in the Dominican Republic in the 1980s:

The Banco Agrícola in the Dominican Republic began to offer passbook savings services in 1984 because it was in serious financial difficulty and urgently needed funds. By 1987 deposits had increased more than twentyfold. Although 60 percent of the depositors were previous borrowers from the institution, the rest were a new clientele who demanded only a safe and convenient store for liquidity (from the World Bank, World Development Report 1989, Washington, DC, USA, 1989, p. 119).

12. Robert C. Vogel, 'Savings Mobilization: The Forgotten Half of Rural Finance', in D. W. Adams, D. H. Graham and J. D. Von Pischke (Eds), Undermining Rural Development with Cheap Credit, Westview Press, Boulder, CO, USA, 1984, pp. 249-250.

13. Marguerite S. Robinson, 'Savings Mobilization and Microenterprise Finance: The Indonesian Experience', in Maria Otero and Elisabeth Rhyne (Eds), The New World of Microenterprise Finance: Building Healthy Financial Institutions for the Poor, Kumarian Press, West Hartford, CT, USA, 1994, p. 30.

14. Bank Rakyat Indonesia. The main clients of the highly successful KUPEDES program are small- and medium-scale savers and borrowers.

the rural poor than projects based on low-interest-rate lending. Low interest rates create an excess demand for credit, thereby forcing financial institutions to ration credit away from small borrowers without traditional collateral who are perceived to be risky and costly to serve. .. . Such rationing consists not only of loan refusals but also of transaction costs that can easily exceed interest costs for small borrowers. . ..

Resource Allocation

Effective savings mobilization by financial intermediaries draws resources away from unproductive investments, especially inflation hedges, as the opportunity is provided to make deposits that earn positive real rates of interest. .. . These resources can be on-lent by financial intermediaries for those activities that promise the highest rate of return. .. .

Financial Institutions

The positive effect of savings mobilization on financial institutions is the third argument in favor of savings mobilization. Financial institutions neglecting savings mobilization are incomplete institutions. They not only fail to provide adequate services for rural savers, but they also make themselves less viable, as can be seen most clearly in the high rates of delinquency and default that plague most agricultural development banks.. . . When financial institutions deal with clients only as borrowers, they forgo useful information about the savings behavior of these clients that could help to refine estimations of their creditworthiness. Furthermore, [in the case of local financial institutions] 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.. . .


Savings mobilization provides appropriate incentives and discipline not only for rural financial markets and institutions but also for governments and international donors. .. . financial institutions are likely to have little interest in savings mobilization or loan recovery when cheap funds are available through government loans, central bank rediscounts, or loans from international donors. It is largely ignored that the volume of resources that can be obtained through effective programs of savings mobilization and loan recovery is potentially far greater than the most optimistic estimates of the amount of subsidized loans and grants available from governments and international donors. .. . Emphasis on savings mobilization is also incompatible with programs of low-interest-rate lending because financial institutions cannot be expected to mobilize savings and on-lend them at interest rates that cover neither interest payments to depositors nor administrative costs. It has sometimes been alleged that government officials use subsidized lending as a means to distribute patronage. ... If true, this provides another reason for imposing the discipline of savings mobilization. . . .16

Rural finance overlaps with the field of microfinance, and much of the ferment and creative evolution in financial systems in recent years has taken place in the context of microfinance institutions. Frequently, their borrowers are more urban than rural (BancoSol in Bolivia), and in rural areas they may represent shopkeepers and traders as much as or more than farmers (Grameen Bank in Bangladesh), but nevertheless microfinance institutions can contribute significantly to agricultural development.17 They contribute directly, in the form of production loans, and indirectly by supporting the agricultural marketing sector. Sections throughout in this

17. Microfinance has lent significant amounts to farmers in Indonesia, Cambodia, Thailand, Albania and Mali, among other countries.

chapter are devoted to questions related strictly to agricultural finance, but equally much of the discussion about developing rural financial systems follows the experience of microfinance institutions.

In regard to the development of microfinance in general, María Otero and Elisabeth Rhyne have written:

Savings mobilization is an indispensable ingredient ... as important as credit. .. . When there is no institution available, poor people tend to save in other than financial form, such as in small livestock or jewelry. .. . The rise of financial institutions that specialize in reaching the poor opens a window for defining microenterprise finance as part of a broader financial system. It also forces a change in focus - from creating good projects to creating healthy financial institutions for the poor.18

These considerations underscore the importance of increasing the opportunities for saving in financial form and of improving techniques of managing credit, so that the sector - and the rural economy in general - may realize more fully their potentials for productive investments.

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