DF201|Assignment Two
Yes high real interest rates should be of concern to not only the poor peasants but also to “all academic economists concerned with this subject” (Ref. 2, page 477). One fundamental assumption that both Bottomley and Bhaduri uses in their models is that the Money Lender is a monopolist and thus receives monopolistic profits (Ref. 1, page 249 “Monopoly Profit” and 2, page 468 monopolistic advantages). While yes by definition the poor have little in assets, I believe they have alternatives to the local money lender. Access to commercial banks and even State Agricultural Banks may be difficult, but the formal side can still provide alternatives with cooperatives as in Users Associations, Credit Unions, informal savings clubs and rotating savings and credit association (ROSCA). Next the poor have access to the informal sector by tapping into anyone that has excess liquidity for the short term. The first place that is available is friends and families with little or no interest, usually in a reciprocal manner. Local Merchants or input traders may want to lend for short periods to tide over their customers. Crop buyers may place more value for the peasant’s crop than what it is worth at the time of need, and may be expecting future harvests to pay for any opportunity costs of lending in the short term. Landlords, other wealthy individuals or even local politicians may be of assistance.
One reason that poor peasants have little access to formal markets is due to the cost structures of Money Lender’s cost or more broadly to include local lenders versus Urban Bank’s costs (Ref. 1, page 244). Bottomley’s theoretical cost structure shows that at lower denomination of loans the local lender is more cost effective that the Urban Bank. Since the personal interaction between the local lender and the borrower, administrative cost, default cost and overall risk premium are lower than the Urban Bank. As the size of the loan and borrowers net income is increased, the basic rate or pure rate takes up a larger share of the local lenders costs (75% local lender vs. 50% for urban bank. The basic rate for the local lender is greater since he/she may have idle cash for long periods with little investment opportunities in the short term. Even though at higher denominations default is less of a cost factor, Bottomley does not explain why the default would be lower for the urban bank. I would assume that at any level of loan the local lender would be best able to collect through a wide variety of intimidation and/or social pressures.
The second assumption is that poor peasants have an inelastic demand curve for the money lenders services. Taking into the fact that peasants have alternatives listed above and that even the poor have assets, then options are available. Even in some of the poorest in countries such as India, many families have jewelry or other non-productive assets that can be sold or pawned. And according to Patrick: “In developing countries, a considerable portion of the savings used relatively unproductively are probably hoarded by large numbers of relatively poor people.” (Ref. 3, page 57). When peasants are facing long term unfavorable conditions (as shown in Figure 5.1, Unit 5, Development Finance Handbook) then this should tell the economy to transfer resources to more productive uses. This is evident in the migration from rural areas to urban areas for quite some time.
Since we are looking at the problem of rural peasants having the feast or famine cycles, we could devise plans that tried to smooth out the cycles of liquid assets. While none of these require direct government control, the government should act as educator and facilitator. One is to grow food and basic needs for the family to avoid having to borrow for the basic needs. Another is to have more than one type of crop that alternates harvest times and thus income times.
Another problem facing poor peasants and most all farmers is inelastic demand curves for their products. If crops are bountiful, then per unit prices garnered goes down and may not help the farmer in total cash generated. One option is for the government to set up markets to purchase excess supply on the short term and distribute it in the long term.
Rural poor peasants face higher real interest rates because of the size of loan and underlying net income, and overall costs that the money lender has to factor into the loan (Ref. 1, page 244). Bhaduri believes there are perverse incentives for the money lender to undervalue the assets of the peasants and covet those assets. The reason for undervaluing the assets is there may be little to no market for the peasant’s assets and thus any price is more subjective than market derived. The money lender may create interest rates high enough that he feels default is most assured and then he can dispose of the assets at a profit (especially if he has access to outside markets) or use for his own benefit. If there were markets created for the peasants assets then this would reduce this market imperfection.
Some social pressures on money lenders because of the “highly personalized nature” (Ref. 2, page 476) limit the money lender from foreclosing on peasants assets. Large land owners, local merchants, input traders or crop buyers with excess liquidity may not want to alienate the local population to gain in the short term. And some groups may not want to deal with disposing of assets like the merchants. And lastly if a default occurs on a large scale, then even money lenders may be painting themselves as carpetbaggers and be dealt with harshly.
Laws and regulations can lessen the incentive for money lenders to seek to liquidate the assets of the poor peasant. Legislators need to balance the property rights of both the lender and the borrower and thus try to eliminate incentives to default or create defaults. Most countries continually work to make a good balance between these rights.
Given that poor peasants face high interest rates at times when liquidity of other groups may also be low, then the traditional approach to economic development has been to subsidize loans in the rural areas. Some reasons for this approach has been the view that credit was a major constraint for farmers, the credit shortage led to high interest rates, high interest rates caused a vicious cycle of poverty and indebtedness combined with limited savings resulted in the need for “supply led” strategies in the form of formal financial institutions (Page 4-5, Unit 6, Development Finance Handbook).
Government loans that are subsidized “rarely give a satisfactory profit compared with the returns from investments in agricultural research and extension or in social capital” (Page 5, unit 6, Development Finance Handbook). And “it is much easier to expand the supply of loans than to implement land reform, extend rural roads and infrastructure, improve irrigation and drainage, or diffuse new technology. (Page 15, unit 5, Development Finance Handbook)
Not only is government financed loans economically inefficient, they misguide the market and not accomplish the goals it assumes to fix. Just because interest rates are lowered and there is increased availability of loans does not mean that there will be a resulting increase in capital. “Both substitution and diversion create obvious difficulties for purpose specific credit programs” (Page 9, unit 6, Development Finance Handbook). This means that loans are fungible and can be used for whatever purpose the borrower so wishes. Even when granted in goods (for example food stamps), these goods can be exchanged for cash. Under microeconomic theory, subsidizing food or any other good may not increase the utility of the recipient more than cash transfers. The recipient may even sell his goods at a loss rather than keep the goods for self consumption.
Subsidized interest rates distort the market by creating negative real interest rates resulting in an income transfer (from saver to borrower), fails to reward savings adequately, undervalues the real costs of capital in different sectors, results in excess demand and conversely a shortage of savings, and does not reflect the social scarcity of capital (Page 9-10, unit 6, Development Finance Handbook). And in turn this leads to credit rationing that favors the richer borrowers as shown by Bottomley (Ref. 1). So the policy to increase loans to poor farmers actually resulted in fewer loans to poor farmers. This is shown by Gonzalez-Vega in “it has been estimated that only about 5 percent of farmers in Africa and perhaps 15 percent of farmers in Asia and Latin America have had access to formal credit” (Ref. 5, page 366).
To avoid the traps with subsidized credit and market manipulations with regard to interest rates, innovative institutions may be the solution. ROSCA is one such approach that rotates the members between creditor for multiple time periods and debtor for one time period (Page 15, unit 6, Development Finance Handbook). This can lead to “landless laborer buying land, a porter or driver purchasing a rickshaw or taxi, or a peasant household buying cattle” (Page 18, unit 6, Development Finance Handbook). But too often this looks to be a lottery that would be used for trivial and non-investment purposes. This is especially true if interest rates are high since it would entail a transfer of wealth from last debtor to the first debtor. The first to receive the bounty would pay back the “debt” at cheaper dollars while the last to receive the bounty would have paid in with expensive dollars and received cheap dollars in return. With high interest rates, the cycle would have to become shorter and shorter until it no longer had any savings value to the participants.
Other cooperatives may also play some role in allocating credit in rural areas. Just as Japan used Postal Savings, many LIC’s may benefit from this. The government can improve the cost of transactions and reduce the spread between saving and lending rates. Just as it was suggested that the government would be best to improve the infrastructure of the economy than to subsidize loans, the government could improve the infrastructure of the RFMs by disseminating information and training, providing group loans to get groups formed, using the postal services assets to provide banking services also, and lastly to advise and consent.
While groups lending has some benefits of reducing loan transaction costs, the “recent research on group lending shows results that are less positive than originally hoped” (Ref. 4, page 482). But “group loans appear to work best where groups have non-credit reasons for collective actions” (Ref. 4, page 482). Finding the social bonds that will make groups work does present a challenge, but once the social bonds are in place then the default rate should be low as well as transaction costs and administrative costs. Thus credit unions that are tied to a job should do better.
The last point I want to make is that even if governments want to promote the well being of poor peasants with subsidized investment and loans, it should first make sure that macroeconomic policies support the rural farmers. Stable prices and stable money supply would help more in the long run. Even massive inflows of aid can reduce the ability of farmers to compete in the world market. “Wuyts argues that the net effect of aid inflows was to foster a pattern of accumulation and industrialization that was not sustainable in the long term” (Page 19, unit 7, Development Finance Handbook).
References:
1. Bottomley, Anthony (1975) ‘Interest Rate Determination in Rural Areas’, reprinted in Von
Pischke et al. (1983).
2. Bhaduri, A. (1977) ‘On the Formation of Usurious Interest Rates in Backward Agriculture’,
reprinted from Coats and Khatkhate (1980) pp 465–77.
3. Patrick, Hugh T. (1966) ‘Financial Development and Economic Growth in Developing Countries’,
Economic Development and Cultural Change, vol 14, no.2, January, The University
of Chicago Press, Chicago.
4. Adams, D.W. and Robert C. Vogel (1986) ‘Rural Financial Markets in Low-income Countries:
Recent Controversies and Lessons’, World Development, vol 14, no 4, April.
5. Gonzales-Vega, Claudio (1983) ‘Arguments for Interest Rate Reform’, Chapter 43 in Von
Pischke et al. (1983).
One reason that poor peasants have little access to formal markets is due to the cost structures of Money Lender’s cost or more broadly to include local lenders versus Urban Bank’s costs (Ref. 1, page 244). Bottomley’s theoretical cost structure shows that at lower denomination of loans the local lender is more cost effective that the Urban Bank. Since the personal interaction between the local lender and the borrower, administrative cost, default cost and overall risk premium are lower than the Urban Bank. As the size of the loan and borrowers net income is increased, the basic rate or pure rate takes up a larger share of the local lenders costs (75% local lender vs. 50% for urban bank. The basic rate for the local lender is greater since he/she may have idle cash for long periods with little investment opportunities in the short term. Even though at higher denominations default is less of a cost factor, Bottomley does not explain why the default would be lower for the urban bank. I would assume that at any level of loan the local lender would be best able to collect through a wide variety of intimidation and/or social pressures.
The second assumption is that poor peasants have an inelastic demand curve for the money lenders services. Taking into the fact that peasants have alternatives listed above and that even the poor have assets, then options are available. Even in some of the poorest in countries such as India, many families have jewelry or other non-productive assets that can be sold or pawned. And according to Patrick: “In developing countries, a considerable portion of the savings used relatively unproductively are probably hoarded by large numbers of relatively poor people.” (Ref. 3, page 57). When peasants are facing long term unfavorable conditions (as shown in Figure 5.1, Unit 5, Development Finance Handbook) then this should tell the economy to transfer resources to more productive uses. This is evident in the migration from rural areas to urban areas for quite some time.
Since we are looking at the problem of rural peasants having the feast or famine cycles, we could devise plans that tried to smooth out the cycles of liquid assets. While none of these require direct government control, the government should act as educator and facilitator. One is to grow food and basic needs for the family to avoid having to borrow for the basic needs. Another is to have more than one type of crop that alternates harvest times and thus income times.
Another problem facing poor peasants and most all farmers is inelastic demand curves for their products. If crops are bountiful, then per unit prices garnered goes down and may not help the farmer in total cash generated. One option is for the government to set up markets to purchase excess supply on the short term and distribute it in the long term.
Rural poor peasants face higher real interest rates because of the size of loan and underlying net income, and overall costs that the money lender has to factor into the loan (Ref. 1, page 244). Bhaduri believes there are perverse incentives for the money lender to undervalue the assets of the peasants and covet those assets. The reason for undervaluing the assets is there may be little to no market for the peasant’s assets and thus any price is more subjective than market derived. The money lender may create interest rates high enough that he feels default is most assured and then he can dispose of the assets at a profit (especially if he has access to outside markets) or use for his own benefit. If there were markets created for the peasants assets then this would reduce this market imperfection.
Some social pressures on money lenders because of the “highly personalized nature” (Ref. 2, page 476) limit the money lender from foreclosing on peasants assets. Large land owners, local merchants, input traders or crop buyers with excess liquidity may not want to alienate the local population to gain in the short term. And some groups may not want to deal with disposing of assets like the merchants. And lastly if a default occurs on a large scale, then even money lenders may be painting themselves as carpetbaggers and be dealt with harshly.
Laws and regulations can lessen the incentive for money lenders to seek to liquidate the assets of the poor peasant. Legislators need to balance the property rights of both the lender and the borrower and thus try to eliminate incentives to default or create defaults. Most countries continually work to make a good balance between these rights.
Given that poor peasants face high interest rates at times when liquidity of other groups may also be low, then the traditional approach to economic development has been to subsidize loans in the rural areas. Some reasons for this approach has been the view that credit was a major constraint for farmers, the credit shortage led to high interest rates, high interest rates caused a vicious cycle of poverty and indebtedness combined with limited savings resulted in the need for “supply led” strategies in the form of formal financial institutions (Page 4-5, Unit 6, Development Finance Handbook).
Government loans that are subsidized “rarely give a satisfactory profit compared with the returns from investments in agricultural research and extension or in social capital” (Page 5, unit 6, Development Finance Handbook). And “it is much easier to expand the supply of loans than to implement land reform, extend rural roads and infrastructure, improve irrigation and drainage, or diffuse new technology. (Page 15, unit 5, Development Finance Handbook)
Not only is government financed loans economically inefficient, they misguide the market and not accomplish the goals it assumes to fix. Just because interest rates are lowered and there is increased availability of loans does not mean that there will be a resulting increase in capital. “Both substitution and diversion create obvious difficulties for purpose specific credit programs” (Page 9, unit 6, Development Finance Handbook). This means that loans are fungible and can be used for whatever purpose the borrower so wishes. Even when granted in goods (for example food stamps), these goods can be exchanged for cash. Under microeconomic theory, subsidizing food or any other good may not increase the utility of the recipient more than cash transfers. The recipient may even sell his goods at a loss rather than keep the goods for self consumption.
Subsidized interest rates distort the market by creating negative real interest rates resulting in an income transfer (from saver to borrower), fails to reward savings adequately, undervalues the real costs of capital in different sectors, results in excess demand and conversely a shortage of savings, and does not reflect the social scarcity of capital (Page 9-10, unit 6, Development Finance Handbook). And in turn this leads to credit rationing that favors the richer borrowers as shown by Bottomley (Ref. 1). So the policy to increase loans to poor farmers actually resulted in fewer loans to poor farmers. This is shown by Gonzalez-Vega in “it has been estimated that only about 5 percent of farmers in Africa and perhaps 15 percent of farmers in Asia and Latin America have had access to formal credit” (Ref. 5, page 366).
To avoid the traps with subsidized credit and market manipulations with regard to interest rates, innovative institutions may be the solution. ROSCA is one such approach that rotates the members between creditor for multiple time periods and debtor for one time period (Page 15, unit 6, Development Finance Handbook). This can lead to “landless laborer buying land, a porter or driver purchasing a rickshaw or taxi, or a peasant household buying cattle” (Page 18, unit 6, Development Finance Handbook). But too often this looks to be a lottery that would be used for trivial and non-investment purposes. This is especially true if interest rates are high since it would entail a transfer of wealth from last debtor to the first debtor. The first to receive the bounty would pay back the “debt” at cheaper dollars while the last to receive the bounty would have paid in with expensive dollars and received cheap dollars in return. With high interest rates, the cycle would have to become shorter and shorter until it no longer had any savings value to the participants.
Other cooperatives may also play some role in allocating credit in rural areas. Just as Japan used Postal Savings, many LIC’s may benefit from this. The government can improve the cost of transactions and reduce the spread between saving and lending rates. Just as it was suggested that the government would be best to improve the infrastructure of the economy than to subsidize loans, the government could improve the infrastructure of the RFMs by disseminating information and training, providing group loans to get groups formed, using the postal services assets to provide banking services also, and lastly to advise and consent.
While groups lending has some benefits of reducing loan transaction costs, the “recent research on group lending shows results that are less positive than originally hoped” (Ref. 4, page 482). But “group loans appear to work best where groups have non-credit reasons for collective actions” (Ref. 4, page 482). Finding the social bonds that will make groups work does present a challenge, but once the social bonds are in place then the default rate should be low as well as transaction costs and administrative costs. Thus credit unions that are tied to a job should do better.
The last point I want to make is that even if governments want to promote the well being of poor peasants with subsidized investment and loans, it should first make sure that macroeconomic policies support the rural farmers. Stable prices and stable money supply would help more in the long run. Even massive inflows of aid can reduce the ability of farmers to compete in the world market. “Wuyts argues that the net effect of aid inflows was to foster a pattern of accumulation and industrialization that was not sustainable in the long term” (Page 19, unit 7, Development Finance Handbook).
References:
1. Bottomley, Anthony (1975) ‘Interest Rate Determination in Rural Areas’, reprinted in Von
Pischke et al. (1983).
2. Bhaduri, A. (1977) ‘On the Formation of Usurious Interest Rates in Backward Agriculture’,
reprinted from Coats and Khatkhate (1980) pp 465–77.
3. Patrick, Hugh T. (1966) ‘Financial Development and Economic Growth in Developing Countries’,
Economic Development and Cultural Change, vol 14, no.2, January, The University
of Chicago Press, Chicago.
4. Adams, D.W. and Robert C. Vogel (1986) ‘Rural Financial Markets in Low-income Countries:
Recent Controversies and Lessons’, World Development, vol 14, no 4, April.
5. Gonzales-Vega, Claudio (1983) ‘Arguments for Interest Rate Reform’, Chapter 43 in Von
Pischke et al. (1983).
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