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«Productivity of Rural Credit: A Review of Issues and Some Recent Literature M.S. Sriram W.P. No.2007-06-01 June 2007 The main objective of the ...»

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Research and Publications

Productivity of Rural Credit:

A Review of Issues and Some Recent Literature

M.S. Sriram

W.P. No.2007-06-01

June 2007

The main objective of the working paper series of the IIMA is to help faculty members, Research

Staff and Doctoral Students to speedily share their research findings with professional colleagues, and to test out their research findings at the pre-publication stage




Research and Publications

Productivity of Rural Credit:

A Review of Issues and Some Recent Literature M S Sriram* Abstract The policy intervention in agriculture has been credit driven. This is even more pronounced in the recent interventions made by the State, in doubling agricultural credit, providing subvention and putting an upper cap on interest rates for agricultural loans, the package announced for distressed farmers. We use existing literature and data to argue that the causality of agricultural output with increased doses of credit cannot be clearly established.

We argue that Indian agriculture is undergoing fundamental change wherein the technology and inputs are moving out of the hands of the farmers to external suppliers. This, over a period of time may have resulted in the de-skilling of farmers and without adequate public investments in support services and without appropriate risk mitigation products has created a near-crisis in agriculture.

Thus, we argue that policy interventions have to be necessarily patient and holistic.

Looking specifically at the rural financial markets, using some primary data we argue that it is necessary to understand the rural financial markets from the demand side. We conclude the paper by identifying some directions in which the policy intervention could move, keeping the overall rural economy in view rather than being unifocal about agriculture.

* Professor, Indian Institute of Management Ahmedabad. This is a substantially revised version of the paper presented at the National Symposium on Farm Credit for Inclusive Growth, College of Agricultural Banking, Reserve Bank of India. Pune: January 12-13, 2007. Contact: mssriram@iimahd.ernet.in

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Introduction The overall thrust of the current policy regime assume that credit is a critical input that affects agricultural/rural productivity and credit important enough to establish causality with productivity. A brief review of the recent policy directions from the State assume that de-clogging credit for agriculture is desirable. The thrust of doubling agricultural credit in three years through the banking channel, revival of co-operative credit structure through the package recommended by the Vaidyanathan committee and policy response to farmer suicides, including the Vidarbha package are excessively skewed towards intervention in the agricultural operations through intervention in credit. There have also been committees set up by the state and/or the Reserve Bank of India to look into the aspect of financial inclusion, farmer indebtedness, integrating moneylenders with the mainstream market and on farmer distress.

In addition to the above, some policy interventions having implications at the operational level include the pegging of interest rates for agriculture which yields a risk-adjusted return that is below the weighted average cost of funds. The state governments have gone a step further and announcing interest subsidies over and above the unrealistic levels set by the union. All these are unifocal in making credit available and affordable for agriculture.

All these initiatives give singular importance to rural credit and also look at rural credit from the supply side. In this paper we try to deconstruct this problem and examine the components to see if we can get a better understanding of the rural situation. However, it is difficult to establish a causal relationship to show that the increased supply and administered pricing of credit will help in the increase in agricultural productivity and the well being of agriculturists. Why such a relationship is

difficult to establish is detailed below:

1. Credit is a sub-component of the total investments made in agriculture. The investments come from a basket of sources – ranging from non-monetised investments such as the farmer’s labour, saved seeds, use of local resources for pest control and fertilizer; and monetised investments that include both the savings of the agriculturist and borrowings. Borrowings could infact be from multiple sources in the formal and informal space. We are considering a part of this sub-component – borrowing from formal sources – in order to establish the causality. With data being available largely from the formal sources of credit disbursal and indications that the formal credit as a proportion of total indebtedness is going down, it becomes that much more difficult to establish the elusive causality.

2. The diversity in cropping patterns, holding sizes, productivity, regional variations also make it difficult to establish such a causality for agriculture or rural sector as a whole, even if we had data.

Therefore this paper will restrict itself to reviewing the recent work of scholars on the relationship between some broad macro economic trends and its implication on agricultural credit. In the process of our discussion we shall also be using some data collected from some regions of the country to highlight the issues to be discussed Page No. 3 W.P. No. 2007-06-01


Research and Publications anecdotally. We will thus try and turn the discussion around to examine if it is possible to look at the issue of agricultural/rural credit from the demand side. Obviously, we do not have extensive data from the demand side to examine this issue from a policy making perspective. However, with the limited data that we have from the field we would be in a position to look at some broad patterns. In the process we will also highlight the need for looking at “rural financial services” as a broad theme rather than limit the theme to agricultural credit. We argue that the rural markets are quite vibrant and offer opportunities for intervention much broader than agricultural credit.

Some Recent Literature While we look at the productivity of agricultural and rural credit, it might be pertinent to review some recent papers that touch on this theme.

An important paper that examines the possible relationship uses panel data on rural poverty and spread of bank branches argue that increase in access to credit has helped reduce rural poverty. They conclude that the fact that banks open branches makes formal credit accessible and in the long run seems to have had a positive impact on poverty (Burgess and Pandey, 2003). To illustrate their argument, they contrast the poverty rates with the period of pre and post liberalisation [characterised by the condition to open more branches in unbanked areas was dispensed with]. While establishing their argument they also cite others (Eastwood and Kohli, 1999) who argue that the expansion of branches actually enhanced the lending to the rural small scale sector where the growth was faster. Thus it is possible to take these independent conclusions together to indicate that possibly positive impact on poverty might have come from the non-farm sector. In fact the authors argue that market forces possibly may not take care of the poor and backward areas by providing counter example from microfinance which has grown largely without large geographic target setting from the state. They cite evidence that microfinance has not been successful in reaching backward areas. So the thrust of Burgess and Pandey is that in order to address poverty, it is necessary to have formal banking outlets. However the impacts on poverty seem to come from non-primary sectors like enterprise and the resultant wage employment that these enterprises generate. They also argue that since banks provide a complete suite of financial products – including savings – they are more effective than pure microCredit institutions. However the paper does not provide evidence of a link between credit and agriculture.

Capital formation in agriculture and the type of current investments being made in agriculture in the context of farmer suicides is examined in detail to see if there are any inter-linkages (Vaidyanathan 2006). This paper also does not indicate any direct relationship between investments and productivity. Infact the author argues that some of the recent trends in investment in agriculture could be ill conceived and thus could lead to a negative spiral. He cites the case of increased indebtedness of farmers towards both formal and informal sources in cash crops like cotton, not necessarily resulting in increased productivity, and in many cases leading to failure. He argues that even private capital formation in agriculture might not be yielding better productivity because farmers are digging deeper to tap groundwater, thereby incurring more costs to maintain the same levels of productivity and in cases where the wells fail, getting into serious indebtedness. Both these observations indicate that while it is important to have increasing investments in agriculture, and much of these private investments in agriculture should be desirably funded through formal sources of credit;

there could be no causality between investments and productivity, unless they have been directed in a well thought out manner. Thus mere increase in supply of credit is not going to address the problem of productivity, unless it is accompanied by investments in other support services. Therefore public capital formation that address

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maintenance of larger irrigation structures, that have a long term vision of management of resources like water are important for addressing productivity.

Another paper examines the overall growth of agriculture and the role of credit (Rakesh Mohan 2006). Agreeing that the overall supply of credit to agriculture as a percentage of total disbursal of credit is going down, he argues that this should not be a cause for worry as the share of formal credit as a part of the agricultural GDP is growing. However, even here one is unable to establish the relationship between increased supply of credit and productivity. If we look at Table 1 we find that the relationship between the value of input and the value of agricultural output over the last decade has remained in the same band, with the output being around five times the value of input. The figures are stated at current prices, and if we adjust for inflation, we find that there would be no dramatic increase in the value of output in the past decade. This loosely establishes that while credit is increasing, it has not really made an impact on value of output figures. This is not a robust way of establishing causality, but points out the limitations of credit.

It is important to see that even at the highest level of production, credit forms around 5 percent of the total output value. Thus expecting something that has so little a share in the output value to have significant impacts on the output/productivity values might not be in order. However, the data quoted pertains to agricultural credit from formal sources and given that the short term credit is increasing as a percentage of inputs, this might actually be replacing informal credit. Thus there might still be some headroom to increase credit availability from the formal sources, with the clear intent of moving the customers from the informal to the formal sources rather than with the intent of increasing incomes or agricultural productivity.

Data indicates that agriculture in itself is not very profitable and varies widely across states and regions. For instance the data from the 59th round of NSSO, 2003 indicates that in 2002-03, the net receipt from cultivation for each household across the country was around Rs.969 per month. This figure varies widely and forms less than 50 percent of the overall pie of the income sources of the households. Interestingly in some states like Jharkhand, Kerala, Rajasthan, Tamilnadu and West Bengal, the earnings from wage labour is higher than the earnings from cultivation (NSSO, 2005:14). When we look at the overall cost of cultivation we find that interest expense for loans for cultivation averages around 1 percent of the total cost of cultivation, never exceeding 3 percent of the cost of cultivation. The most significant costs of cultivation are labour and fertilizer (NSSO, 2005:19).

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Significant inputs in percentage terms are labour [22 percent], lease rental [5 percent] and other expenses [15 percent] – a greater investment in these inputs would not increase the inherent productivity of the land. The inputs that establish causality are seeds [16 percent of input costs], irrigation [12 percent] and fertilizers [23 percent].

Thus if we were to ascribe causality to credit, we may have to look at the incremental outputs due to investments in these inputs which account for about 50 percent of the costs and see if externally spurred investments would make a difference.

The NSSO data does not show the significance of credit in the overall productivity of agriculture. It also highlights the fact that rural incomes are getting to be increasingly dependent on alternative and diverse sources.

With these inputs, we can examine if there is head room for formal sources of credit to replace the current financing patterns. The growth in agricultural finance may be partially filling in this headroom. Even if this headroom is filled up, it would only reduce the borrowing costs of the farmer to a limited extent without possibly having significant impacts on productivity. The credit linked productivity enhancement may come through technological innovations that make agriculture more capital intensive with a dramatic incremental input-output multiplier.

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