Financial market development and structural economic constraints.

1. Carlos E. Guice, Sr.
Development Finance - University of London
RURAL CREDIT AND FINANCIAL MARKET DEVELOPMENT
RETHINKING RURAL CREDIT
In the broader context of financial liberalization theory, the supply-leading policies designed to
deliver credit to rural farmers in low-income countries were seen as inefficient and real barriers to growth
and productivity in agrarian economies. The supply-leading proponents made no a priori assumptions
regarding demand elasticity for financial services in agrarian markets, nor did they ignore the existence of
the inadequate legislation, cultural barriers, and market failures endemic of low income rural economies that
challenged the classical models of supply-and-demand (Patrick, pp. 51). Finance - now viewed as an active
determinant in productivity and growth – became treated as a factor of production, as programs and
institutions were developed in rural economies with the hopes, “…to induce real growth by financial means”
(Patrick, pp. 25).
A shift in thinking about agrarian credit grew in the advent of liberalization theory that challenged
the economic soundness of the tools proposed by supply-leading advocates i.e., directed credits, sectoral
planning, and interest rate subsidies. These economic practices, commonly associated with repressed
financial markets, were hypothesized as causative factors in the existence of credit shortages, inadequate
savings rates, resource misallocation, and “thin” financial markets. Embedded in this new approach to rural
finance resides policy implications that influence loan recovery, interest rates, domestic savings, transaction
costs, and market distortions. Moreover, they help frame the normative issues that balance market efficiency
against the optimum optimorum.
POLICY IMPLICATIONS
Low Interest Rate Policy and Non-Price Rationing
An important calculus of policy formulation requires the evaluation of interest rate subsidies as a
means to allocate credit both efficiently and equitably among rural farmers. To this end, a few economic
principles should provide some insight.

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Rural credit programs experience a high cost burden due to reporting, regulatory requirements, and
other costs associated with loan administration. Since these costs are fixed, the lender experiences a
downward-sloping, relative, cost function. So, if the lender’s ability to establish price is constrained by
policies that place a ceiling on interest rates, then lending feasibility only improve by underwriting larger
loans. The lender’s potential for recovering operating expenses becomes increasingly, compromised as the
loan size diminishes. And since private firms seek to recover costs, maximize profits and increase firm value,
it only follows that financial institutions would act in a similar fashion through the origination of larger loans.
As a result, the bulk of available credit in the rural economy is rationed to the large, successful farmer since
they have more capacity and are better able to afford loan repayment. And to make matter worse, subsidy
benefits are misallocated to an unintended segment of the rural economy; namely, the large farmer who
receives income transfers originally intended for the small rural farmer. Policy misses the mark.
Marginal Efficiency of Capital
In further consideration of interest rate policy, the marginal efficiency of capital provides an
additional reference in framing the issues. It quantifies the expected annual rate of return on additional
investment spending, and measures the maximum interest rate at which the project breaks-even. In economic
theory, the marginal efficiency of capital is depicted as a downward-sloping curve, which simply captures
the notion that if all the possible projects in an economy were arranged beginning with the project yielding
the highest break-even return, and ending with the project promising the lowest return, any rational investor
would chose only those projects whose break-even rate is greater than her capital cost, plus compensation for
risk. If money prices are held below the market equilibrium, then scarce financial resources are in danger of
being allocated to lower-yielding projects. Thus, farming investments get funded that normally would not;
and the economy incurs a real opportunity cost equal to the present value of the loss productivity and growth.
Market Determined Interest Rates
Reviewing cost functions, efficiency theory, and the profit maximizing behavior of the private firms;
provides some indication as to the inadequacies inherent in interest rate subsidy programs. For these reasons
and more, the new paradigm of rural financial markets requires an interest rate policy that addresses the
program failures of traditional rural credit programs. More appropriately, an interest rate policy that allows
the price of credit to freely adjust to the market pricing mechanism would better allocate funds to farm
investments that contribute to growth, and increase the income levels of the developing rural economy.
However, the market pricing mechanism does not necessarily resolve the issue of equity and income

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distribution. As a policy tool, it may not be sufficient to achieve the equally important objective of
maximizing social welfare.
Savings Mobilization
Tangent to establishing market interest rates is the formulation of policy that seeks to mobilize
indigenous resources in the form of bank savings deposit since lack of a domestic deposit base could leave
the agrarian economy vulnerable to the external shocks of donor countries withdrawing funds. The higher
real interest rates are thought to provide incentive for individuals and households to change their consumption
patterns, substituting present for future consumption. Unproductive consumption should be discouraged in
favor of utilizing local savings in productive activities, and accumulating investment capital.
Loan Recovery Rates
Another important policy consideration is the poor loan recovery rates associated with rural farm
credit. Loan recovery has been a persistent problem for supply-leading credit programs in most developing
rural markets; and everything from bad weather, price declines, moral hazard, and market failure have been
blamed (Adams and Vogel, pp. 36). Improving loan recovery is an important focus for regulatory policy
since deficiencies in laws, regulations, and institutions are seen as contributing factors in poor recovery rates.
Government actions to improve title and registration process, and prudent laws for secured transactions are
just two examples of policy actions required in rural financial markets.
Market Failure
The definition of market failure can be broad or narrow; however, we will stipulate to the definition
found in the MIT Dictionary of Modern Economics (1994) as, “The inability of a system of private markets
to provide certain goods either at all or at the most desirable or ‘optimum’ level.” If credit facilitates access
to agricultural inputs, and inputs are determinants in productivity and growth, then limited access to credit
constrains the most desirable outcome of the agrarian economy - maximum productivity and growth. We
can therefore make the normative statement that access to credit should not be restricted by market failures
since productivity and growth are vital to poverty reduction. The state of affairs described in the papers of
Anthony Bottomley (1983), and A. Bhaduri (1980) highlight the existence of the market’s failure to
efficiently allocate credit to the small farmer in the agrarian economy.
Even though they do not arrive at the same conclusions, regarding the determinants of market
failure, they separately deduce that distortions exist in the rural credit market, and manifest as fragmented
markets, prohibitive cost, high default ratios, and huge interest rate spreads – all of which, for the sake of

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productivity and growth, justify policy intervention. The crux of Bhaduri’s argument is essentially that the
underlying structure and characteristic of the agrarian credit market prevents the critical observer from taking
the capital costs and default rates as exogenous variables. As proof for his thesis, Bhaduri sites the isolation
that exists between the organized money market and the unorganized rural credit market. He further describes
the unfair economic power enjoyed by the rural money lenders which results in a systematic and
monopolistic, undervaluation of the peasant borrower’s assets. According to Bhaduri’s algebraic model,
capital cost; money prices; and collateral values bear no cogent relationship in the isolated credit market. In
fact, they are subject to arbitrarily adjustment by the moneylender who seeks to maximize wealth even if it
means setting credit prices at levels that guarantee default. Meanwhile, the moneylender acquires land or
collateral that the small farmer would normally not dispose of through sale. In short, the rural money lenders
are price-makers, not price takers.
Bhaduri rejects as inadequate the a priori assumptions of conventional economic theory, especially
when analyzing agrarian credit markets i.e., demand-and-supply. In contrast, Bottomely’s point of departure
is conventional economic theory as he treats the cost of capital and default rates as exogenous variables.
However, taken together both papers provide insight into important policy initiatives that can work to correct
existing market failures. One such implication which seems undeveloped in the assigned readings is the role
of government in devising policy that promotes the integration of the agrarian credit markets into the
organized money markets, creating programs and incentives to reduce structural barriers responsible for
isolation and fragmentation.
Fragmented and Isolated Markets
Markets are fragmented for a variety of reasons, ranging from diseconomies of scale in important
aspects; high inventory cost i.e., opportunity cost associated with warehousing funds; and requiring local
control to operate successfully. The benefits of market integration can be demonstrated mathematically by
analyzing the lending cost curves presented in Bottomely’s paper (pp. 2). He presents hypothetical cost
curves for a rural moneylender and an urban bank. His computation of average lending cost factors money
prices, loan administration, default rates, loan size, and borrower’s income. The cost curves incorporate likely
advantages and disadvantages facing the moneylender and urban banks due to geographical dispersion,
information asymmetries, and collateral quality. For instance, one would assume that the urban bank would
enjoy an advantage of money prices over the cost of funds experienced by the rural moneylender, while the
money lender’s administrative cost and default ratios would be superior to those experienced by an urban

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bank. Using Bottomely’s numbers, a third cost curve can be constructed, showing the moneylenders and
urban banks jointly, participating in rural lending. A mathematical formulation of the third cost curve and a
comparative graphical depiction are shown below.
Φ = lending rate
η = default rate
Г = Loan Principal
Π = Admin Cost = .33(.9974)г
; г = {x|99.99<x<1001}1
θ = Opportunity Cost of Capital
Я = Lending Cost = Π + θ
Equation 1: Joint Lending Cost Curve
Φ + Π + [η * (Г + Я)]
(1- η)
Figure 1: Behavior of hypothetical costs assuming participating loans
The behavior of the joint-lending cost curve in Figure 1 suggest that small farmers could benefit
from policy that seeks to bring the “money-lender-function” into the formal sector by providing strong
1
The ratio method was used in estimating the exponential function that in modeled the hypothetical administration cost. The cost
allocation of joint lending assumes 25% urban bank and 75% local money lender.
0%
20%
40%
60%
80%
100%
120%
1 2 3 4 5 6 7 8 9 10
Loan Par (100's)
Lending Cost
Money Lender
Urban Bank
Joint Lending
Benefits from market integration for loans < $550

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disincentives against usurious and coercive practices while encouraging joint lending practices between
financial institutions and rural moneylenders. Effective programs can be instituted by the central bank,
central taxing authority, or other government agencies. Specifically, these programs could support a
secondary market for participating loans, provide credit enhancement, grant tax incentives to participating
lenders, or provide competitive, grant funding as seed capital for creative operations. Such initiatives could
be effective in reducing formidable barriers that constrain urban banks from participating in rural credit
market. These barriers include, but are not limited to, small loan sizes, geographical dispersion, admin cost,
default ratios, covariance of risk, and scarcity of traditional collateral pledges. Presumably, appropriate
incentives would exist to encourage reinvestment of the marginal benefits received by the small farmer into
farming inputs that increase productivity and growth.
Complementary Reform
Liberalizing land markets would be an important component to deepen the portfolio of asset class
via financial claims. Thus, land concentration and land leasing through tenancy contracts would need to be
highly regulated. Land banking policies that allow poor farmers access to land could be instituted as well as
policies that develop land rental markets and increase tenant rights and bargaining powers. Overvalued land
prices can exist in economies that favor non-agricultural uses and can be substantially higher than any
amounts than can be capitalized from farming profits. These market distortions should be addressed by
policy.
THE SOCIAL OPTIMUM
As money’s central utility is its exchange value relative to non-money goods and services; by
extension, we can posit that the central utility of agricultural credit is that it facilitates access to the very
factors of production that determine agricultural output and growth, namely inputs and new farming
technologies. Therefore, the implication is that only policy that works to reduce barriers to credit access -
barriers that constrain productivity and growth – can effectively meet the objective of economic growth and
poverty reduction. Economic growth and social equity, this is what supply-lending attempted to accomplish;
however, market distortions and misallocation of subsidy were an unintended side effect of these policies,
which is why Claudio Gonzalez-Vega (pp.371) characterized this system of rural finance as regressive.
Lending programs that target the rural poor are politically alluring. Since promises of social equity may
contribute to political stability which may further facilitate growth and economic stability. It is, therefore,

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not difficult to imagine that the fiscal illusion of the supply-lending approach would have a wide appeal to
political decision makers in the low-income countries.
If equity is to remain an important economic consideration, then sequencing consideration must be
addressed so that the required complementary markets and institutions are in place prior to instituting
significant reform in the rural financial markets. This is to preclude the large farmers from securing unfair
gains that would otherwise be tempered within a system of prudential regulations. Perhaps the litmus test
for effective economic policy is a rural financial market that - with minimum disruption to the market
economy - provides maximum access to the small rural farmer who is large constituent of the agrarian
economy, and a major determinant of productivity and growth in the low-income countries.
The following policy suggestions would be consistent with both balancing equity and efficiency:
1. The targeting failures experienced by rural credit programs can be addressed by imposing
a high opportunity cost on farmers not intended to benefit from the policy.
2. Government agencies could seek small farmers to participate in experimental research and
development programs that promote technological improvements and farming “best
practices”. Such as policy could have positive long-term benefits to the rural economy as
a whole while providing sustenance and access to new farming techniques to the small
farmer.
3. Group lending practices could serve to reduce transaction cost by raising average loan
values.
4. Consumption smoothing and non-farming rural projects should not be crowded out by
interest rate reform.
5. Transparency policies should be encouraged to ensure that resources allocated to special
programs actually reach the intended constituents.
6. Policy intervention associated with special lending program should be financially
sustainable and finite, weaning recipients over time to participate in the broader financial
market.
7. While a rural financial market reform may be a better determinant for income growth, it
should not preclude establishing programs that target the poor peasant farmers that would
be denied credit under market reform.

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Works Consulted
Adams, Dale W. and Robert C. Vogel Rural Financial Markets in Low-Income Countries: Recent
Controversies and Lessons. Development Finance Principles and Experience: Reading Volume 3.
Reprinted 2000
Bhaduri, A. On the Formation of Usurious Interest Rates in Backward Agriculture. Development
Finance Principles and Experience: Reading Volume 3. Reprinted 2000
Bottomley, Anthony. Interest Rate Determination in Underdeveloped Rural Areas. Development
Finance Principles and Experience: Reading Volume 3. Reprinted 2000
Gonzalez-Vega, Claudio. Arguments for Interest Rate Reform. Development Finance Principles and
Experience: Reading Volume 3. Reprinted 2000
Patrick, Hugh T. Financial Development and Economic Growth in Developing Countries.
Development Finance Principles and Experience: Reading Volume 3. Reprinted 2000