September 5, 2006EconomyPublic Policy

Just heart alone won’t suffice

Resolving the agrarian crisis’ requires understanding the laws of economics

This is an archived blog post from The Acorn.

P Sainath’s years of experience covering India’s countryside lends a credibility to his voice. How unfortunate it is then that he should expend it on framing the issue in partisan, rich vs poor, urban vs rural terms. Here’s an excerpt from a recent interview he gave Tehelka

(The agrarian crisis’) happened because through the reform years, we’ve been diverting resources, we’ve been robbing the poor to pay the rich. Now I cover guys who commit suicide because they’re not able to get less than 10% interest on Rs 8000 crop loan. I go back to my urban middle-class home in Mumbai where I get an invitation from my bank buy a Mercedes Benz, no collateral at 4% interest’. So if you’re buying a Mercedes Benz – unproductive expenditure – you pay virtually no interest. If you are the food producers, you’re paying two to three times that interest. That’s the sheer injustice of it. [Tehelka, via Amit Varma]

In the interview he rails against the government (especially the previous one) for not doing enough, against journalists for being more interested in covering India Fashion Week and, quite unsurprisingly, at multinationals and genetically modified cotton for undermining the farmer.

It has been the The Acorn’s case that this crisis is caused by the government’s determined refusal to allow market forces to play in the agriculture sector. Its policies have created perverse incentives: leading to a scarcity in formal sources of credit that is the primary financial cause of farmer suicides. (See this post on Amar Akbar Anthony). The solution to India’s agrarian crisis’, therefore, lies not in government largesse, but in its retreat. It lies in making rural and agricultural markets work.

Supporters of Sainath’s view may be quick to dismiss such proposals, coming as they do from people who have not been there’. So here’s an article from someone who has (and still is) .

The discomfiting fact is that interest rates of informal lenders are difficult to control, whereas formal institutions which are under public scrutiny have to keep their interest rates low. Thus formal institutions tend to ration credit to small farmers since they are not able to meet their full costs. Transaction costs on small loans are necessarily higher than for large loans, when expressed as a percentage of the loan amount. The pricing should cover the cost of funds, the transaction costs and the risk costs (likelihood of bad debts). Most arguments in favour of lower interest rates for small farmers do not take this into account. As a result, banks find it unprofitable to lend to small farmers and effectively cut their losses by lending as little as they can get by without incurring regulatory wrath.

In India, though interest rates on small loans by RRBs and cooperative banks were deregulated in 1996, the amount of credit by these banks has not gone up significantly. This is because the regulatory cap was never removed for the largest channel of rural credit, the commercial banks, thus ensuring that RRBs and cooperatives could never significantly increase their interest rates. More recently, the government has been asking (though it has refrained from getting the RBI to direct) banks to reduce interest rates to farmers to 9%, on the grounds that interest rates on housing loans to the urban middle class were down to 7-8%. Though it is acceptable to compare these rates, what is not discussed is that the transaction cost of an urban housing loan is much lower because of high volumes per branch and much lower risk levels. Bad debts for housing loans are a fraction of one percent while those for agricultural loans are anywhere from 3-5%, even without the risk of politically motivated loan waivers, and with those included, the bad debt costs are much too high to be built into any reasonable interest rates.

Politicians, intellectuals and farmers all need to accept that small loans are more expensive and must be priced accordingly. Thus an answer to the credit needs of small farmers in India is to free up interest rates, not just in terms of regulation but in terms of acceptability. At the same time, the government should permit a whole spectrum of credit providers, formal and informal, to enter the field and compete with each other so that they can enhance the total credit flow and eventually bring down costs. No regulation can control supply and price simultaneously. So if more credit has to flow to farmers, the price (interest rate) must be deregulated. Initially it may go up, attract more players and then they will compete and bring down the rates. Ironically, this lesson from the housing and consumer finance market has been missed by our policy-makers. [Seminar]

This post also appears on The Indian Economy Blog.

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