Responsible researcher: Eduarda Miller de Figueiredo
Author: Timothy Besley
Original title: How Do Market Failures Justify Interventions in Rural Credit Markets?
Location of Intervention: -
Sample Size: -
Sector: Agriculture
Variable of Main Interest:-
Type of Intervention: Rural Credit Market Policies
Methodology: Others
Summary
Interventions in the rural credit market in developing countries are common, where direct credit subsidy is a standard policy in many countries. The author of this article seeks to discuss this problem, investigating whether and how interventions can be used to compensate for deficiencies in existing markets. For this discussion, the economic concepts discussed by the author in this article were briefly presented. Which concludes that there may be good arguments for intervention, some of which may be based on market failure.
Interventions in the rural credit market in developing countries are common and take different forms, with direct credit subsidies being a standard policy in many countries. Thus, the presence of a bank in a particular area is not a sufficient reason to assume that that bank has chosen to operate in that region or that it is operating profitably.
Charging below-market interest rates generates excess demand for credit and, as a result, banking operations are often governed by selective credit allocation rules. Therefore, for the author, it seems fair to say that rural credit markets in developing countries (India, Mexico, Philippines) have rarely operated on a commercial basis, where substantial subsidies are often implicit in regulatory schemes.
It is recognized, according to the author, that these policies of below-market interest rates and selective credit allocation are not cost-free and lead to financial repression (McKinnon, 1973). Thus, it became popular to advocate financial liberalization and the relaxation of government regulations.
Criticism of these policies has led to a considerable rethinking of intervention in rural credit markets in developing countries, in which such interventions should be restricted to cases in which a market failure has been identified. This idea was investigated by this study, which investigates whether and how interventions can be used to compensate for deficiencies in existing markets for allocating credit.
Thus, in the article studied here, the inability of a free market to produce a restricted and Pareto efficient credit allocation will be considered as a marked failure [1] . And based on this understanding, the article examined the implications of this concept.
A market failure occurs when a competitive market fails to produce an efficient allocation of credit. In which credit, containing its supply and demand, must be priced high enough for some individuals to postpone their consumption, but low enough for individuals taking out loans to be willing to pay, given their current needs for consumption. In an idealized credit market, loans are traded competitively and the interest rate is determined through supply and demand.
Credit markets also diverge from an idealized market because information is imperfect, that is, a lender's willingness to lend money depends on having sufficient information about the trustworthiness of the individual receiving the loan, where the absence of good information can lead creditors to opt out of serving some individuals. Therefore, efficiency in credit allocation must be examined considering these practical realities.
Applying the restricted Pareto efficiency criterion narrows the scope for market failure, but still leaves room for a fairly broad set of cases in which resources may end up being allocated inefficiently. In Pareto improvement, only the well-being of two individuals involved is considered, but when externalities are considered – that is, when a third party is affected by the decision of the other two – a Pareto improvement is not guaranteed. Especially because markets operate inefficiently when there are externalities (Greenwald and Stiglitz, 1986) and a government policy that deals with externality problems is important to improve the functioning of the credit market.
Rural credit markets in developing countries are different from other credit markets in the degree to which problems are felt. In developing countries, problems in credit markets are felt much more acutely than in other contexts. And that is why governments consider policy initiatives in this area so important.
For the author, the issue of enforcing loan payments constitutes the central difference between rural credit markets in developing countries and credit markets elsewhere. And in this article, the pure “enforcing payment” problem is defined as a situation where the loan recipient is able to pay but does not want to pay. Most developing country credit market models discussed are not concerned with execution and assume that when projects are sufficiently profitable, loan repayment is guaranteed. Such a situation can be seen, for example, in debt forgiveness programs, where a government announces that farmers are forgiven of their past debts, making loan recipients aware (and confident) that they can stop paying a debt. loan with impunity, thus starting to consider loans as donations.
The author chose to carry out a conceptual discussion of cases already documented in developing countries and their rural credit market policies.
According to the author, there are good reasons to expect market power to develop in credit markets. Where, in a world of imperfect information, those with privileged access to information can gain some market power. Where market power can also be important because as lenders grow, their ability to diversify risk improves and their lending activities take on monopolistic tendencies. Therefore, one might expect a market structure with a few large lenders, each of which is capable of intermediating funds to a large group of borrowers,
However, the author points out that this scenario may not characterize rural areas in developing countries very well, due to the high costs of obtaining the information necessary to operate in many different locations. Pointing out, however, that experience suggests that these large lenders in rural areas may attempt to use their market power (Lamberte and Lim, 1987).
Besley asserts that monopoly does not always lead to inefficiency. But, the usual monopoly inefficiency, where lenders restrict funds to increase their profits, arises only when loan arrangements cannot be tailored to each individual. In this case, an argument for intervention can be made. Where direct regulation of interest rates is one option, but moneylenders operating informally can be difficult to regulate and so a second option is to reduce the monopoly power of established companies by providing alternative sources of credit.
Thus, one can argue in favor of rural subsidies in credit institutions as an indirect way of reducing market power, but experience has shown that it is very difficult to make such schemes work effectively. Since the ability of moneylenders to collect information and demand repayment is great, it should therefore be replaced by an institutional structure that can fulfill these functions equally effectively.
The article studied here brought arguments that associate market failures with the case of interventions in rural credit markets. These are: application difficulties, imperfect information, market power, among others, which were briefly discussed in this text.
Finally, the author highlights that where supervision is a problem, governments can intervene by strengthening property rights to increase the effectiveness of the guarantee, even if this is not a direct intervention in the credit market. However, it must be noted that the government can be both part of and the solution to the problem, as many government-backed credit schemes fail to sanction defaulting borrowers.
References
Greenwald, Bruce, and Joseph E. Stiglitz. 1986. “Externalities in Economies with Imperfect Information and Incomplete Markets.” Quarterly Journal of Economics 101(May):229-64.
Lamberte, Mario B., and Jospeh Lim . 1987. "Rural Financial Markets: A Review of the Literature." Working Paper 87-02 , Philippine Institute for Development Studies, Manila. Processed.
McKinnon, Ronald . 1973. Money and Capital in Economic Development. Washington, DC: The Brookings Institution.
[1] The market is efficient when it is not possible to make someone better without making someone else worse off.