What factors affect the demand for rural credit in developing countries?

Responsible Researcher: Viviane Pires Ribeiro

Paper Title: Borrowing costs and the demand for rural credit

Authors: DW Adams and GI Nehman

Location of Intervention: Bangladesh, Brazil and Colombia

Sample Size: Not specified

Big topic: Finance

Variable of Main Interest: Rural credit

Type of Intervention : Analysis of empirical information

Methodology: Bibliographic research

In view of the continued lack of credit use among a significant portion of the low-income rural population, Adams and Nehman (1979) argue that in developing countries, high borrowing costs discourage many rural residents from using formal loans. Borrowing costs are defined as nominal interest payments, plus the transaction costs of the loan, plus changes in the purchasing power of the monetary value borrowed. Farm-level information from Bangladesh, Brazil, and Colombia is presented to show that small borrowers incur substantially higher borrowing costs on formal loans than large borrowers.

Assessment Context

In recent years, the supply of agricultural loans in many developing countries has expanded very rapidly, with some countries experiencing increases of 50 to 100 percent in a single year. In most cases, such funds have been intended to stimulate agricultural production. Thus, many governments, together with several development agencies, have also tried to direct a considerable portion of these additional funds to the low-income rural population. However, in many countries cases have been identified that indicate that increased credit supply has supported increased product production, but it is becoming increasingly evident that relatively little of the additional loan funds have actually gone to the rural population of low income.

At least three explanations have been given for the continued lack of credit use among a significant portion of the low-income rural population: urban interests conspire against the low-income rural population and deny them access to significant amounts of credit; widely used concessional interest rate policies, combined with relatively large loan transaction costs to serve small or new borrowers, discourage financial institutions from lending more to rural producers; and most of them do not seek formal credit because they do not have profitable investment opportunities, are not aware of the availability of formal credit, do not know how to use credit, or are too shy to apply for formal loans.

Intervention Details

According to Adams and Nehman (1979), all three explanations given above for the continued lack of credit use among the majority of the low-income rural population are at least partially valid in many developing countries. Therefore, the authors propose a fourth explanation, not previously discussed in the literature. The explanation focuses on differences in borrowing costs between various types of formal borrowers. In other words, the authors argue that these differential borrowing costs strongly affect the willingness of low-income rural populations to seek loans from formal lenders. To do so, the authors draw on data from several developing countries to support this argument.

Methodology Details

Most credit demand analyzes equate the nominal interest rate charged on a loan with the price of the loan. Thus, Adams and Nehman (1979) suggest that a more appropriate “price of credit” would be the actual net cost incurred by the borrower in acquiring the loan. Borrowing costs can include three separate elements: the nominal interest payments made to the lender (NI); the additional loan transaction costs incurred by the borrower (TC); and changes in the purchasing power of monetary value over the loan period. In most cases, the borrower can accurately predict the NI and TC elements of their total borrowing costs. The expected change in prices (AP*) will likely be closely related to recent changes in the purchasing power of the currency experienced by potential borrowers. The expected borrowing cost (BC*) used by the potential borrower in making loan demand decisions is equal to NI + TC - AP*. Many potential rural borrowers in developing countries are unlikely to ignore TC and AP* when making loan demand decisions.

For analysis, Adams and Nehman (1979) argue that small-amount borrowers and individuals who do not have loan experience may incur relatively large transaction costs to acquire a loan. At least three types of transaction costs may be involved. This includes: (i) loan charges charged by the lender in addition to interest payments, through application fees, forced purchase of other services, service fees, bribes, balances and closing costs; (ii) in many low-income countries, rural borrowers may be forced to negotiate with someone outside the formal agency before a loan application is formally reviewed; and (iii) in many cases, the largest and most important transaction costs are the borrower's time and travel expenses involved in the loan transaction. Many small and new borrowers are required to visit the formal lender several times to negotiate the loan, withdraw portions of the loan, and make payment.

Results

Adams and Nehman (1979) highlight the difficulty they had in documenting the relative importance of borrower transaction costs and expected changes in currency purchasing power in loan demand decisions. The authors did not identify any research that reports how expected changes in purchasing power affect lending decisions in rural areas. Surprisingly, there were also few farm-level studies documenting borrower transaction costs. Therefore, the authors identified only three studies that address this issue: one in Bangladesh, another in Brazil and one in Colombia. Despite the limited coverage of these studies, they provide some valuable insights into the relative importance and composition of borrowers' transaction costs.

The three studies report borrowing costs primarily among farmers who had prior experience with formal loans. An individual who has not previously borrowed from a formal lender can be expected to face higher transaction costs compared to an established borrower. Furthermore, not all formal credit applicants receive a formal loan. Many of these applicants who are unsuccessful in obtaining credit incur significant formal transaction costs before being rejected. After rejection, they may be forced to seek informal loans. The expected borrowing costs of a new formal loan applicant may be increased by these rejection possibilities. These rejection costs may be quite relevant if the probability of approval of a new formal loan application is relatively low.

Public Policy Lessons

The limited scope of the empirical information presented in the article restricts the policy recommendations that can be developed. Thus, Adams and Nehman (1979) argue that the most important conclusion of the study is that the transaction costs of lending above and beyond nominal interest payments may be an important factor as they discourage small and new borrowers from using formal loans. These loan transaction costs appear to represent a significant portion of borrowing costs for many small and medium-sized borrowers. In relative terms, these transaction costs appear to be less important for experienced and large borrowers. These large borrowers may be more sensitive to nominal interest rates and expected changes in the purchasing power of the loan.

The policy implications of the major differences between the various classes of borrowers in the importance of various elements of borrowing costs are quite evident. Adjustments to nominal interest rates will have a direct and weak effect on borrowing costs and demand for loans from small and new borrowers. Changes in loan transaction costs can have a much larger impact on your lending decisions. At the same time, demand for loans among experienced and large borrowers will be much more sensitive to changes in real interest rates.

If a society's goal is to reach as many low-income rural residents as possible through formal lending, the borrower's transaction costs must be reduced. Because opportunity costs and travel expenses are relatively large for small borrowers, initial attention may be directed to reducing travel expenses and the number of visits required. Group lending, mobile banking and bank branches in small villages can be partial solutions. In many cases, however, it appears that formal lenders impose substantial loan transaction costs on small and new borrowers as a way of keeping unprofitable businesses away from the bank.

The problems of extending formal financial services to low-income rural populations in developing countries are difficult and persistent. It will take much more than pressure from international agencies, government incentives or good intentions on the part of some formal creditors to resolve these problems. The loan repayment performance of rural people should be improved, the lender's transaction costs for small amounts should also be reduced, and the lender's income from making small loans should be increased. Some policies, especially those related to interest rates, should be adjusted so that small loans to low-income rural people are more attractive to formal lenders. The authors believe that attention should also be focused on making formal loans more attractive to small and new borrowers by reducing loan transaction costs. However, it may be impossible to do this if governments insist on adopting low interest rate policies for the rural population.

References

ADAMS, Dale W.; NEHMAN, Gerald I. Borrowing costs and the demand for rural credit. The Journal of Development Studies , vol. 15, no. 2, p. 165-176, 1979.