Credit's effect on productivity in Chinese agriculture : a microeconomic model of disequilibrium

Policy, Research, and External Affairs ,< WORKING PAPERS L Agricultural Policies Agriculture and Rural Development Department The World Bank January 1991 WPS 571 Credit's Effect on Productivity in Chinese Agriculture A Microeconomic Model of Disequilibrium Gershon Feder Lawrence J. Lau Justin Y. Lin and Xiaopeng Luo Not all farmers - sometimes only a minority - are constrained in their farming operations by inadequate credit. And part of formal credit is diverted to consumption so the effect on output of greater supplies of formal credit might not be as large as one would expect if one assumed that it would all be used produc- tively. The Policy, Research, and Extemal Affairs Complex distributes PRE Working Papers to disseminate the findings of work in progress and to encouragc the exchange of ideas among Bank staff and all others interested in development issues. These papers carry the names of the authors, reflect orly their viess, and should be used and cited accordingly, The findings, interpretations, and conclusions are the authors' own. They should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries.  Policy, Rearch, and Exlornal AffaIrs Agricultural Podlces WPS 571 This paper - a product of the Agricultural Policies Division, Agriculture and Rural Development Departmint - is part of a larger effort in PRE to evaluate agricultural credit policies and review institutional designs so as to formulate better guidelines for Bank activities in rural credit. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Cicely Spooner, room N8-035, extension 30464 (27 pages). Many government programs want to provide actually be used for consumption and invest- more credit to the farm sector to increase agricul- ment. Indeed, medium- and long-termn formal tural productivity. If the marginal effect on credit is practically nil among the agricultural productivity is small, those resources might be households in the study area. Rolled-over short- put to better use elsewhere. term credit is sometimes used for small-scale investments. The diversion of short-term credit Feder, Lau, Lin, and Luo conducted an for farmn investment is about 40 percent for an econometric analysis of the effect of credit on average household in the study area. This output supply which recognizes that credit implies that almost a third of the forrnal credit is markcts are not necessarily at equilibrium - so used for consumption (of current goods or that credit rationing (with unsatisfied demand) durables). and nonborrowing (when credit could be avail- able) are both possible. Only about 37 percent of What conclusions does this suggest in the farners in the study area were constrained by evaluating the probable effect of expandin, inadcquate formal credit. Informal credit agricultural credit? First, not all farmers, and sources provided funds for specific non-agricul- sometimes only a minority, are constrained in tural activities that were not fungible. their farming operations by inadequate credit. And second, greater supplies of formal credit The results indicate that one additional yuan will be diverted in part to consumption, so the of liquidity (credit) yielded 0.235 yuan of likely effect on output will be smaller than what additional gross value of output. These results one might expect if all funds are assumed to be suggest that for the area of China covered in the used productively. study, a good part of the short-term credit may The PRE Working Paper Series disseminates the findings of work under way in the Bank's Policy, Research, and Extemal Affairs Complex. Anobjectiveof theseries is togetthesefindingsoutquickly, evenif presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the PRE Dissemination Center  Credit's Effect on Productivity in Chinese Agriculture: A Microeconomic Model of Disequilibrium by Gershon Feder, Lawrence j. Lau, Justin Y. Lin, and Xiaopeng Luo ,able of Contents I. Intro Juction I II. China's Farm Sector and Rural Credit Market 3 III. A Model of Farm Household Consumption, Production, and Investment 5 IV. Econometric Specification and Empirical Results 8 V. Implications 13 References 1 4 Footnotes 1 5 Annex 1 6 Appendix 24  1. INTR(DUCTION Credit is an important element in agricultural productlon systems. It allows producers to satisfy the cash needs Induced by the production cycle which characterizes agriculture: preparation, planting, cultivation and harvesting of the crops are typically done over a period of several months in which very little cash revenue is earned, while expenditures on materials, purchased inputs and consumption need to be made in cash. Cash income is received a short time after the harvest. In the absence of credit markets, farmers would have to maintain cash reserves so as to facilitate production and consumption in the next cycle. The availability of credit allows both greater consumptlon and greater purchased Input use, and thus increases welfare of the farmers. If a producer faces an infinite supply of liquidity at a given price, the production decisions will be independent from consumption decisions, as has been shown in the household models of Singh et al. However, asymmetric information and adverse selection typically prevail in credit markets, giving rise to credit rationing as an optimal behavior (Stiglitz and Weiss). Furthermore, government intervention in the form of interest rate ceilings or subsidized interest rates is common in many countries' agricultural sertors, necessitating rationing. When credit is rationed, some borrowers cannot obtain the amount of credit they desire at the prevailing interest rate, nor can they secure more credit by offering to pay a higher interest rate. In such circumstances, liquidity can become a binding constraint on many farmers' operations. When liquidity is a binding constraint, the amounts and combinations of inputs used by a farmer deviate from their notiornal optimal levels (the levels that would have been utilized if liquidity were not a binding constraint). - ie marginal contribution of credit is therefore to bring input levels closer to the optimal levels, thereby increasing output and, since the quantity of land  -2- is fixed, yie!d. This potential gain in productivity is one motivation underlying many government programs seeking to provide more credit to the farm sector. An Important issue in the context of agricuiltural credit policy is the magnitude of the expected productivity gain. If the marginal productivity effect of credit is small, then the resources may be more beneficially deployed elsewhere. Assessment of the expected productivity gain Is not trivial because the effect of credit is likely to differ between liquidity-constrained and unconstrained farm households. Some studies attempt to identify the effect of credit by estimating separate production functions or supply functions for borrowers and non-borrowers, and then proceeding to compare the estimates (see review in David and Meyer, 1980, pp. 206-215). One major weakness of this approach is the implicit assumption that all borrowers and all non-borrowers are respectively homogenous with respect to their credit demand/supply situations. This assumption is often not valid, as many non-borrowers do not borrow because they actually have sufficient liquldity from their own resources and not because they cannot obtain credit, while some cannot borrow because they are not credit-worthy. Similarly, the marginal effect of credit may actually be zero for borrowers for whom liquidity is not a binding constraint. The same criticism applies to other studies in which all sampled observations are pooled to estimate production functions (or output supply functions) with credit as a production input or as a supply determinant. As will be argued in a subsequent section, the supply function is alfferent (both in parameters and in variables) depending on whether- liquidity is a binding constraint. Estimates which do not take account of these restrictions on the specification are therefore flawed. The present study reports an econometric analysis of the effect of credit on output supply which avoids some of the aforementioned pitfalls. The central feature is the recognition that credit transactions are not necessarily in equilibrium at the household level. That is, the amount of credit desired and tne amrourt offered are not necessar,,y equ4l so th:t creiit SL.ppy  - 3 - rationing (with unsatisfied demand) and non-borrowing (while supply Is potentially avalIabl) arre both possible. The analysis utilizes cross-sectional household-level data from a study area in northeast China, obtained in a recent farm survey designed by the authors. The pian for tloe paper is as follows: Section II provides background on the farm sector and the ru al cre sit market In China, and describes the specific study area and data utilized in the analys.s. Section liI discusses the formal model underlying the empirical analysis (the mathematical model ts pr e(ente 8 in an annex). It is followed by a discussion of the econometric procedure and tr e e j>cal results In Section IV. The last section discusses the implications of the results. II. CHINA'S FARM SECTOR AND RURAL CREDIT MARKET China introduced a smaliolder agricultural production system in a series Of reFcrms between the years 1979-1984. The "household responsibility system" made individua! householes, rather than the communes to which they belonged, the decision-makers and mariagers of the C'N farms. Individual families were allocated land by the communes on leases that run tycicairl fc' 15 years. The improved incentives brought about a significant increase in agricuwtura! cut_tc ac in rural income (Lin). While prior to the reforrns there was only Vimited nter3act on retbe households and financial institutions, the emergence of smalilholder ag:-!cu'tur e im;: -s t',t households now need liquidity for seasonal production and consumption, or longer-rer . e finance investment, construction and ceremoniai social events. Most of agricultural households' transact,ons w;th the fcrma f ' sector ?are the rural crecit cooperatives (RCCs).1 The interest rates for agricuitura oans tas ve 2-: - loans) made by forma! credit institutions are fixed :by the government, vith some _a- a, according to loan categories. In 1987, the rates of interest for agrcu!tural Scans between 7 and 1 4 percent. The degree of intc, est subsidy is believed to Wave been s'L There is evidence that following the introduction of r-efcr-ms the voiu;Tce of . obtained from informal sources is substantial in China. Jiang asserts that ron-;rsl tutic'a,  sources contribute roughly half of the credit volume In rural areas. Feder et al. (1989) report non-institutlonaTcredit shares of between one third and two thirds In several study areas. The most common sources of informal credit In China are relatives and friends. Most of such loans carry no Interest charges. Possible reasons for the absence of a substantial profit-motivated informal credit market In China are discussed In Feder et al. (1990a). They include, unclear legal status, residual ideological resisLance and absence of collateral assets.2 The present study relies on data collected in December 1987 in Gongzhuling. Gongzhuling is located in Jilin province, within the corn belt of northeastern China, where agro-climatic conditions dictate essentially one corn season a year. The original sample consists of 2U0 households selected at random from eight rdndomly selected townships. The information gathered covers inputs, outputs, financial assets, credit transactions, and household characteristics. Thirteen households are deleted after determining that tneir main activity was not agriculture or that thei: situation was unusual (e.g., a widow maintaining a home garden plot). The data show that nearly three quarters of the sample borrowed from formal sources (essentially the RCCs) during the study season. The frequency of informal credit transactions is much lower than that of formal transactions (about one fifth of the sample), and three quarters of Lhese loans were provided free of interest. Given the significant differential between the rates of interest on the two types of loans, this may be taken as evidence that .nformal credit is not a good substitute for formal credit due to limited fungibility (otherwise every borrower would exhaust his or her informal credit first before going to the RCC). The share of formal credit in the total volume of new credit is 66.5 percent. Table 1 presents the distribution of loans by purpose and by type of lender. It is readily apparent that the predominant stated purpose of formal loans (all of whicn are short-term) is for the financing of current production. Most of the informal credit is reported to have been obtained for purposes other than production, with construction and social expenditures appearing  -5- dominant. Informal loans contracted for these purposes, however, cannot be easily diverted to finance day-to-7ay consumptlon or production, because the lenders, mostly relatives and friends, can easily monitor compliance. The bulk of the fungible credit, defined as credit which is not granted for easily monitored purposes, In the study area thus comes from the formal sector (87 percent). Given the dominance of formal credit, a key issue for tha present study is the extent to which its supply is a constraini on households' desired activities. The survey data collected permit an answer to this question. Borrowing households were asked if at the go ng rates of interest they would have liked more institutional credit than the amount they were actually granted. Households which did not borrow were asked the reason for not borrowing. The most common reason for not borrowing was availability of sufficient own resources. The borrowers who indicated a desire for more credit, and the non-borrowers who responded that they could not obtain credit, are classified as credit-constrained. As reported in Table 2, about 37 percent of the farm households in Gongzhuling were constrained by credit accordina to this classification. The liquidity position of credit-constrained households as compared to non-constra ned households is compatible with intuitive expectations: They have significantly lower deposils in financial institutions, and overall, their liquid resources per unit of land are 12 percent teIcA those of unconstrained households. lll. A MODEL OF FARM HOUSEHOLD CONSUMPTION, PRODUCTION AND INVESTMENT Suppose the household considers the allocation of resources at its disoosai at :"e beginning of the production period between the following uses: (i) current consumpt on, investment; (iii) the purchase of variable inputs for current production (inclueing lator a'ncw fertilizers). Variable inputs, in combination with land and existing capital, will produce this perici s output. Investment will not mature by the time this period's output is produced, but Its contribution to the household's welfare may be accounted for through a valuation function wlich  TABLE 1: Distribution of Loan Purposes by Type of Lender (Percent) P u r p o s e Sample Prod- Farm Constr- Consump- Social Other Size uction Equip- uction tion (Wedding ment Funeral, etc.) S.U.lr ce (Number o f L oans of Loans) rO' rp.Sl. 209 92.3 4.3 1.9 0 1.0 0.5 l C mal 44 9.1 4.6 20.5 1 5.9 27.3 2 2.7 TABLE 2: Extent of Formal Credit Constraint t ite Crs SamDle % Constrained s.ze (Nulber of Households) .'. s ;frS 145 41.3 or' - tCr , D~n'es 42 28.3 187 37.4  summarizes tne contribution of capital to the future consumption stream. The household's Initial endowments of-liquid resources, family labcr, capital, and lana (the latter two assumed not convertible to liquldity during the perlod) can be augmented by borrowing at the beginning of the period. Whether the household can borrow the entire desired amou. t or is constrained by a binding upper limit on the availability of credit Is of considerable consequence, as it determines whether production decisions are separable from the consumption decisions. The household is assumed to maximize a utility function defined over consumption per family member in the current and next period, plus the utility of future streams of consumption summarized by the valuation function of next period's capital, per family mcember. The optimization can be carried out under two scenarios: (I) The supply of credit is greater than or equ_l to the demand (i.e., credit constraint not binding); and (ii) The supply of credit is less than the notional demand for credit (credit constraint binding). The essence of the results of such a model 3 is that under case (i) above, the supply of output Is not affected by the level of licuidity (including credit), the size of the household'b own family labor force or the total size of the household. The parameters of the output supply function in this case are determined by the production function alone. Under case (ii), however, output supply is positively affected by increases in liquidity (e.g. increased credit supply) and in the household's labor endowment, while the effec. if total household size is indeterminate. 1,,creases in the initial endowments of land and capital would have a positive effect on output supply in both cases (i) and (i), while they would have an indeterminate impact on input demands, depending on substitutability. The parameters of the output supply function under case (ii) are determined by both the production function and the utility function.  - 8 - IV. ECONOMETRIC SPECFICATION AND EPRICAL RESULTS The econometric model most suitable for estimating the output supply tunction with the data avallable to us Is the switching regression model with an endooenous criterion function described in Maddala (pp. 223-228). The model postulates fo'r any observation I (1) Y P1 XIl + U11 iff 7 Z1 + UO <