The impact of formal finance on the rural economy of India

K Policy Research | WORKING PAPERS- Agricultural folicles Agriculture and Rural Development Department The World Bank August 1992 WPS 949 The Impact of Formal Finance on the Rural Economy of India Hans Binswanger and Shahidur Khandker India's supply-led approach to agricultural credit paid off in nonfarm growth, employment, and rural wages. The impact of expanded credit on agricultural output has been modest, and the benefits of agricultural income exceed the costs of the program only if optimistic assumptions are made about repayment rates on farn credit. Policy Rescarch Working Papers disseminate thefindings of work in progress and encourage the exchangeof ideas among Bank staff and an others atarested in developrdent isBan. ThesBpapers, distnbuted bymaeRestaorh Advisory Staff, cariy thenames of.thauthors, reflect only their views,asnd shouddbeuscd and dted aecordingly. The findings, interprotations, and conclusions are the authors'own.They should not be attributed to the World Bank, its Board of Dircors, its management, or any of its member countries.  fi ~~~~~~~Policy Research Agriculturail Policies WPS 949 This paper - a product of the Agricultural Policies Division, Agriculture and Rural Development Department- is partof a larger effort in the department to analyze rural credit policy. Theresearch was funded by the Research Support Budget under research project "Agricultural Investment, Financial Intermediation, and Socioeconomic Mobility" (RPO 673-35). Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Hans Binswanger, room 14-049, extension 31871 (August 1992, 53 pages). India has systematicly pursued a supply-led more impact on inputs than on output, so the addi- approach to increasing agricultural credit. Its objec- tional capital investment has been more important in tives have been to replace moneylenders, to relieve substituting for agricultural labor than in increasing farmers of indebtedness, and to achieve higher levels crop output. of agricultural credit, investment, and output. But overall, rural credit and expansion of the India's success in replacing moneylenders has rural financial system have had a positive effect on been outstanding. Between 1951 and 1971 their share rural wages. Creating nonfarm jobs has apparently of rural credit appears to have dropped from more added more to total employment than the substitution than 80 percent to 36 percent. (It may have dropped to of capital for labor has subtracted it in agriculture. So, as low as 16 percent by 1981, but that estimate is wages have risen even for agricultural workers, albeit disputed.) modestly. Still, institutional credit is far from reaching all The supply-led approach to agricultural credit farmers. Only about a quarter of cultivators borrow, that has been pursued for three decades has clearly and no more than 2 percent take out long-term loans. benefited current borrowers and farm households Most small farmers have little access to credit, and formerly indebted to moneylenders. It has also long-tern credit goes mostly to large farmers. spurred fertilizer use and investment in agriculture. It Overall, farm debt has probably not increased has been less successful in generating viable institu- sharply in real terns, as formal credit has primarily tions - and has failed to generate agricultural substituted for credit from other sources. Moreover, employment. with the rapid growth of commercial banks in the The policy's costs to India's government have 1970s, the system mobilized more deposits than it lent been high as portfolio losses associated with poor in rural areas in 1981. Of course, enhanced deposit repayment ultimately have to be borne by the govern- services are a useful service for the rural population, ment or one of its institutions under optimistic but one must ask what has been the impact of heavy assumptions. The benefits of the agricultural income rural credit and better financial services on agricul- are at best no more than 13 percent higher than the tural investment, production, and rural incomes. cost to the government of the extra agricultural credit. Binswanger and Khandker's econometric results If assumptions about the cost of supplying the credit suggest that the rapid expansion of commercial banks and about repayment rates are less optimistic, the in rural areas has had a substantially positive effect on social costs - and the costs to the government of rural nonfarm employment and output. The availabil- providing the credit - would have exceeded the ity of better banking facilities appears to have benefits in agricultural income. overcome one of the obstacles to locating nonfarm The expansion of commercial banks to rural areas activities in rural areas. paid off in nonfarm growth, employment, and rural Expanded rural finance has had less of an effect wages. The question is: Could these benefits have been on output and employment in agriculture than in the achieved without imposing agricultural credit targets on nonfarm sector. The effect on crop output has not the commercial banks and credit cooperatives? Or did been great, despite the fact that credit to agriculture the commercial banks expand only because they were has greatly increased the use of fertilizer and private forced to lend to agriculture? The authors could not investment in machines and livestock. There has been answer these questions with the data at hand. he Policy ResearchWorking PaperSeries disseminates t he findings of work under way in the Bank. An objective of the series C is to get these ftndings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent of ficial Bank policy. Produced by the Policy Research Dissemination Center  The Impact of Formal Finance on the Rural Economy of India by Hans Binswanger and Shahidur Khander Table of Contents 1. Introduction 1 2. Evolution of the Rural Financial System 5 3. The Econometric Framework and the Data 12 The Econometric Framework 12 Data and Variable Description 17 4. Econometric Results 21 Rural Nonfarm Growth and Rural Wages 30 5. Reflections on Benefits and Costs of Subsidized Credit 31 Benefits 32 Government Costs 33 Additional Private Costs 36 6. Summary and Conclusions 37 References 41 Annexes  Q1