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3. Rural Financial Markets

3.1. Policy Reforms
3.2. Transitional Issues
3.3. New Market Compatible Policies

3.1. Policy Reforms

The principal reforms to the rural credit markets have involved the descaling, elimination, or privatization of the public rural development banks that had been the principal conduit of highly costly and regressive subsidies to agriculture before the reforms. Subsidies for rural credit have been reduced or eliminated as have interest rate controls on private sector rural credit and forced allocations of credit to agriculture. Governments have also reduced their roles in the provision of insurance for use as collateral for loans.

In Colombia, reform of the rural financial sector between 1990-94 raised real interest rates to near market levels, and restructured and recapitalized the rural development bank, the Caja Agraria. In Ecuador, subsidies to the Banco Nacional de Fomento were lowered beginning in 1991, and interest rate ceilings on deposit accounts were removed in 1993. Haiti closed its national bank for agricultural and industrial development, BNDAI, in 1989. In Mexico, rural finance reform beginning in 1989 streamlined and downsized the rural development bank. Banrural closed 300 of its 500 branches, reducing staff from 22,000 in 1988 to 10,000 in 1992. Banrural was allowed to diversify its loan portfolio to non-agricultural sectors. Interest rate subsidies were reduced, leading to positive real interest rates. Government transfers to development banks were decreased and agricultural credit declined from 22% of all credit in 1983 to 8% in 1992. Small farmers with bad debts have been turned over to the public welfare program, Pronasol. Agricultural insurance was restructured with reduced total subsidization. In Nicaragua, the Banco Nacional de Desarrollo raised real interest rates significantly beginning in 1992. In Peru, preferential interest rates to agriculture were eliminated and banks free to set interest rates. The Agrarian Bank, BAP, was declared bankrupt in 1992. A new second-tier institution, BFN, was set-up to lend to small businessmen and farmers. Reform in Venezuela beginning in 1989 raised the low ceilings on private sector interest rates for agricultural loans. However, ceilings continued to keep agricultural loans rates below rates for non-agricultural loans.

3.2. Transitional Issues

Political obstacles to reforms. Many governments experienced strong political pressures to continue policies of lenient loan recuperation and rescheduling, and to maintain subsidized interest rates. In Colombia, Law 34 of 1993 refinanced loans to farmers affected by the crisis of 1992. This policy may discourage loan repayments in the future. Also in Colombia, Law 101 of 1993 capped interest rates and mandated subsidized credit to agriculture. Mexico experienced widespread protests from farmers when the government curtailed the bloated Banrural credit program in the early 1990's. The issue of restructuration of bad debts for many farmers with commercial banks remains an open policy issue that currently limits the ability of agriculture to modernize and diversify in response to the new system of price incentives created by exchange rate depreciation and trade liberalization.

Property titling institutions. In many countries, the process of titling of property was streamlined in order to lower borrower transactions costs. Existing titling programs are being expanded beyond land to include other durable goods and equipment. Titling programs are fundamental for the penetration of commercial banks in agriculture and to give access to smallholders to these sources of finance using land and other assets as collateral.

3.3. New Market Compatible Policies

Collateral and access to credit. In general, the financial market reforms have had a strongly negative impact on the access of smallholders to credit. Many smallholders who could have borrowed from the development banks are unable to meet the more stringent collateral requirements of commercial banks. While titling programs will help, this will not solve the problem of many of the rural poor who have little collateral to pledge. The challenge thus remains to find market based solutions to the problem of access to credit by smallholders who lack collateral assets. Many institutional innovations have been introduced in recent years to solve this problem, both by the public and private sectors.

There are a number of institutional solutions to the reconstruction of a rural financial system with the potential of giving access to smallholders, both those who were previously served by rural development banks, and those who were always marginalized from access to credit. In Mexico, Pronasol's Crédito a la Palabra Campesina is a public program that provides small loans with no interest charge to small scale producers who have outstanding bad debts and consequently do not qualify for loans from Banrural or commercial banks. No collateral was required for the loans, but borrowers lose their right to future loans if they default. The program suffers from low recuperation rates and is therefore far from self-sustainable. The Mexican government is currently adjusting the law on financial institutions to favor diffusion of credit unions, but this is still an incipient system in the rural areas.

In Guatemala, financial NGOs (Genesis and Fundap) are following the model of Acción Internacional to mediate the relationship between organized credit groups and commercial banks. Credit groups are self-formed and all members are jointly liable to repay the loan received by each member. Since members have privileged access to information about the other members (which the commercial bank does not have) they can avoid adverse selection (incorporation in the group of risky members) and moral hazards (members refusing to pay when they can or placing false claims for mutual insurance by other group members) by group members. The NGO adds a 7 points service margin to the interest rate charged by the bank. Repayment rates have been exceptionally high, at least among merchants and microentrepreneurs. Group lending is more problematic for smallholders due to the high covariation of risks, unless they engage in highly profitable activities and associate in groups with diversified activities.

In Peru, many NGOs have entered the field of lending to organized groups, with an iron discipline for repayment since not only are groups jointly liable for repayment, but also the community is made liable for all groups. Due to the exceptionally high interest rates charged by commercial banks, loanable funds are obtained through concessional loans from international development agencies or grants from international donors. While the system performs well in terms of repayment, its expansion is severely confined by access to loans from donor agencies.

There are a number of unresolved issues regarding the reconstruction of financial services for agriculture following the collapse or the restructuring of rural development banks.

- One is the problem of graduation of households from schemes of access to credit without collateral such as Pronasol or financial NGO loans to solidarity groups. If these households have accumulated enough assets under group lending, these assets can serve as collateral for individual loans from commercial banks. For many, this will not be sufficient. Credit records could be made available to commercial banks to facilitate individual access to credit on the basis of weak physical collateral compensated by strong reputational capital. Most schemes have no explicit graduation strategy, often because it is not in the interest of the NGO to lose its best performing customers to commercial banks.

- Another issue is the role of decentralized commercial banks at the level of village branches versus financial NGOs. The latter may be seen as transitory institutions to be displaced by village branches once the formal system of financial intermediation has been reconstructed. In this case, financial NGOs would only continue to play a role with the more marginal and least organized potential borrowers. Village branches of commercial banks can access local information about borrowers by using village agents and giving them adequate incentive contracts to truthfully reveal this information (Fuentes, 1995).

- A third issue is the potential reorganization of the rural development banks. In Mexico, Banrural, after having shed its non-performing customers, has continued to lend under strict performance criteria. These banks could absorb the lending technology developed by financial NGO and extend their clienteles to smallholders, potentially through subcontracting the services of financial NGOs. Innovative institutional solutions linking formal development and commercial banks, with the advantage of diversified loan portfolios and access to broad financial markets, to local institutions and agents with informational advantages are still largely to be developed. Many interesting experiments are in progress to achieve this goal and they are worth monitoring carefully. Indeed, one of the main policy implications of the theory of imperfect and asymmetrical information derived from the new institutional economics is the advantage of linking modem with local/traditional institutions to cumulate gains in risk reduction and market integration (afforded by the former) with gains in information (afforded by the latter) to reduce adverse selection and moral hazard problems in financial transactions.

Credit as a poverty alleviation tool. Credit access programs will only be effective for the credit "constrained" - those with access to productive investment opportunities who are unable to pursue these opportunities for lack of financial resources. Lack of access to credit does not imply an unmet credit need. Hence, it is often more efficient to provide assistance to marginal producers via targeted public assistance programs rather than via credit. NGOs can have an important role to play in assisting marginal producers formulate potentially profitable new projects. Once this has been done, the challenge remains for the lending institutions to recognize the entrepreneurial poor with no collateral to offer, in terms of their ability and willingness to repay, and to define a lending technology that is mutually advantageous.

Lender transactions costs and access to credit. Lender transactions costs create an incentive for banks to minimize the number of loans they make, thereby discouraging them from making small loans. To encourage commercial banks to loan to smallholders, governments can provide fixed transaction cost subsidies to small rural loans. The World Bank has supported such an initiative in Mexico. This type of subsidy is preferable to an interest rate subsidy as it encourages the bank to contract with smallholders and does not distort the capital intensity of projects. Ideally, transactions costs subsidies should be accompanied by technical assistance for the definition of projects and the management of loans, as is effectively done by FIRA in Mexico.

Development of private rural financial institutions. There is a need for government regulation and supervision of commercial banks, credit unions, and credit cooperative to enhance consumer confidence in these institutions, particularly if they are to mobilize rural savings. There is also a need to provide technical assistance and training to new RFI's, especially small scale credit unions and credit cooperatives. Definition of a regulatory framework to codify the initiatives of financial NGOs as well as the provision of financial services by RFIs are still also largely to be defined and require urgent policy attention.

Savings mobilization and sustainability. The removal of caps on deposit interest rate and deregulation of the commercial bank sector should encourage savings mobilization, which is crucial for the long term sustainability of RFI's. Privatization of the social security system, as was done in Chile, is an effective way of mobilizing savings for the private sector. Other countries in Latin America such as Bolivia are emulating the Chilean example, and many other countries are pondering shifting their welfare system from a pay-as-you-go to a capitalization scheme. In Mexico, commercial banks are opening windows on both sides of the U.S. border to assist in the transfer of remittances and channel deposits toward potential investors in the emitting communities, thus helping use remittances for local employment creation, and the eventual reduction of future migration flows.

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