Principal investigator: Eduarda Miller de Figueiredo
Author Timothy Besley
Original title: How Do Market Failures Justify Interventions in Rural Credit Markets?
Location of the Intervention: –
Sample Size:
Sector: Agriculture
Primary Variable of 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 subsidies are 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. To this end, the economic concepts discussed by the author in this article are presented very briefly. The conclusion is that there may be good arguments for intervention, some of which may be based on market failure.
- Policy Problem
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. Therefore, the presence of a bank in a particular area is not sufficient reason to assume that the bank chose 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, according to the author, it seems fair to say that rural credit markets in developing countries (India, Mexico, Philippines) have rarely operated on commercial bases, 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 without costs and lead to financial repression (McKinnon, 1973). Thus, it has become popular to advocate for 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, where such interventions should be restricted to cases in which a market failure has been identified. This idea was investigated by this study, which explores whether, and how, interventions can be used to compensate for deficiencies in existing markets for allocating credit.
Thus, in the article studied here, market failure will be considered to be the inability of a free market to produce a constrained and Pareto-efficient allocation of credit.[1]Based on this understanding, the article examined the implications of this concept.
- Implementation and Evaluation Context
A market failure occurs when a competitive market fails to produce an efficient allocation of credit. Credit, encompassing both supply and demand, should be priced high enough for some individuals to postpone consumption, but low enough that borrowers are willing to repay given their current consumption needs. In an idealized credit market, loans are traded competitively and the interest rate is determined by supply and demand.
Credit markets also differ from an idealized market because information is imperfect; that is, a lender's willingness to lend money depends on having sufficient information about the creditworthiness of the individual receiving the loan, and a lack of good information can lead lenders to choose not to serve certain individuals. Therefore, the efficiency of credit allocation must be examined considering these practical realities.
Applying the restricted Pareto efficiency criterion limits the scope for market failure, but still leaves room for a fairly wide range of cases where resources may end up being allocated inefficiently. In Pareto improvement, only the well-being of two individuals involved is considered, but when externalities are taken into account – that is, when a third party is affected by the decision of the other two – a Pareto improvement is not guaranteed. This is because markets operate inefficiently when there are externalities (Greenwald and Stiglitz, 1986), and a government policy that addresses the problems of externalities is important to improve the functioning of the credit market.
- Policy/Program Details
Rural credit markets in developing countries differ 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.
According to the author, the issue of loan repayment enforcement constitutes the central difference between rural credit markets in developing countries and credit markets elsewhere. In this article, the pure problem of "enforcement" is defined as a situation where the loan recipient is able to repay but unwilling to. Most of the credit market models discussed in developing countries do not concern themselves with enforcement and assume that, when projects are sufficiently profitable, loan repayment is guaranteed. This situation can be seen, for example, in debt forgiveness programs, where a government announces that farmers are forgiven their past debts, making loan recipients aware (and confident) that they can default on a loan with impunity, thus leading them to view the loans as donations.
- Assessment Method
The author chose to conduct a conceptual discussion of cases already documented in developing countries and their rural credit market policies.
- Main results
According to the author, there are good reasons to expect market power to develop in credit markets. In a world of imperfect information, those with privileged access to information can gain some market power. 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 can expect a market structure with a few large lenders, each of whom is able to intermediate funds for a large group of borrowers.
However, the author points out that this scenario may not accurately characterize rural areas in developing countries, due to the high costs of obtaining the information needed to operate in many different locations. He emphasizes, however, that experience suggests that these large lenders in rural areas may attempt to leverage their market power (Lamberte and Lim, 1987).
Besley argues that monopoly does not always lead to inefficiency. However, the usual inefficiency of monopoly, where lenders restrict funds to increase their profits, arises only when loan agreements cannot be tailored to each individual. In this case, an argument for intervention can be made. Where direct regulation of interest rates is an option, but informally operating loan sharks can be difficult to regulate, a second option is to reduce the monopoly power of established firms by providing alternative sources of credit.
Thus, one could argue in favor of rural subsidies in credit institutions as an indirect way to reduce market power, but experience has shown that it is very difficult to make such schemes work effectively. Since the ability of loan sharks to collect information and demand repayment is considerable, it should be replaced by an institutional structure that can fulfill these functions equally effectively.
- Lessons in Public Policy
The article studied here presented arguments linking market failures to interventions in rural credit markets. These failures include: implementation difficulties, imperfect information, market power, among others, which were briefly discussed in this text.
Finally, the author points out that where oversight is a problem, governments can intervene by strengthening property rights to increase the effectiveness of the guarantee, even if this does not involve direct intervention in the credit market. However, it should be noted that the government can be both part of and solution to the problem, since 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 off without worsening the situation of another person.
