Responsible Researcher: Viviane Pires Ribeiro
Paper Title: Borrowing costs and the demand for rural credit
Authors: DW Adams and G.I. Nehman
Location of the Intervention: Bangladesh, Brazil and Colombia
Sample Size: Not specified
Main theme: Finances
Main Variable of Interest: Rural credit
Type of InterventionAnalysis of empirical information
Methodology: Bibliographic research
Given the continued underutilization of credit among a significant portion of the low-income rural population, Adams and Nehman (1979) argue that in developing countries, the high costs of borrowing discourage many rural residents from using formal loans. Borrowing costs are defined as nominal interest payments, plus transaction costs of the loan, plus changes in the purchasing power of the borrowed monetary value. Farm-level data from Bangladesh, Brazil, and Colombia are presented to show that small borrowers incur substantially higher borrowing costs on formal loans than large borrowers.
Evaluation 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, along with various development agencies, have also attempted to direct a considerable portion of these additional funds to the low-income rural population. However, in many countries, cases have been identified indicating that while the increased supply of credit has supported increased production, it is becoming increasingly evident that relatively little of the additional lending funds has actually gone to the low-income rural population.
At least three explanations have been given for the continued underutilization of credit 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 lack opportunities for profitable investments, are unaware 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 previously given for the continued underutilization of credit among the majority of the low-income rural population are at least partially valid in many developing countries. Thus, the authors propose a fourth explanation, not previously discussed in the literature. This explanation focuses on the differences in borrowing costs between various types of formal borrowers. That is, the authors argue that these differential borrowing costs strongly affect the willingness of the low-income rural population to seek loans from formal lenders. To this end, the authors rely on data from several developing countries to support this argument.
Methodology Details
Most credit demand analyses 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 “credit price” would be the actual net cost incurred by the borrower in acquiring the loan. Borrowing costs can include three separate elements: nominal interest payments made to the lender (NI); additional transaction costs of the loan incurred by the borrower (TC); and changes in the purchasing power of money 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 have a close relationship with recent changes in the purchasing power of money experienced by potential borrowers. The expected cost of borrowing (BC*) used by the potential borrower in making loan demand decisions is equal to NI + TC – AP*. It is unlikely that many potential rural borrowers in developing countries will ignore TC and AP* when making loan demand decisions.
For analysis, Adams and Nehman (1979) argue that small-amount borrowers and individuals lacking borrowing experience may incur relatively large transaction costs to secure a loan. At least three types of transaction costs may be involved. These include: (i) loan charges levied by the lender in addition to interest payments, through application fees, forced purchase of other services, service fees, bribes, offsetting 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 considered; and (iii) in many cases, the largest and most significant 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 multiple times to negotiate the loan, withdraw portions of the loan, and make payments.
Results
Adams and Nehman (1979) highlight the difficulty they had in documenting the relative importance of borrower transaction costs and expected changes in the purchasing power of money in loan demand decisions. The authors did not identify any research reporting how expected changes in purchasing power affect borrowing decisions in rural areas. Surprisingly, there were also few farm-level studies documenting borrower transaction costs. Thus, the authors identified only three studies addressing this issue: one in Bangladesh, one 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 borrower transaction costs.
The three studies report on borrowing costs primarily among farmers who had prior experience with formal loans. It can be expected that an individual who has not previously borrowed from a formal lender will face higher transaction costs compared to an established borrower. Furthermore, not all formal loan applicants receive a formal loan. Many of these unsuccessful applicants 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 can be increased by these rejection possibilities. These rejection costs can be quite relevant if the probability of approval for a new formal loan application is relatively low.
Lessons in Public Policy
The limited scope of the empirical information presented in the article restricts the policy recommendations that can be made. Thus, Adams and Nehman (1979) argue that the most important conclusion of the study is that transaction costs of borrowing above and beyond nominal interest payments can be an important factor in discouraging small and new borrowers from using formal loans. These transaction costs of borrowing 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 political implications of the key differences between the various classes of borrowers on the importance of the various elements of borrowing costs are quite evident. Adjustments in nominal interest rates will have a direct and weak effect on borrowing costs and the demand for loans from small and new borrowers. Changes in loan transaction costs can have a much more significant impact on their borrowing decisions. At the same time, the 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 inhabitants as possible through formal loans, borrower transaction costs must be reduced. Since opportunity costs and travel expenses are relatively high for small borrowers, initial attention can be directed towards 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 to keep unprofitable business away from the bank.
The challenges 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 from some formal lenders to solve these problems. Loan repayment performance for rural populations must be improved, lender transaction costs for small amounts must be reduced, and lender revenue from small loans must be increased. Some policies, especially those related to interest rates, must be adjusted to make small loans to low-income rural populations 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, this may be impossible if governments insist on adopting low-interest rate policies for rural populations.
References
ADAMS, Dale W.; NEHMAN, Gerald I. Borrowing costs and the demand for rural credit. The Journal of Development Studies, v. 15, no. 2, p. 165-176, 1979.
