EXORBITANAT RURAL INTEREST RATES

AND ITS CONSEQUENCES

INTRODUCTION
1. The English during their rule followed a double edged strategy of
procuring raw materials from India and at the same time using the
Indian markets to sell their finished products.
2. This resulted in a steady decline of the indigenous Industries, and India
was reduced to a primarily agricultural economy.
3. The exploitative Zamindars were mainly interested in the cast crops,
and thus, there was a sharp decline in the production of food grains.
4. The end result was the occurrence of large scale famines.
5. Hence, when India gained independence, in the first five year plan
(1951-56), highest priority was given to agriculture, building of public
infrastructure and reduction of inflation, with minimal attention
towards savings and consequentially to capital accumulation.
6. However, the second five year plan was primarily constructed by Prof.
PC Mohalanobis, who emphasized that, to ensure steady growth of the
economy, it was essential to devote a major part of the total
investment in building of heavy industries, that is, capital goods
manufacturing industries.
**A brief discussion of the Feldman Mohalanobis Model**
Hence, the primary takeaway from this discussion is, during this initial
period following Indias independence, the agricultural sector received a
lower proportion of investment, and this resulted in its relative
backwardness with respect to the industrial sector. Thus, the agricultural
sector, even today faces a host of problems such as lack of innovation,
low levels of savings, and the abnormally high interest rates in the rural
sector.
ABSTRACT
In this paper, I discuss a few potential issues resulting in the third
problem.
The most popular and perhaps simplistic explanation is the one of the
monopolization of the rural credit market. The formation of said
monopolies can be explained as follows:
The typical rural worker does not earn enough, to save any significant
amount. Hence, the only savers in the rural economy are the land-owners,
and are the only ones who can extend loans.
The second possible explanation as provided by Kaushik Basu in his 1983
paper, is the inter-linkage of various markets in the rural economy.
Thirdly, market fragmentation is another approach, which is perhaps a
more sophisticated version of the monopoly approach. The essence of this
explanation is basically the lenders risk hypothesis. That is, given a
situation, where the landlord lends to a worker, there is always a chance
of the worker defaulting on his loan. This incentivizes the moneylender to
lend only to a certain group of workers (such as the ones who work for
him, since he can easily withhold wage payment in the event of a default).
Here it is additionally assumed that workers cannot migrate from one
employer to another, which is often the case in realty.
Following the explanations of exorbitant interest rates in the rural sector, I
then discuss some of the consequences of the inaccessibility of credit, to
the overall economy. I further describe some of the policies implemented
by the government in the recent and distant past (JAM trinity for example)
and briefly evaluate the success of a few of them.
Finally, I provide some remedies of my own which would hopefully
increase the supply of institutional credit, thereby eliminating the need for
these local money-lenders.
WHY THE EXORBITANT RATES?
The Monopoly explanation:
The formation of monopolies in the rural credit market is best explained,
by the existence of personalized relations between the lender and
borrower. That is, the lender has an intimate knowledge of the economic
conditions of the worker. It is therefore very difficult for potential
competitors to break into a local money market if he comes from another
district.., as explains in his 1964 paper.
Formalization:
Firstly, we assume that the borrower is a price taker and can get a loan
only from one lender, namely the landlord. Suppose the inverse loan
demand function is given by,

i=i ( L ) , i' ( L )< 0

Where L is the amount of credit and i is the interest rate.

Since, personalized relations exist, the risk of default is assumed away.

Now suppose there exists a institutional interest rate r. The last
assumption for the purpose of illustration is that, the borrower himself
borrows at the institutional rate r and then lends to the workers at the
rate i. Now, the landlords objective function is given by,
max Li ( l )Lr

Where L is the choice variable. The FOC of maximization yields,

r=i ( L )+ i' (L) L

This condition can simply be interpreted as follows. The LHS is the

marginal cost of lending, since the landlord borrows at the rate r. The RHS
is the extra revenue of lending one more unit. Hence, the optimum
amount of lending as shown by the FOC is where the marginal revenue
and costs equalize.

We have shown in the above diagram, interest rate offered to the worker
is significantly higher than the institutional rate r.
** Emperical evidence from RBI 1977**

Inter-linkage explanation:
In this model, Basu explains that one reason of high rural interest rates.
This is because the distinction between the various markets is often thin
or even non-existent in some cases. For example, a landless agricultural
laborer, who is looking for a credit for say buying a piece of land, can get
access to it only though the local landlord. The interesting thing to note
here is, that often this landlord is the same one, for whom this landless
laborer works. This is an example of inter-linkage of the credit and the
labor market.
In such a situation, as described above, the landlord offers the laborer, a
package which consists of a vector (w,i), where, w is the wage rate offered
to the worker and I is the interest rate which he needs to pay.
**Formalization**
SUCCESS OF GOVERNMENT POLICIES:
** Sarap 1991, JAM empirical evidence**