Cost of Credit – Informal vs. Institutional Credit
According to most development projects, smallholder farmers, such as the family from Central America depicted in the photo, are in urgent need of credit to the degree that providing institutional credit has become a major part of many development projects. While credit may be important, there are many surveys that do not list it as the highest priority for smallholders. Perhaps it is a service the donors feel they can easily provide. Also, farmers, even when offered institutional credit at subsidized interest rates that are typical 20% or less annually, often prefer to utilize informal credit at what appears to be usury interest rates that are usually quoted at 100%/crop season. This rate is nearly universal over most developing countries. However, the repayment is often quoted in-kind rather than in cash which makes the actual interest rate difficult to compute. An example is 5000 Tanzania Schillings (TSh) of credit at land preparation for a standard bag of rice after harvest with an expected value of 10,000 TSh at harvest. However, since the value of the repayment will vary with the normal cyclic price increases with time after harvest, the interest starts at 100% and goes up depending on how long the lender can hold the rice.
The in-kind payment may actually be highly desirable by the lender as an incentive for rapid repayment. Since the number of bags required for repayment will not change even if the value of the bag goes up, it is best for the borrower to make the repayment as soon as possible after harvest. The lender is then responsible for all the post harvest losses from spoilage, grain weevils, rats, etc. In Tanzania approximately 90% of the informal loans were repaid within two months of harvest.
This opens the question in smallholder economic environments: what are the costs of providing informal credit from both the farmer’s and provider’s perspective?
From the informal credit providers’ perspective, what are their administrative costs that might justify the 100% seasonal interest rates? Since it is impossible to raise interest rates once the loan has been offered, the rate has to be quoted at the maximum rate acceptable fully anticipating any games the borrowers might play, and they can play games as rarely do farmers queue up in front of lenders’ homes at the end of the season with their clean bags of grain to repay their loans. The interest rates can always be discounted, if the borrower makes timely repayments without any major hassles. This actually happened about 50% of the time. For the other 50%, what are the costs incurred by informal income providers? A brief study in Tanzania indicated they could be substantial. In the study the providers of informal credit were established members of the community and included neighbors, relatives, and local shop owners. The administrative costs of managing the loans included the need to closely supervise the borrowers’ fields to make sure they were maintained sufficiently to produce enough to repay the loan. When possible and if the repayment history indicted it necessary, the lenders even supervised the harvest to make certain the borrowers made the in-kind repayment. All of this requires time and effort, either by the lenders or someone they hired. These costs have to be recovered from the interest charged.
Also, when the in-kind repayments were made, the bags of rice often contained excessive amounts of straw, chaff, stones, mud, etc. Thus, the bags had to be re-winnowed and as much as 25% of the volume discarded. Bags with this much foreign material would never be accepted by private traders coming into the area after harvest to purchase the crop and thus can only be a deliberate effort on the part of the borrower to reduce the interest rate. The poor quality repayment cost the lender additional money to hire a winnower as well as making an automatic 25% reduction in the interest rate. While the 24% trash is excessive, trash frequently exceeds the 1% allowed by processors and result in some Discounts per Bags to cover the estimated amount of trash and cost to remove it. This could be as much as 10 to 15% the value of the bag.
In addition, the lender has to absorb any defaults and listen to many a sob story as to why payments are delayed. However, no mafia style strong arm tactics were used. Again, all of this represents legitimate costs that have to be recovered from the interest charged and reduce the extent to what appears to be usury rates represent the underlying costs of doing business. It would be interesting to see what would happen to farmers who shortly after harvest voluntarily brought their bags of clean rice to the lender to honor their repayment obligation. Would the lender then give him a discount on the interest? It would be in the lender’s best interest to do so as an encouragement to others. However, since the lender is most likely also a local merchant the discount could also be in-kind such as a bottle of cooking oil, some kerosene, etc. and be somewhat difficult to calculate. In Zambia one informal credit provider for maize production would provide a good client with 10 kg of maize seed for the next crop when a loan was repaid on time and with good quality. Finally, there would also be a small costs to the lender to monetize the grain back to cash and close the circle of cash loan.
In a similar manner, the true cost of providing institutional credit needs to be evaluated if the credit program will be sustainable beyond a specific donor-funded project. This has to take into consideration the same business costs discussed for the informal lender, as well as some of the administrative convenience issues, and possible informal baksheesh sought by the administrators, most likely independent of the donor knowledge. Again in Tanzania the institutional credit provided to farmers for land preparation by the donor project experience the same problems in repayment as the informal credit providers including considerable running around by the cooperative officer to collect individual bags and high level of foreign material contained in the bags used for repayment. In this case the costs of collecting the repayment may actually have equaled or exceeded the value of the loan. If the administrative costs are not covered by their subsidized interest charges, then the credit program becomes more a short term donor give-away than a sustainable effort to assist the smallholder beneficiaries.
There is a real need for a full evaluation of the forms of credit available to smallholders with full appreciation for the contributions of the informal credit system. To what degree is the “usury” interest rates reflecting the availability of money vs. the administrative cost of administering the loans.
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