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1.2 The Subsidized Agricultural Credit Paradigm

In the 1960s to 1980s, old-paradigm, subsidized, directed agricultural credit programs were common in top-down government and donor policies and programs. Unfortunately, attempts to resolve supposed market failure often ended up as government failure.[1] Thus a new financial systems paradigm emerged that contributed to the development of microfinance.[2]

Although there were important exceptions, the old paradigm as employed in many countries had several common features. At the national level, it was believed that economic growth would be accelerated by imposing lending targets on financial institutions and providing incentives for rural branching. At the farm level, the strategy was implemented without careful analysis of the real causes of the supposed credit market failures. Interventions were often considered necessary to induce commercial lenders to supply credit for farmers to adopt GreenRevolution production packages, and artificially low interest rates were justified to accelerate adoption. Credit was often targeted to meet food production targets, specialized agricultural development banks and cooperatives were created to deliver loans, interest rates were usually subsidized, and one-size-fits-all credit models were commonly used for lending.

With some exceptions, this paradigm largely failed to meet expectations and there were many unexpected consequences. Increases in lending contributed to some short-term increases in food supplies, but did not lead to sustainable credit supplies. Low interest rates crowded out commercial banks,[3] stimulated excess demand for loans and induced credit rationing that tended to favor richer and politically powerful farmers.[4] High-borrower transaction costs coupled with long delays in credit delivery reduced the advantage of formal loans for farmers relative to informal sources. A combination of low operating margins and poor loan recovery undermined financial institutions; some failed while others required repeated recapitalizations. A bad debt culture developed among borrowers, especially when loans were perceived as coming from the government. Government failure occurred because directed credit failed to resolve the basic screening, incentive, and enforcement problems of rural lending (Hoff and Stiglitz, 1990).

  • [1] Market failure describes the condition where the allocation of goods and services by a free market is not efficient while government failure occurs when government intervention causes an inefficient allocation of goods and services.
  • [2] Some of the most comprehensive and accessible publications of the vast literature discussing this evolution include Von Pischke et al. (1983); Adams, et al. (1984); World Bank (1989); Yaron et al, (1997); Conning and Udry (2007). A recent study of the impacts of subsidized credit policies concerns China (Jia, Heidhues and Zeller, 2010).
  • [3] See Vogel (2005) for a description of crowding out of commercial banks by the Banco Agrario del Peru.
  • [4] Gonzalez (1984) explained this as a logical outcome of the Iron Law of Interest-Rate Restrictions.
 
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