Indigenous Institutions, Benevolent Intervention and Justice

Contemporary Issues and Ideas in Social Sciences

June 2010

Indigenous Institutions, Benevolent Intervention and

Justice: The Case of Rural Credit Markets in India

Naresh Kumar Sharma1

Abstract

The rural credit markets in poor economies have presented many puzzling

features. Traditionally, indigenous credit institutions relied primarily on

the private moneylenders resulting in evolution of various indigenous credit

systems. However, over past hundred and fifty years and more, rural lenders

and corresponding credit institutions have been viewed suspiciously. Hence

[benevolent] government intervention was considered particularly desirable

for the benefit of the poor and disadvantaged. However, the few studies

that did look at the question of cost of private rural credit did discover

the disturbing and rather paradoxical phenomenon of rise in cost of private

credit with increasing presence of institutional finance. This paper takes a

close look at the rupture of indigenous institutions, often through benevolent

government intervention, and its consequences for the economy and society

in general and for the poor and disadvantaged in particular, through study of

the particular case of rural credit. It draws upon the author’s in-depth study

of credit market in a village in India. The credit market is highly fragmented

and ”regressive” in nature. Some of traditional credit systems continue to

1Address for correspondence: Centre for Gandhian Economic Thought & Depart-

ment of Economics, University of Hyderabad, Hyderabad - 500 046 (INDIA). Email:

[email protected]

exist with practically no change. There are implicit subjective costs as well

as subjective benefits to the lending business; and mostly subjective costs

arising out of act of borrowing (in addition to explicit objective costs). There

is substantial perceived increase in the risk of default on private (source)

loans, after great surge in institutional rural finance.

There is also a political economy dimension to this phenomenon. Intro-

duction of institutional finance, benefiting mostly the better-off and powerful

sections of the village society, itself is governed by local political economy.

The higher cost of institutional credit faced by the poor is not a matter

simply of corruption, but also of alliances between the local elite and the

functionaries of financial institutions. This nexus is not incidental. In addi-

tion, the same phenomenon further accentuates power relation between the

same powerful (usually) lenders, and now residual, mostly poor borrowers.

The study calls for a fresh look at the role of village lenders in the rural

economy. First, it facilitates a more open approach to understanding the

functioning of village lending systems in history afresh with an unpreju-

diced eye which can help in devising and developing better functioning rural

credit institutions today; second, it calls for giving due recognition to the

inherent strengths of the village lenders; third, it implies consideration of

a much greater role for village lenders in the rural economy. Formal insti-

tutions and village lenders can be complementary rather than competitors

as perceived till now. It is important to realize that there are substantial

transactions costs involved in lending by formal institutions. Leaving actual

lending mostly to the village lenders, and confining the public institutions

to basically a refinance function will help in all round cost reductions.

Keywords: Institutions, Rural Credit Markets, Development.

JEL Classification: D82, N25, O16, O17.

2

Sharma: Indigenous Institutions, Benevolent Intervention and Justice 3

1 The Prologue

The greatest story-teller and novelist of modern Hindi, Munshi Premchand

wrote a story, “Sava Ser Gehun” (A seer and quarter of wheat) sometime

during the first quarter of twentieth century. The story most graphically

depicted the pathetic economic condition of the ordinary cultivator and at

the same time illustrated the greed and ruthlessness of the “moneylender”.

A poor cultivator borrows from the village moneylender (the mahajan) a seer

and a quarter of wheat to entertain a guest to his household. Considering

the loan to be too insignificant, he returns much more grain at subsequent

harvest and also on several other occasions as gift to the mahajan, thus

believing himself to be free from that debt. Several years pass, when one

day the mahajan confronts the peasant, with proper records and all, about

repayment of loan, now grown to several maunds. The peasant ends up as

a bonded labour to the mahajan.

The above story provides the long enduring legend of the village mon-

eylender, which of course was not born from that story. Thus, Wolff (1919)

says, “It is usury - the rankest, most extortionate, most merciless usury -

which eats the marrow out of the bones of raiyat [the peasant] and condemns

him to a life of penury and slavery in which not only is economic production

hopeless, but in which also energy and will become paralysed and man sinks

down beaten into a state of resigned fatalism from which hope is shut out

and in which life drags on wearily and unprofitably as if with no object in

view.” (Quoted in Ghatak: 1976, pp.70-1).

Prior to that the Famine Commission (1880) depicted equally stark pic-

ture of the poor agriculturist, “Being too ignorant to keep accounts, he [the

agriculturist] was content to leave all such matters with the village banker,

who supplied him with food and other necessaries in the months before the

harvest, and took over the greater part of the crops in repayment of these

advances with interest.” (Appendix: p.162, emphasis added). The contrib-

utors to the Famine Commission Report also suggested the remedy, namely

the establishment of agricultural banks “One of the greatest advantages

4 CIISS June 2010

consequent on the establishment of such banks will be that money-lenders

will necessarily lower their rates, and the cause of the cultivators’ grievance,

the exaction of high rates of interest by the money-lenders, will be removed

without difficulty.” (Appendix I: p.195, emphasis added).

Though efforts were made during the British rule to address the problem

of “usurious” money-lenders, the policies on the lines suggested above were

more vigorously pursued after India attained Independence. Expansion of

institutional credit to rural areas was considered essential for releasing pro-

ductive potential in agriculture and allied areas together with relieving the

poor peasant from misery of carrying the money-lender’s yoke.

The main purpose of this paper is to investigate the results of public

intervention in the rural credit markets through establishment and expansion

of institutional finance in rural areas particularly for the rural poor about

fifty years down the line.

The approach of the study is to take cognizance of institutions tradi-

tionally existing in the village society - which may be viewed as indigenous

institutions - that are integral to not only social functionality of the soci-

ety but also to the economic organisation of productive activities. In this

set up the Government benevolently intervenes as an “outsider” to the vil-

lage society, for ameliorating the problem referred to above. It will be seen

that short-circuiting of the local economy and polity results in the benefits

getting misdirected and justice actually getting vitiated rather than being

established. (See Sharma, 1994a, p.96).

2 The setting and the problem

In this study, we draw heavily from our investigations into functioning

of the credit market in Palanpur, a medium size village in western part of

Uttar Pradesh2. Though there is plethora of theoretical models of rural

2See Dreze, Lanjouw and Sharma (1998), Sharma (1989) and Sharma (1994b), Chapter

8 for a detailed study of various aspects of credit market in Palanpur. This paper, drawing

upon these studies, presents much new analysis.


credit markets in developing countries, careful empirical investigations are

few and far between. In this context, Palanpur provides almost a unique

opportunity for the study on hand. First, useful and reliable information

on various aspects of the Palanpur economy is available over a fairly long

period of nearly half a century, covered in five extensive and intensive village

surveys, roughly at ten year intervals. Second, the quality of data and

completeness of information on a sensitive subject such as credit, are of very

high order. The present author (along with several other researchers) was a

field investigator as well in two of the five investigations referred to above,

and stayed in the village continuously for over one year and subsequently

paid frequent visits to the village over the next two decades. Indeed, it is

almost impossible to find micro studies covering change in credit market

over time - almost all of them being one shot studies. Third, the study is

on the census basis, and thus covers all households in the village. Fourth,

this is one of very few investigations that studies rural lenders also in some

detail.

The institutional credit was introduced in Palanpur in a significant way

in early nineteen fifties in the form of a Farmers’ Cooperative Service Society,

though even prior to that a highly specialized public lending institution, Seed

Store, existed in the village having been established in 1942. Institutional

credit expanded rapidly in the village (subsequently a few other public credit

institutions started operating in the village, including banks), and share of

credit from all private sources reduced significantly. However, contrary to

the expectations voiced so eloquently in the Report of the Famine Commis-

sion (1880), the cost of private interest bearing loans has been increasing

all through. This is particularly worrisome, as the poor are especially ad-

versely affected since they depend much more on the private credit and have

relatively poor access to the institutional finance for myriad reasons.

Hoff and Stiglitz (1998) provide interesting models of rural money lend-

ing to show that institutional intervention in credit market in the form of

subsidies may perversely result in increased cost of private credit. The pa-

6 CIISS June 2010

per, apparently inspired by findings of Aleem (1990), on which it banks

heavily for empirical support, presents a model of monopolistic competition

in presence of imperfect and asymmetric information involving substantial

transaction costs. Though the model seems to provide an explanation to

the phenomena observed in Palanpur, as enunciated above, we shall show

that evidence of Palanpur does not support situations abstracted in Hoff-

Stiglitz model - indeed, there is hardly any empirical evidence from available

empirical studies to support it.

Aleem (1990), through a careful study of rural credit market in Sind

province of Pakistan, shows that the credit market is almost a textbook

example of a Chamberlinian monopolistic competition. Taking off from this

result, Hoff and Stiglitz (1998) construct three models wherein under mo-

nopolistic competition, with product differentiation, imperfect information

and arbitrage, an increase in government subsidy in the credit market leads

to increase in the interest rates of private lending. This is shown as a result of

increase in marginal costs, consequent upon new entry and hence shrinking

of market for individual moneylender (in presence of scale economies) or as

a result of enforcement externalities (increasing informational requirements

and enforcement costs).3

Aleem’s (1990) study, itself being a snap shot does not investigate changes

in private credit costs consequent upon government subsidy increases. How-

ever, it brings out many remarkable features of that credit market, not

generally shared by other studies that may be briefly recapitulated here for

future reference. First, lenders from the market town dominate credit mar-

ket in the surrounding rural areas. Second there is a significant amount of

arbitrage between institutional finance on the one hand and lending to the

3Though of limited usefulness in explaining increase in private lending rate concomitant

with expansion of institutional credit – often ostensibly subsidized – the model is of some

general interest as well. Considering figure 2 of their paper, downward shift of the average

cost curve must lead both to increase in competition in the market due to fresh entry and

an increase in price at the same time under monopolistic competition for any product,

implying that entry prevention is favourable to consumers.


farmers on the other. Third, there is excess/abundant supply of credit.4

3 Main common features of rural credit markets

It may be useful to recapitulate some important features of Palanpur

credit market, many of which are quite widely reported in other studies.

One, there is conspicuous sparseness of professional money-lenders.5 Two,

the fragmented and distributively regressive nature of credit market has been

widely reported.6 Three, there is significant private lending, which is interest

free. Four, private lending is mostly from own funds.7 Five, agriculturists/

cultivators constitute one of the most important private sources of rural

credit.8 Six, there is a tendency for the formation of standard terms (this

is even more so for labour and tenancy markets). Seven, there is credit

rationing in each segment of credit market. Eight, almost all village lending

is without collateral basically on trust.

4 Trends in the volume of debt owed to different

credit sources

Total volume of credit grew substantially between 1957 and 19849. At

4It may be mentioned here that the credit market under that study also shares some

commonly observed features such as: lending mostly on personal security; credit market

fragmentation; lending is mostly by non-specialized lenders; and also interlinking of loan

and commodity markets (the claim about the last aspect above being a common feature in

developing areas is somewhat exaggerated with rather thin empirical evidence to support

it. See Dreze, Lanjouw and Sharma, 1998, p.574, fn. 77).5See, Ghatak (1976, p.13) for evidence.6See Dreze, Lanjouw and Sharma (1998), for references cited in fn. 74 p.572 and text

on the same page for a discussion of distributionally regressive impact of public lending

institutions.7Ghatak (1976), Bottomley (1975), Platteau et al (1980),8RBI (1954), p.311,9For the purpose of analysis in this paper, the 1984 debt and credit survey is used,

it being much more comprehensive compared to later quick surveys (excluding the latest

round of the survey underway for the past two years, which is very comprehensive but still

8 CIISS June 2010

the same time, institutional debt in the total village debt has grown even

more rapidly to claim a very large share of total debt. (See Table 1 below).

It was little over one third of total debt in 1957, and became about two thirds

by 1974-5 and had grown to become nearly 80 percent of total outstanding

debt by 1983-4.

Table 1: Growth of Credit in Palanpur (at current prices)

Year Institutional

Debt

Private Debt Total Outstand-

ing Debt

1957 7,322 (35.5) 13,158 (64.5) 20,480 (100)

1974-5 60,801 (64.1) 24,000 (35.9) 94,801 (100)

1983-4 339,607 (79.0) 90,256 (21.0) 429,863 (100)

Source: Sharma (1989) p.32.

Expansion of institutional credit is a widely shared phenomenon in India.

(See Subba Rao et al, 1997, pp.543-4). This information is summarized

below in Table 2 for period between 1951 and 1981. It can be seen that

share of institutions in household debt increases from 7.1 percent in 1951

continuously to 61.2 percent of total debt in 1981. At the same time, as

pointed by Binswanger and Khandker (1989, p.33), debt to equity ratio has

surprisingly declined between 1951 and 1981 from already a low 5.9 percent

to still lower 1.8 percent. This information is also included in Table 2. This

result appears to be a combined effect of Indian cultivators’ preference for

utilizing own funds to the extent possible together with a sluggish and rigid

supply of loans.

Table 2: Change in Household Debt over Years (%)

at an early stage of compilation of data). The purpose being to understand the process of

formal institutional intervention and its consequences, this period (1957 to 1984) is also

quite appropriate as being one of fairly significant rise in the institutional finance.


Year Institutional

Debt

Private Debt Total Out-

standing

Debt

Cash debt

to equity

ratio

1951 7.1 92.9 100 5.9

1961 14.8 85.1 100 7.1

1971 29.2 70.8 100 4.0

1981 61.2 38.8 100 1.8

Source:(1) K. G. K. Subba Rao, K. S. Ramachandra Rao and A. K. Tripathi

(1997), pp.543-4 (columns 2 to 4).

(2) Binswanger and Khandker (1989), p.33 (column 5).

RBI (1962) also reports a preponderance of agriculturist money-lenders

among suppliers of credit in its study of nine districts in various parts of

India in 1950s, professional money-lenders had relatively minor role except

in some pockets (e.g. Barmer district of Rajasthan), and all institutional

sources accounted for equally small proportion. (See RBI, 1962, p.30, Table

3.9).

5 Trends in private credit costs

There is normally some spread in the rate of interest charged by private

lenders of cash, in contrast to loans in kind, which have relatively standard-

ized terms. Even so, it is possible to identify currently going rate of interest

at any given time, (except at times of transition). The rate of interest on

loans from private sources was predominantly 24 percent in 1957 (interest

rates are in fact normally specified in monthly terms by the private lenders

and they are simple rates of interest). It went up to rule between 24 and

36 percent in 1974-5, and in 1983-4 the emerging rate of interest was 60

percent, a rate that was firmly established in subsequent years. Even af-

ter accounting for different rates of inflation in these periods, there is no

mistaking the substantial increase in the cost of credit from private sources.

This rise in cost of private credit squarely coincides with substantial

10 CIISS June 2010

increase in institutional outstanding debt - both in relative as well as in

absolute terms.

We have been unable to discover many studies covering similar aspects

because most other studies on credit are one time investigations. One ex-

ception is Swaminathan (1990) who furnishes the evidence on change in

Gokilapuram between 1977 and 1985 (a period of rapid expansion of insti-

tutional credit), that “contradicts the widely held view that the expansion

of formal banking system, and improvements in agricultural production,

lead to a reduction in the rates of interest charged in the informal sector.”

(pp.8-9) Corroborating evidence, though of different nature, on linkage be-

tween expansion of formal credit and rise in interest rates in the informal

credit market, is available from Swaminathan (1990) study quoted above as

well as in Bhende (1986). In both cases, it is found that in a comparison

between different types of villages (which are even geographically quite far

apart from each other), it is found that rate of interest on private loans is

much higher in those villages in which institutional finance has much larger

presence. (See Swaminathan, 1990, p.46 and Bhende, 1986, p. A-123).

Increase in costs of informal credit from village lenders together with

expansion of institutional finance in rural areas appears to find much wider

support across India as can be inferred from a number of sources. Subba

Rao et al (1997) provide information on average interest rates and share

of institutional agencies in total debt for 1971 and 1981 (p.546). Average

interest rates across all households came down from 16.3 percent to 14.2

percent when ’nil’ rate of interest is included and from 17.6 percent to 16.0

percent if ’nil’ interest rate is excluded. Over the same period the share of

debt from institutional agencies went up from 29.2 percent to 61.2 percent.

Keeping in mind that recorded rate of interest on institutional finance is

rather low, it does not require a great deal of computational ability to infer

that average interest rates charged on private debt must have substantially

increased (it can be easily computed, if data on average interest rate on debt


to institutions is available).10

In 1950s, debts with interest rates above 25% accounted for not much

more than 10% of total debts as per RBI (1972). According to RBI (1954,

p.321), “Of the total borrowings from agriculturist moneylenders, borrow-

ings at rates varying between 18 to 25 percent accounted for substantial

proportions in western Uttar Pradesh, Punjab-PEPSU and Madhya Bharat,

and Western Madhya Pradesh regions. In most of the southern regions a rel-

atively small proportion of total borrowings from agriculturist moneylenders

was at rates exceeding 18 per cent.”

In contrast, 5 percent per month appears to be widely reported rate

of interest in various part of India for the past couple of decades (this is

based mostly on non-systematic evidence as gleaned from newspaper reports,

generally reported whenever peasant distress surfaces).

Thus, benevolent intervention by the government, for the benefit of small

farmers and to free them from the clutches of usurious local moneylenders

(and in the interests of increasing productive potential constrained by capital

requirements), has paradoxically resulted in the very opposite consequences

as far as cost of credit to poor, marginalized small farmers is concerned.11

6 Discussion

It was contended earlier that Hoff-Stiglitz (1998) theory does not provide

adequate or suitable explanation for this phenomenon. The characteristic

features of credit market (See section 3 above), which are widely shared

among other studies, invalidate the basic premise of that theory. There is

very little arbitrage between institutional finance and private money lend-

10Assuming average interest rate of 10% for institutional finance gives 21% average

private interest rate for 1971 and 26 % for 1981; assuming average institutional interest

rate to be 8 % gives average private interest rate figures of 22% and 29% respectively for

1971 and 1981.11A second objective of providing institutional finance was related to enhancing the

productive potential and it has, no doubt, met more favourable results. But this is not

our focus in this paper.

12 CIISS June 2010

ing. This can be precluded as a regular feature on account of procedures and

conditions for obtaining institutional finance. Most of borrowers are credit

rationed, and there is no over supply of credit or even of money lenders.12

The most serious objection to Hoff-Stiglitz theory is on its kingpin, namely

the exacting informational requirements for successful private money lend-

ing.

If any agent has informational advantages in a village economy, then it

is the resident economic agent, which a village lender most surely is.13 The

economic circumstances of village households are fairly well known at a gen-

eral level, across the village (in small or medium size villages like Palanpur,

and in the locality in larger villages). Assumptions on high information costs

are thus untenable.14

Table 3: Distribution of Households by Number of Loan Partners

12Though there may appear to be many potential moneylenders from within the village,

given high potential returns on such ’investment’, and that many better off villagers can

’spare’ money, this does not actually happen due to skills required for money-lending. See

Dreze, Lanjouw and Sharma (1998, section 5.1) for a detailed discussion on the subject.13As far as asymmetry of information between the borrower and lender is concerned,

this follows from the peculiar nature of credit market - transaction is completed not at a

point of time but by nature, over a period of time. Private village lender is not particularly

disadvantaged in this aspect vis–vis institutional lender.14The following passage from Timberg and Aiyer (1980, p.290) colourfully captures this

feature of informal credit markets, “The borrowers in the informal market are ’known’

parties, under continuous surveillance in the closely packed lanes of urban wholesale mar-

kets. Each bale of cloth that comes in or out is observed by neighbours, the finance brokers

among them; an expensive night on the town is reported and judged the next morning

in the market gossip. In contrast to the relatively anonymous world of the Western busi-

nessmen, even in the larger metropolitan centres, Indian businessmen live their lives in a

narrow social ambit. Most of the brokers interviewed seemed incredulous that they would

have to ask formal questions of borrowers whose shops they visited each day, and with

whose business confreres they were in continual contact.” This pertains to urban informal

credit markets. It is so much more true of a more closely interwoven village society.


Number of loan

partners

Households that

borrow from num-

ber of lenders as

in column (1)

Households that

lend to number of

borrowers as in

column (1)

1 36 19

2 31 8

3 18 2

4 13 2

5 5 -

6 2 -

7 1 2

8 1 1

11 - 1

12 - 1

19 - 1

21 - 1

Sub-total 107 38

Zero partners 36 105

Total 143 143

Source: Sharma (1989), p.53, Table 9.

Further, the private credit market is not dominated by a single or even a

small number of lenders. Out of a total 143 village households, as many as

38 households provided a lender.15 There is also striking fact that twice as

many borrowers (71 households) borrowed from more than one source than

those (36 households) that borrowed from a single source. (See Sharma,

1989, p.53). Distribution of households by number of loan partners is given

in Table 3 above.

15This dispersed nature of set of private lenders is noted by Aleem (1990), Maloney and

Ahmed (1988), and even more strikingly by Platteau et al (1980), the last in a situation

of fishing villages.

14 CIISS June 2010

Thus, any adequate explanation of this phenomenon requires a closer

look at the characteristic features of both informal and formal credit mar-

kets, their inter-relationships, and the real nature of intervention introduced

in the existing indigenous credit market institutions. Though deeply in-

grained is the image of a lender to be that of necessarily an evil villain of

the piece exercising extortionate lending practices, the reality has been far

more complex. It is slowly being recognized that the stereotype picture of

local lender has led to a distorted understanding of rural market function-

ing.16 Bouman (1989, p.8) very perceptively points out that the new interest

in the informal finance is emerging due to negative experience with formal

rural credit programmes. Further, “[t]his new interest in the informal fi-

nancial sector revolves, in principle, around the potential role of informal

intermediaries in the mobilization of savings on behalf of formal insti-

tutions.” (Bouman, 1989, p.9, bold italics emphasis added, ordinary italics

in the original).

It must be understood that village lenders and their clients interact with

each other as persons, as members of the same local society, unlike bor-

rower relation with institutional lenders, which is quite impersonal. Village

lenders too normally work within local institutional framework of their so-

ciety. Intervention from outside (i.e. not requisitioned by any significant

section of the local society) - for better or for worse - disturbs this existing

institutional framework and often also alters power balance, and also feasi-

bility and economic viability of a range of actions and activities, resulting in

16See Maloney and Ahmed (1988, p.44), “Informal loans are often not so exploitative

as some people imagine.” Also, Bouman (1989). However, others continue to hold that

”informal credit markets are synonymous with exploitation (charging exorbitant rates of

interest being one form of exploitation),..” (Gill, 1996, p.587, emphasis added). Indeed, it

only reflects a lack of understanding of reality of rural markets to argue that 50 percent

interest in kind over a crop season is usurious (Bhaduri, 1973), whereas villagers themselves

find such credit to be particularly soft. See also Ghatak (1976, p.102). Bottomley (1975)

not only questions the stylized fact of village moneylenders being exploitative, but also

even contends that at low lending volumes and low income levels, the village moneylenders

may be able to operate more efficiently than public agencies.


altered costs of many pre-existing activities, leading to reduction and aban-

donment of some of them and emergence of several new activities. In this

there are winners and losers.

Two most important aspects of rural credit market as apparent from

study of Palanpur which are relevant for the present purpose are sharp

fragmentation and segmentation of credit market, particularly after the in-

troduction of institutional finance, and substantial hidden costs of institu-

tional credit. Thus, not just the segmentation of credit market characterizes

regressive nature of the village credit market structure (whereby better off

households have access to cheaper institutional finance, whereas poorer, and

socially disadvantaged households have to basically depend on the expen-

sive village lenders), but also regressive nature of credit from institutions

themselves: poorer borrowers on average face higher costs of finance from

lending institutions than the prosperous borrowers on account of collusion

between the latter and institution officials, corruption, lending procedures

etc.17

Two important problems of rural credit delivery system (of institu-

tional finance) are high transaction costs and poor repayment performance.

Though attention has been drawn to the supposed high transactions costs of

administering informal credit, much less thought has been given to the prob-

lem of transaction costs of institutional rural finance. In contrast, tendency

for main contracts in any of the rural markets getting standardized helps

in substantially reducing transactions costs for the within village contract

17Bhende (1983, p.2) remarks, “while the traditional money lending has some in-

equitable features, it appears to be at least as effective in terms of volume of lending

as the official agencies. Furthermore, official agencies may introduce at least as much

or more inequity into the distribution of credit than moneylenders.” (emphasis added).

See also Sharmistha Deb, Meenakshi Rajeev (2007, p.280) on shying away of institutions

from providing credit to the poor. Interestingly, they also provide evidence that transac-

tions costs of obtaining loans are significantly higher for the poor borrowers than for rich

borrowers. So, it is not just the banks and other formal financial institutions that incur

higher transactions costs in dealing with small borrowers but these borrowers too suffer

from similarly high transactions costs.

16 CIISS June 2010

partners.

The following observations are useful in understanding the rise in the

cost of private credit. With increasing adoption of new technologies, capital

requirements in agriculture have enormously increased. In Palanpur non-

labour inputs constituted only about 6 percent of gross output in 1957-8,

this increased to 33 percent in 1983-4.18 Thus, there is large increase in

demand for capital. Second, though institutions account for 80 per cent of

accumulated debt, their share in fresh borrowings is much more modest -

indeed all institutions together account for less than half of fresh amount lent

in 1983-4 (see Sharma, 1989, p.51, Table 7). Thus, private sources remain

a major presence in supplying fresh loans. It is an important indicator that

even with increasing indebtedness to formal lending institutions, villagers

have to often turn to the local lenders for obtaining credit for their current

needs, an important factor in understanding dynamics of market for current

loans, which is relevant for determination of price of credit.

Third and relatedly, the accumulated debt19 and inherited debt creates

barrier to fresh borrowing from any of lending institutions. Fourth, many

borrowers are reluctant to approach lending institutions for the fear of being

cheated. These are inevitably poorer and less powerful among the village

households. Fifth, institutions are rigid, bureaucratic, rule and procedure

oriented and lack flexibility and quickness exhibited by the village lenders,

who lend without any formalities, for any purpose and without demanding

any collateral basically on personal security, and trust.20 Sixth, the only

18These input costs exclude labour, land tax, interest on capital, depreciation etc. Fur-

ther, no value is given to managerial inputs, time spent in chasing offices, attending to

markets etc.19Kahlon (1991) claims that it is defective loan policies, that provide for inadequate

credit, are responsible for large accumulated debts. This happens since inadequate credit

leads to sub-optimal use of other resources preventing farmers from developing capacity

to repay their loan. Surprisingly, much better appreciation of the pitfalls of providing

inadequate volume of credit is found in pop novel Carpetbaggers by Robbins (1961) than

seen in “prudent” credit policies of many an institution.20On the flexibility of private actors and rigidness of the officials in a different context


recourse for meeting the “non-productive” financial requirements is the vil-

lage lenders. Thus, consumption requirements during off season, emrgencies,

medical expenses, family crisis send the borrower to village lender. Seventh,

borrowing from village lender is also part of continuing relationship. Sup-

plementary credit is more easily possible, repayment scheme can be quite

flexible, total repayment may not be required or expected.21

Last, with segmentation of credit market, the institutions largely mop up

good risks, leaving the village lenders to service relatively poor, and risky

borrowers. Thus, an important reason for rise in cost of private credit is

high risk loans “left” to be serviced by the local lenders. Though actual

default on private credit is not very frequent, but then that is the outcome,

consequent to the caution exercised by village lenders combined with their

special attributes such as being elderly, belonging to influential family etc.

(See Dreze, Lanjouw and Sharma, 1998, p.552, for some informal evidence on

defaults in private credit market in Palanpur). The risk of default may have

been exacerbated by much greater (physical) mobility, and also, lessening of

social and political authority at the village level.

With the introduction of public lending and consequent weaning of pros-

perous and powerful away from village lenders, the power balance between

borrowers as a group on the one hand and lenders on the other also tilts

towards the latter. In addition to the factors already discussed, increas-

see, Famine Commission (1880, p.194, emphasis added): “It is a fact indeed that most

zemindars in North-Western Provinces did on the occasion of the late famine offer valuable

assistance to their tenants. I can enumerate instances in which they not only postponed

the recovery of the rents due from tenants, but also sold their jewels in order to provide

corn and cattle to them. . . . The existing courts are founded on sublimest principles of

justice, and therefore they are bound to respect all agreements and contracts entered into

between parties voluntarily. . . . It is no part of their duty to use, or rather abuse, the

authority vested in them by canceling a legal debt merely because the debtor is a poor

person. Such proceedings, if ever adopted, would prove more injurious to the debtor than

to the creditor.” It is an eloquent testimony to necessity of maintaining sanctity of formal

institutions even over questions of life and death.21See Brouwer (1999) on some interesting contrasts between indigenous and modern

institutions in India.

18 CIISS June 2010

ing interest costs on private credit also reflect this change in bargaining

strengths of the lenders and borrowers. The discussion of this para, and of

the last part of the previous para may seem at odds, but the changing bal-

ance of bargaining power between those who are still available to negotiate

and erosion of social and political authority with respect to a group, the

members of which have escape routes available as the last recourse, are not

incompatible.

7 Role of village lenders

It may be appropriate to discuss certain strengths of local lenders, which

may serve larger economic purpose if local indigenous lenders/ institutions

are allowed or encouraged to develop in right directions. Village lenders have

low informational costs. Transaction costs faced by institutional lenders for

small loans are fairly high (thus, Satyasai and Badatya (2000) show that

transactions costs for purveying a loan through PACS comes to Rs. 18.6 for

every Rs. 100 of loan. p.316).

Opportunities for interlinking of credit transactions with other markets,

in particular with trade in crops has often been viewed as a device that

gives that much extra power to the lender. However, these opportunities

can be of mutual benefit since these provide avenues for reducing pervasive

transactions costs by having simultaneously dealings in several markets be-

tween the same partners. In other words transaction costs are reduced by

internalizing certain externalities. As observed earlier, transactions costs

are also reduced by standardization of contracts. Long term relationships

also help in bringing down anxiety levels, provide a sense of security, and

thus improve quality of life. (Of course, existence of high inequality among

partners is the very antidote of this).22

22Anita Gill (1996, p.587) provides interesting evidence on credit-crop interlinkage with

mutual benefit. There is no evidence or claim of under-pricing of crop by arhtiyas (the

grain trader) while rate of interest charged is 2% per month for borrowers with good credit

history, which goes up to 3% per month against a borrower not paying back on time.


A more creative role for village lenders will facilitate greater capital avail-

ability to the rural sector.23 For this to happen, the village lenders must be

viewed not as adversaries, but as partners. Instead of competitors, they can

complement institutional finance. They may be encouraged through more

freedom to operate in rural credit market, with institutions supporting them

with refinance facilities. Of course, an overall but realistic regulatory regime

will be necessary. The village lenders incur much lower transactions costs

in terms of their information of village borrowers, their capacity to assess

and conduct credit operations, if allowed to function relatively freely, but

they do face greater transactions cost from perceived difficulties in enforcing

contracts, under prevailing legal, institutional (formal) framework.24 This

can change significantly with the institutional regime change as suggested

above.

23The strength of local informal lenders is recognized by the apex rural financial agency,

NABARD, as follows: “One of the major reasons for the dependence of the rural borrowers

on informal sources is its easy accessibility coupled with flexibility in approach. In order to

provide easy access, credit institutions will have to simplify their procedures and reorient

their approach so as to make available tailor-made credit packages to the clientele. This

would require a high degree of expertise on the part of management and staff as well as

favourable mind set to work in rural areas. Employees who are better able to balance the

requirements of banking operations and the needs of customers should handle the interface

between the bank and its customers. This calls for formal or non-formal professional

training of the bank staff so that an exclusive cadre to deal with the target group customers

emerges.” (p.197). An extremely tall order that for a formal lending institution with all

the rules and procedures in tow. It simply does not occur to them that the services of

the actors, who already have all the attributes cited and are available in situ, can be and

should be enlisted!24“Interest rate ceilings and credit allocation quotas . . . are self-defeating and in fact,

raise the cost of credit to the very sector that the government intends to support [small

enterprises, including agricultural sector]”. (Bhat, 1985, p.91) The following observation

by Bhat (1985, p.91) is also pertinent, “Since transaction costs and risks for dealing with

small enterprises are higher for the banks . . . , the banks either would not lend to the small

sector or forestall the government directions by passing on a greater part of their costs

and risks to the small sector through non-interest charges of various types.” (emphasis in

original).

20 CIISS June 2010

It is noteworthy that the banking sector provides very small amount of

credit to the artisans, who are mostly rural: 0.6 per cent of total bank credit

flowing to artisans, who constitute the largest productive sector of the Indian

economy after agriculture, and who form the indigenous component of the

Indian industrial sector. (See EPW Research Foundation, 2000 (henceforth

EPWRF), p.400, Table 11). The small scale sector gets much better share

of credit from banks (8.7%) but then only 8.5 percent of it goes to the rural

small scale sector whereas 74% goes to urban small scale sector (EPWRF,

pp.400-01, Tables 11 and 12). Even agriculture, which employs much above

half the working population, gets only about 11 % of bank credit. (EPWRF,

p.400, Table 11).

The break down of the mutual linkages among the various rural industries

and virtual drying up of channels of credit to rural industries, are perhaps

among the most important factors for impoverishment of rural India. The

artisans, who were the mainstay of rural industries, have been the worst

hit as a consequence. It is well known that credit-deposit ratios are very

low for rural areas where as they are very high for the metropolitan areas.

(EPWRF, p.398, Table 9). Even for Regional Rural Banks CD ratio was

about 48% as on 31 March 1997 (NABARD, 1998) Thus, formal banking

sector has been more instrumental in draining away capital from rural areas

rather than injecting it. This scenario has not changed in the intervening

10 years as seen from later special issues of EPW on Money, Banking and

Finance. The small size of credit advances provided by banks to this sector

can also be (indirectly) seen from total credit to micro enterprises, micro-

credit etc as available in Economic Survey by Government of India (2010,

p.A-59, Table 4.6).

Thus, the indigenous credit institutions can be relied upon to stem this

outflow of resources. Formulation and implementation of regulatory regime

must primarily lie with local self government institutions, conceived at suit-

able aggregation of villages as an entity. Of course this requires greater

regional autonomy not just in matters of credit institutions but in whole


range of economic, political and social fields. Short circuiting local democ-

racy and decision making powers in the name of protecting the weak and

vulnerable from the local elite and powerful with the help of outside inter-

vention just does not work in the long run - the same local vested interests

corner most benefits of such interventions.

These are larger issues that cannot be addressed here adequately. On the

specific issue of credit institutions, one corollary that follows is to carry out

fresh studies on the functioning of the indigenous credit institutions - with

the village lender in the centre - which are free from erstwhile prejudices.25

This will be useful in understanding what will work today and what will

not. Two, if the initiative has to lie with the local people, then what is the

role of the state, and what comes in the way of that initiative are important

questions to investigate. Last, further careful empirical research into func-

tioning of the local credit markets, as they exist at present; as they have

been changing over time; and as they have been reacting to interventions,

is required.

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Indigenous Institutions, Benevolent Intervention and Justice

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