Economics India

Sunday, March 12, 2006

India’s Budget for FY2006-07: Interest Subsidies on Agricultural Loans

Do you think if the interest subsidy scheme launched by the new budget is based on rational economic decision-making? Will this program help boost the flow of credit into agriculture – or may end up reducing it? Past domestic and international experience with interest subsidies on rural lending, dependent as they are on government budgetary funds -- does not support this policy.

The interest rate subsidy program also ignores the earlier government committee recommendation that interest subsidy element in credit for the priority sectors (including agriculture) should be totally eliminated! What is important for intended beneficiaries is the timely and adequate availability of credit rather than the cost of credit!

Finance Minister Mr. Chidambaram’s budget speech on February 28 started with a quotation from Swami Vivekanand: “We reap what we sow – we are the makers of our own destiny”. So true! But will India’s millions of farmers, poor and non-poor, be able to reap more produce and improve their own destiny by interest subsides?

At issue is not whether farmers deserve subsidies – we have to address this question taking into account a range of macro-and micro-economic aspects, including the need for targeting scare resources to farmers below certain income levels or those below the poverty line (BPLs) --- but the problem is that the interest rate subsidy might allow prosperous farmers (especially those growing cash crops like sugar cane, horticulture, and livestock) to grab this assistance to the exclusion of the poor farmers – usually those dependent on producing grain crops in rain-fed areas. Since they lack access to bank credit – either because they are not viable or the credit institutions serving them have become non-viable -- how the interest-rate subsidies will reach them?

The new budget initiative is expected to provide a one-time relief to farmers, who availed of crop loans from Scheduled Commercial Banks (SCBs), Regional Rural Banks (RRBs), and Primary Agricultural Credit Societies (PACS) for Kharif and Rabi of 2005-06, in an amount equal to 2 percentage points of the borrowers’ interest liability on the principal amount up to Rs. 100,000. This amount will be credited to their bank accounts before March 31, 2006. GOI will provide a budget allocation of Rs. 1700 crores for this purpose.

Also, with effect from Kharif 2006-07, farmers will receive from SCBs, RRBs and PACS, short-term credit at a low interest of 7 per cent, on loans below the threshold of Rs. 300,000. GOI will provide a subvention to NABARD for this – it is unclear yet how NABARD will administer this scheme. The cost of this new policy to the taxpayer is not readily available but could run into crores of rupees.

In India, the public sector involvement in rural credit started with the All India Rural Credit Survey Report in 1954. It not only did endure over the past five decades but over time deepened and played a dominant role. The government could do this because much of the commercial banking sector came into the public ownership in 1969 and while the cooperatives came to be subject to state control and funding as an outcome of public policy to ensure increased and sustained supply for priority sectors including agricultural production, and for poverty alleviation objectives.

Not long ago, in 1991 and 1998, the two Committees chaired by Mr. M. Narasimham- the Committee on Financial System and the Committee on Banking System Reforms -- took note of the problems with government -directed credit provided on concessional terms (including interest-subsidies) and recommended that it be phased out with required changes in interest rate policies.

As regards commercial banks’ directed credit program (including priority sector lending), Narasimham Committee I (1991) noted that they had played a useful purpose in extending reach of the banking system to cover sectors, which were neglected hitherto. Despite considerable unproductive lending, there was evidence that that contribution of bank credit to growth of agriculture and small industry did make an impact. However, this Committee called for re-examination of the relevance of directed credit programs at least in respect of those (a) who were able to stand on their own feet and (b) to whom directed credit programs with the interest concessionality had become a source of rent.

While recognizing that during the two decades -- 1970s and 80s, - the banking and credit policies had been deployed with a re-distributive objective, the Narasimham Committee believed that the pursuit of such an objective should be the instrumentality of the fiscal sector rather than of the credit system.

In part, the interest subsidy scheme will indeed be funded by fiscal resources but its distortionary effect on the banking sector will be quite serious in that due to GOI regulation that interest rates on agricultural loans up to Rs. 300,000 should not exceed 7% p.a., the banking system will not be ble to lend to these clientele from its own resources -- except without loss, thereby limiting the access of millions of farmers to credit that cannot be subsidized by the government due to fiscal constraints.

Narasimham Committee II (1998) revisited issues concerning banking sector’s directed credit and interest rates and observed that the asset quality had further suffered as a result of directed lending, an outcome not much different from international experience. Directed credit apart from leading to possible misapplication or misallocation of credit resources, had led to an increase in non-performing loans and adversely affected efficiency and viability of banks.

In an environment of directed credit (or priority lending), bank managers are under pressure to meet the targets and in the process credit discipline suffers; borrowers willingly default because they believe creditors will not take legal action against those considered to be in the priority sectors.

Narasimham Committee (II) reemphasized that except for priority lending up to 10% of net bank credit earmarked for lending to weaker sections, the rest of the directed credit be phase out while continuing to lend for agriculture and small scale sector on commercial considerations and on the basis of creditworthiness.

Thus, if the expected benefits of the proposed interest subsidies are so much in question, why did you think the government thought of reintroducing this failed program in this year's budget?

(Note: The views expressed in this post are purely personal).


  • At a Bankers' meeting on March 13, the Finance Minister is reported to have said “The UPA government had taken the bold step to provide agriculture loans at a subsidized rate of 7 per cent interest. The government has laid special emphasis on development of agriculture. The fact is that co-operative credit system in our country has collapsed and there is a need to revamp it”.

    Several GOI, RBI and NABARD committees have thus far addressed the issue of rehabilitating the bankrupt cooperative credit system but with no or very little outcome.

    One major reason for this concerns the vested interest of politicians at the state level -- who do not want to get out of cooperatives -- a source of money and power.

    Many state level ministers have their roots in cooperative credit system -- which have raised them like a nursing mother, instead of helping the poor.

    The Central Government operates like a distant observer vis-a-vis cooperatives --given that this is a state subject and the state governments are unwilling to amend cooperative law to give concurrent jurisdiction to GOI.

    A country which hopes to excel in nuclear power and already does so in many other scientific fields and in software development, cannot rehabilitate or liquidate its bankrupt cooperative system. What a shame!

    Surprisingly, RBI is unconcerned about the safety of deposits kept in trust with cooperatives by millions of uninformed clients, not knowing that the cooperatives have serious liquidity and profitability of problems.

    Clearly, the Finance Minister's scheme to provide agricultural credit to farmers at 7% does not help cooperatives or their depositors; it will help influential borrowers to get cheap money -- a a price lower than its opportunity cost.

    How can this happen in a country which is led by reputed "economists"?

    By Anonymous Anonymous, at 3:36 AM  

  • I think the farmers deserve even better they should get free loans or grants -why mess around with the adminsistrative costs of giving loan. After all we are all subsidized in some way - take the military - they get everything free. So why should not the farmers be any different.

    Let us apply the same economic principles to everyone. Not all farmers are the same and yet they pay not income tax. If we are going to correct - correct everybody.

    What about the subsidized education that IIT and IIM graduates get. and all those IAS officers who use their posts to get housing and other perks.

    Urban areas have other subsidies given.

    To me we need to give incentives and there are trade-offs.

    Even the World Bank is thinking of giving grants.

    There is no easy answer

    By Anonymous Anonymous, at 5:43 AM  

  • The anonymous commentator above seems to have missed the point.

    As the original post said, we are not talking about whether farmers deserve subsidies are not -- the question is how effective is the interest-subsidy as a tool to effectively reach subsidies to farmers who are poor?

    If farmers deserve a subsidy on grounds of poverty or natural disasters, they must get it so also others in the non-farming sector. No one denies the need for a social safety net to cover such situations!

    Unfortunately, no social safety net exists in India, especially for the rural poor, except perhaps the newly started rural employment guarantee scheme -- if it works well!

    Experience with IRDP and subsequent GOI-supported credit programs have amply proved that interest-subsidy programs do not work. This is also the experience in many other developing countries.

    Interest subsidies generally do not reach poor farmers, first, because they lack access to the banking system and, second, if they get access, the cost of securing the subsidized credit is so high (as some 10% of the loan amount goes to corrupt credit officers), that farmers choose to go to money lenders instead. Eventually the subsidies are grabbed by those farmers who have access to the banking system and the political inflence to get the credit. The program is basically faulty and inequitable.

    There is sufficient literature to demonstrate that interest subsidies tend to constrain market-based financial intermediation and reduce the flow of credit because of its linkages to allocation of government subventions which tend to be inadequate (due to broader budgetary constraints) and are released irregularly -- causing financial problems for the banks.

    Because interest subsidies are rarely funded fully by the government, the banks are indirectly forced to cross-subsidize these loans, which results in their reducing the number and amounts of loan approvals -- as the financial intermediation becomes no longer viable.

    Looks like, the interest subsidy program is a cheap attempt (with high cost to the public exchequer with very meagre outcomes) to win the loyalty of the farming community with an eye on the next assembly and parliamentary elections.

    The UPA government (including the Congress and the leftist parties) is using the old card to please farmers to the detriment of the financial sector as well as farmers themselves, for whose benefit the scheme is supposed ot have been designed.

    What farmers want is the timely and adequate availability of credit and not cheap credit -- if they get bank credit even at market rates (i.e. without subsidies), they are happy, as such rates are always lower than those charged by input/output traders and money lenders.

    Hopefully, this regressive scheme will die its own death -- after the next assembly and parliamentary elections -- but in the meantime, it has the potential to do enough damage to the rural banking network and to farmers.

    It is pity that programs such as interest-subsides get revived by a government that is run by internationally renowned economists like Prime Minister Manmohan Singh and Dy. Chairman of Planning Commission, Mr. Montek Ahluwalia -- probably they are under enormous political pressure to do so.

    We thought the PM and all those economists who surround him will take this government out of wasteful subsidy programs that do not reach the real poor -- and improve the investment climate in rural India but probably they are constrained to do so because of their partnership with the leftist parties.

    By Anonymous Anonymous, at 6:33 PM  

  • which is my point too - how do we ensure that the poor are reached ?

    and that we need to reform in other areas too. I was shocked to learn that the bureacrats have given themselves life-long pension at the same rate of their last equivalent appointment. Imagine how much this will cost the exchequer.

    By Anonymous Anonymous, at 10:24 AM  

  • A response to the above concern could be as follows:

    First, subsidy programs should be so designed that targeted individuals or groups benefit on the basis of well-defined criteria; and

    Second, subsidy programs are regularly monitored.

    In India, interest subsidy programs are administered by the purpose of the loan and loan amount (the threshold) which normally cover small and marginal farmers.

    However, there are two problems with this approach: the majority of small/marginal farmers still do not have access to bank credit; and loan amounts could be easily split to qualify for interest subsidy.

    NABARD and commercial banks are trying to improve farmer access to credit through the Self-Help Group scheme but the cooperative banks are lagging for various reasons.

    As of today, millions of farmers are outside the formal credit system and they are unlikely to benefit from the interest subsidy scheme -- this is where the "inequity" in the program begins.

    Under new definitions of loan defaults and provisioning criteria, commercial banks in India prefer to put their obligatory loan funds for agriculture into RIDF - an infrastructure fund administered by NABARD, instead of making loans to farmers. This facility is not available to cooperatives as they operate primarily in rural areas.

    Also, imagine that the beneficiaries of most Micro-finance institutions which make loans to farmers at 15-20% p.a. by mobilizing deposits at equally high rates of interests -- will not benefit from low interest rates. If MFIs are to make loans at 7%, the depositors/savers will have to bear the cost of subsidy. GOI interest-rate subsidy does not reach MFIs.

    Basically, as the original post says, the new interest-subsidy scheme is faulty and will not serve the farming community efficiently and effectively on a equitable basis.

    By Anonymous Anonymous, at 12:05 PM  

  • How do we reach the poor? In response to this comment, Mr. Deshpande, will you soon post a blog taking stock of ongoing government programs aimed at poverty alleviation -- and how these are being dealth with in the budget for FY06-FY07?

    By Anonymous Anonymous, at 11:57 AM  

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