Both informal and formal loans matter in agriculture. However, formal lenders provide many more production loans than informal lenders, often at a cost (mostly loan default cost) higher than what they can recover. For example, the Agricultural Development Bank of Pakistan (ADBP), providing about 90% of formal loans in rural areas, incurs high loan default costs. Yet, like other governments, the Government of Pakistan supports the formal scheme on the grounds that lending to agriculture is a high risk activity because of covariate risk. Hence, such policies are often based on a market failure argument. As farm credit schemes are subsidised, policy makers must know if these schemes are worth supporting. Using a recent large household survey data from rural Pakistan (Rural Financial Market Studies or RFMS), we have attempted to estimate the effectiveness of the ADBP as a credit delivery institution. A two-stage method that takes the endogeneity of borrowing into account is used to estimate credit impact. Results reveal that ADBP contributes to household welfare and that its impact is higher for smallholders than for large holders. Nevertheless, large holders receive the bulk of ADBP finance. The ADBP is, thus, not a cost-effective institution in delivering rural finance. Its cost-effectiveness can be improved by reducing its loan default cost and partially by targeting smallholders in agriculture where credit yields better results. ). Collateral-free lending, proximity, timely delivery and flexibility in loan transactions are some of the attractive features of informal credite2 However, informal finance may not be as conducive to development as formal finance because:* Although the nominal rate of interest is lower for formal loans than for informal loans, the transaction costs of borrowing are higher for formal loans than for informal loans. Some informal lenders also perform an important role by facilitating the marketing of products or purchasing of inputs, such as fertiliser. Additionally, since informal loans are often given in kind and for specific purposes, some client needs are served better by informal than by formal loans.0169-S1S0/03/$ -see front matter 0
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Both informal and formal loans matter in agriculture. However, formal lenders provide many more production loans than informal lenders, often at a cost (mostly loan default cost) higher than what they can recover. For example, the Agricultural Development Bank of Pakistan (ADBP), providing about 90% of formal loans in rural areas, incurs high loan default costs. Yet, like other governments, the Government of Pakistan supports the formal scheme on the grounds that lending to agriculture is a high risk activity because of covariate risk. Hence, such policies are often based on a market failure argument. As farm credit schemes are subsidised, policy makers must know if these schemes are worth supporting. Using a recent large household survey data from rural Pakistan (Rural Financial Market Studies or RFMS), we have attempted to estimate the effectiveness of the ADBP as a credit delivery institution. A two-stage method that takes the endogeneity of borrowing into account is used to estimate credit impact. Results reveal that ADBP contributes to household welfare and that its impact is higher for smallholders than for large holders. Nevertheless, large holders receive the bulk of ADBP finance. The ADBP is, thus, not a cost-effective institution in delivering rural finance. Its cost-effectiveness can be improved by reducing its loan default cost and partially by targeting smallholders in agriculture where credit yields better results.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
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