INFORMAL CREDIT MARKETS

INFORMAL CREDIT MARKETS India has a long history of traditional financiers, or "indigenous bankers" as they came to be called in British times, organized along ethnic community lines. Some of them, such as the networks of Gujarati shroffs, accepted deposits, discounted commercial paper, and facilitated trade and remittances, especially to upcountry areas poorly served by the banks. With the spread of modern banking, these indigenous bankers lost much of their share of the market, but many of them evolved into thriving present-day "finance companies." These continue to be important in financing modern India's trade in cloth, grains, and other commodities, including used commercial vehicles, hand looms, and small industries. Rotating local savings and credit groups, called chit funds, also date back at least several centuries in South India.

References to village moneylenders date back to Vedic times. Their dominance began to be broken only near the end of the nineteenth century, when British officials started promoting cooperatives, introducing legislation to restrict the sale of agricultural land. Such restrictions in Punjab, especially, proved effective in ending the large-scale alienation of land that had been taking place for the previous thirty years. The new class of agricultural trader moneylenders started lending against the security of produce, replacing the earlier large farmer money-lenders. These are still widely used by farmers in the Punjab in preference, or in addition to, the banks.

Size and Types of Lenders

With the growth of cooperative credit after independence, and the massive expansion of rural bank branches since the 1970s, following the nationalization of banks, the share of informal credit in total rural credit has steadily declined from about 90 percent of all outstanding debt in 1951 to about 40 percent in 1991. In 1991 moneylenders still accounted for about 16 percent, and interest-free credit from friends and relatives for about 7 percent. Reflecting the declining share of cooperative credit during the 1980s, the share of "other sources" such as chit funds and finance companies almost doubled from 13 to 24 percent between the rural credit surveys of 1981 and 1991.

In contrast, in the urban areas, informal credit was almost as important as formal, even after excluding large flows of tax-evaded "black" money. More than half was used as trade credit, though there were also other important sectors like small-scale industry, road transport, construction (especially residential), and a large number of service sectors.

Informal credit is heterogenous, encompassing the wide range of activities of wholesale traders, commission agents, and chit fund operators, as well as those of local moneylenders, pawnbrokers, village shopkeepers, agricultural input suppliers, itinerant peddlers, and even friends and relatives. What all these lenders have in common is informality, adaptability, and flexibility of operations, a characteristic that reduces "transactions costs" (i.e., the cost of making, monitoring, and recovering loans) and confers on informal lenders their comparative advantage over formal banks and credit associations.

Areas of Comparative Advantage

Formal and informal finance each have their comparative advantages. Formal finance is more readily able to accommodate large and longer-term loans because of its greater reliance on the pooling of deposits and maturity transformation (being able to lend for longer terms than the average tenure of deposits, because deposits are continually replaced). It is better suited to serving the needs of large- and medium-scale industry, organized trade and commerce, large- and medium-scale farmers who can offer the security of the land they own, and well-to-do urban households. It has been less successful in serving the needs of the large unorganized sector of small and micro-entrepreneurs, small traders, tenant farmers and sharecroppers who do not have title to their land, and small and poor borrowers in general.

The lower transactions costs of the informal sector make it particularly well suited to making transactions that are cost intensive, small, and of short duration. Its flexibility regarding collateral enables it to finance a large number of service activities, where fixed assets are not created as security for the loan. The tying of credit with marketing transactions gives informal lenders a comparative advantage in supplying working capital loans for agriculture, as crop production loans, as well as in small industries, such as those using hand looms or making footwear, where the lender is often also a supplier of raw material or a buyer of the final products.

The two sectors are therefore by and large complementary. Policy should proceed on a recognition of this complementarity and facilitate informal finance in its own area of comparative advantage. There are three major aspects to this broad policy orientation. One is to improve market structure, or the degree of competition between lenders in the informal sector by encouraging ease of entry. Licensing and registration should be restricted as far as possible to deposit taking and the main emphasis of regulation should be prudential. An example of inappropriate regulation is the central government's Chit Fund Act, which requires chit funds with as little as 100 rupees to register with the state registrar. However, the costs of registration would render hundreds of thousands of community chit funds unviable, and the limit should be raised. Usury laws are another example. Although interest rate ceilings have largely been removed in the formal sector, they are still being enforced by some state governments for moneylenders and pawnbrokers. Usury laws only drive informal credit transactions underground, and by making contracts legally unenforceable, increase the risk premium that borrowers have to pay through the interest rate.

The second approach, of promoting "linkages," or increasing lending from the banks to informal lenders, applies to parts of the informal sector that are reasonably competitive and in which lenders do not enjoy market power, but where the cost of funds of informal lenders are high. This approach seeks to take advantage of the lower transactions costs or better informational resources of informal lenders by refinancing them, thereby reducing their cost of funds and enabling them to lower their lending rates. In this approach, the formal sector acts as a "wholesaler," while informal lenders "retail" credit to small and poor borrowers. It is suited, for example, to pawnbrokers and potentially to improving the terms and amount of credit available to farmers from agricultural marketing intermediaries such as commission agents, input suppliers, and agro-processors. Thus in Abohar in the Punjab, the largest cotton market in the country, banks refinance the book debts of commission agents, who lend huge amounts to farmers at the standard 2 percent a month against sales through them of cotton and grains. Farmers prefer the one-stop convenience of dealing with commission agents, who pay for purchases of fertilizer, diesel, and other inputs when they come into town, and who pay interest on balances left with them after the season.

A third approach, applicable to parts of the informal sector in which the problem of market power is not amenable to the previous two approaches (because in some markets informal lenders will always have better information ties to poor borrowers, and will earn "rents" or monopoly profits on such information, no matter what their cost of funds) is that of offering stronger competition to the informal sector, and thereby improving its terms. An example is the huge expansion currently taking place of micro-finance through women's self-help groups, bringing down village moneylender rates for small emergency and consumption loans. In the long run the two sectors are expected to become increasingly integrated but specializing in their own area of comparative advantage.

Chit funds (or kuris in Kerala, "committees" in the north, and bishis in the west) is the Indian term for what are generically known worldwide as rotating savings and credit associations, small neighborhood- or workplace-based community organizations whose major attraction is that they are a convenient vehicle for savings. They entail contractual savings, each member committed to saving a particular amount on a particular date, usually once a month, being entitled to the pooled kitty in turn, the sequence of turns being decided by consensus, lottery, and in more evolved business people's chit funds, by a system of bidding for the kitty, the bid amount becoming in effect the interest earned by other members in that round.

Given the widespread ownership of gold and silver ornaments in India and the convenience of ornaments as collateral (being easy to store, value, and sell), borrowing against the security of ornaments is widespread. A large part of the lending by moneylenders is against the security of pledged ornaments. As a shop-based activity, however, pawnbroking is carried out usually as an adjunct to the activities of goldsmiths and jewelry shops. Much of the lending by smaller unlicensed pawnbrokers is for relatively small amounts and for consumption purposes. In a poor tribal district of Rajasthan, thirteen retail shopkeepers lent an estimated 4,500 bhils in the surrounding hamlets, against the security of silver ornaments. Only about 30 percent of the value of the pledge was lent, difficulties were experienced in redeeming the pledges, and interest rates were high. However, an important part of lending by pawnbrokers in other areas is for crop production purposes. Thus in the agricultural district town of Raichur in Karnataka, farmers top up loan requirements after first exhausting limits available from banks and commission agents. The lending of about fifty active pawnbrokers peaks at the start of the kharif (autumn) crop and winds down from December, when the loans start to be repaid. Loans range from 500 to 15,000 rupees, at an interest rate of 3 percent a month. This appears to be the standard "institutional" rate in most parts of the country.

The banks also make (cheaper) gold loans, motivated primarily by the need to meet their agricultural lending targets. With the emphasis of modern banking on cash flow rather than security-based lending, the term "pawnshop banking" has come to acquire pejorative connotations. The ambivalence of the official stance may also have something to do with the country's policy of discouraging the hoarding of gold as an unproductive asset. However, in providing essential liquidity against gold, banks enable the savings represented by gold to be invested productively. The major advantages pawnbrokers have over banks is the higher proportion of the value of pledged articles they advance, flexibility about exceeding this margin in appropriate cases, and lower borrower and lender transaction costs generally. The optimum division of responsibility between banks and pawnbrokers might be refinancing arrangements by the banks, based on the repledging of pawns to the banks.

Prabhu Ghate

See alsoBanking Sector Reform since 1991 ; Rural Credit, Evolution of since 1952

BIBLIOGRAPHY

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