Xavier Gine , DECRG AADAPT Workshop Goa, Dec 17-21 2009

1. Rural Finance: What have we learned? Xavier Gine, DECRG AADAPT Workshop Goa, Dec 17-21 2009

2. Overview of Financial Services • Credit • Overview • Case Study: DrumNet in Kenya • (Savings) • Insurance • Overview • Case Study: Rainfall Insurance in AP, India

3. Credit: Overview • Data from a stratified random sample of PACS and non-PACS farming borrowers in AP. • Informal lenders are the most use source of credit for all

4. Loan Characteristics • Loans from PACS are the most attractive in terms of maturity and interest rates. • However, they require collateral (also formal sources) and are typically very small.

5. PACS repayment based on Special Report

6. Government Credit • Pressure to forgive debts in bad times or to win political favors. • Relief measures respond more to elections than to rainfall. • As a result, credibility and hence sustainability is jeopardized as farmers will wait to repay until the government announces a relief package. Given soft stance on repayment, PACS are the last lender to be repaid.

7. Why are informal interest rates so high? • Simplest case: R=120% (or 10% per month) • Assume a risk-free rate of 10%, probability of default must be 50% to justify a 120% interest rate under competitive markets if no other costs are involved. • But default rates are typically much lower than 50% • Singh (1968) in India • 1 of 45 transactions, lender lost all the principle and in 29 of these part of the interest not recovered, so default explained 23-43 percentage points of the overall interest rate charged. • Aleem (1980) in Pakistan • The default rate was less than 2% for the median lender and 10% for the maximum.

8. Why are informal interest rates so high? • Aleem also collected detailed information on moneylenders exact monitoring and screening activities, and the costs of such activities. • The direct cost of lending is almost 50 paisa to the rupee, explaining the gap between deposit and lending interest rates.

9. Rural Credit • So rural credit markets are characterized by high lending costs driven by difficulties in screening, monitoring and enforcing • Screening: Determining who is creditworthy • Monitoring: Observing ability to repay a loan (and hence who to collect against) • Enforcing: Collecting the money • In the past 30 years, however, we have witnessed a flurry of innovations, all in some way designed to reduce the cost of lending to the poor

10. The Microfinance Promise • Two ways to reduce lending costs: • Improve the borrower’s incentives, • Threat of future credit denial, escalating loan amounts • Shift key responsibilities from lender to client • Delegate screening, monitoring and/or enforcing to client

11. Key Innovations • Group liability: Clients are liable for each other loans. • Group lending: Public repayments, bank comes to villages • Flexible collateral • Repeat lending (with increasing loan size) • Focus on women • Regular (weekly, monthly, etc.) repayment schedule • Credit with Education • Mandatory savings • Kept by Lender, or available to the group to re-lend out to themselves or others, as an internal investment fund

12. The Microfinance Promise • Harness innovations in financial contracts and institutions to overcome market failures • Help attain development goals more cost-effectively than other measures • Help poor and low-income households take advantage of economic growth • Cover all costs through fees and expand without constraint, ultimately integrating with the commercial finance sector.

13. The MIX Data • Adjusted Financial Information on 124 institutions in 49 countries 1999-2002 • Selected sample since institutions share a commitment to financial sustainability and transparency • 3 Types of Institutions: • Individual-based lenders, • Solidarity group lenders, • Village Banks

14. Financial performance

15. Outreach Indicators

16. Case Study: DrumNet • What are the barriers to the adoption of new technologies faced by small landholders? • Lack of capital • Lack of infrastructure to market • Missing information about profitability or how to adopt them • Inherent riskiness of technology itself

17. Case Study: DrumNet in Kenya • What are the barriers to the adoption of new technologies faced by small landholders? • Lack of capital • Lack of infrastructure to market • Missing information about profitability or how to adopt them • Inherent riskiness of technology itself

18. Motivation • In the region we study in Kenya, • Access to capital is limited because • Banks and MFIs have tried crop financing and farm input loans but have generally failed. • Exporters have tried extension services and out-grower credit schemes with mixed results. • Small-scale agro-supply vendors sell seeds and agro-chemicals on credit but have limited penetration. • Road infrastructure is poor and smallholder farmers have deficient means of transportation • Trust issues with buyers in Nairobi

19. Intervention • Conduct a field experiment with DrumNet, a for-profit Kenyan NGO, to examine whether a package of extension, credit and marketing services helps farmers (organized in Self Help Groups) adopt, finance and market export crops. • Observe take-up • Measure impact

20. DrumNet program • DrumNet is an NGO that encourages the production of an export oriented crop through a cashless micro-credit program by linking directly commercial banks, smallholder farmers, retail providers and exporters. • Solves trust problems found in contract farming.

21. DrumNet program • A farmer that wants to be a member of DrumNet has to: • Be a member of a registered SHG. • Express an interest export crop French beans. • Have irrigated land. • Upon registration, DrumNet members • Receive a 4 week orientation on Good Agricultural Practices and EUREPGAP requirements. • Open a personal savings account with local bank. • Make a cash contribution of USD 10 that will serve as collateral for a line of credit of up to 4 times that amount to purchase inputs (seeds and fertilizer).

22. DrumNet program • Farmers are organized into groups of 5 who are jointly liable for the loans taken out. • At harvest time, DrumNet negotiates a price with the exporter and arranges for the produce pick-up at pre-specified collection points. • A transaction agent is appointed in each collection point to serve as liaison between DrumNet and the farmers. • At these collection points, farmers grade their produce and package it, although exporter has the final word on the grading. • Once the produce is delivered to the exporter, the exporter pays DrumNet who in turn deducts any loan repayment and credits the rest to the member bank account.

23. Experimental Design • Location • Gichugu division in the Kirinyaga district. It was chosen because of its agro-climatic conditions (similar to original DN locations) and because the clustering of participants was feasible logistically. • Sample Framework • Original sample of 96 registered SHGs including disbanded groups. Run a “filter” survey to find out the status. • Final sample of 36 SHG whose combined number of members reached the target DrumNet capacity of 750 individuals (20-40 members in a group). • Randomization of SHGs • 12 got all services except for credit • 12 got all services including credit • 12 Control • All analysis will cluster standard errors within SHG

25. Experimental Design

26. Take-up • Among individual determinants, • - Literacy, being a SHG officer, household size and having irrigated land predict participation. • All in all, participants are not the wealthier farmers nor those that use the most efficient production techniques. • - They face sever constraints (marketing) and that hope DN will mitigate them.

27. Impact after one year • DrumNet led to an increase in cultivation of cash crops, increased usage of financial services and reduction in overall marketing costs. • These gains translate into a significant increase in overall income for first-time growers but not for everyone. • No detectable gain from credit alone.

28. Epilogue • One year after the introduction of EurepGap requirements, exporters refused to purchase the produce since none of the SHGs were certified. • This resulted in DrumNet’s collapse and angry farmers reverting back to growing crops for local markets. • Bitter irony: Trust was a big motivation for DrumNet’s creation.

29. Index-Based Insurance • Innovative product that can improve welfare of the poor by enhancing consumption smoothing and therefore encouraging technology adoption. • Key benefits: • No adverse selection (except maybe temporal), • No moral hazard • Easy to price, provided data is available • Easy to purchase (private company, not government) • Fast claim settlement

30. Insurance Design (Narayanpet) • Insurance splits monsoon into three phases: • Sowing • Podding / flowering • Harvest • Payouts in each phase based on cumulative rainfall in the phase (each is 35-45 days)

31. Uptake of Index-Based Insurance • Although government crop insurance has been available for some time, it is mostly compulsory • As a result, most borrowers remain uninformed as they perceive the premium is as a fee. • Thus, the provision of explicit market-based rainfall insurance to Indian households remains a new and relatively untested concept. • While in some cases financial contracts to hedge risk do not exist, when they do exist, their use is not widespread.

32. Rainfall Insurance Purchases

33. We got it all wrong, and households do not need formal insurance. Government relief may crowd-out insurance. Banks may provide implicit insurance if defaulting loans are restructured In general, households use several ex-ante and ex-post mechanisms to smooth consumption and labor But there is some evidence suggesting that these are: Insufficient, especially for poor households. Costly, in the sense that they trade-off risk for lower return Imperfect if shocks are correlated Why???

34. Households do not want insurance. Afraid of crowding-out of informal arrangements Poor assessment of probabilities (Kunreuther) Basis risk Households do not understand insurance product Households do not trust insurance provider Households do not have cash / liquidity to pay for insurance Why???

35. Design Issues Products can be specifically designed to address the different barriers, but there are tradeoffs. • Voluntary or Compulsory • If cognitive failure matters, make it compulsory, but farmers may not use it as hedging instrument • Frequency of Payouts • Low Frequency (catastrophic) vs High Frequency • If trust matters, perhaps high frequency in the initial stages.

36. Design Issues • Linked to credit? • Stand-alone or bundled • Information • Who should provide it? How much? How? • Amount of Coverage? • Type of beneficiary • Household • Financial Institution • Crowding-in • Subsidies?