Interest rate subvention in Indian agriculture: A demand-side analysis and proposed alternatives

The migrant worker crisis engendered by the current lockdown in India is a strong reminder of the suboptimal policies that have left the rural economy underdeveloped. There is a pressing need to make agriculture economically viable, and the dependence of farm incomes on the harvest cycle, the requirement of large upfront investment in agricultural inputs, the dominance of informal moneylenders and the lower ability of small and marginal farmers to save necessitate sound agri-credit policies that enable easy availability of small-, medium-, and long- term institutional credit in rural areas. Institutionalisation is important in order to give farmers access to cheaper credit and reduce the possibility of exploitation by moneylenders; even today approximately 30% of agricultural households borrow exclusively from non-institutional sources. Crop failure, loan defaults, and loan waivers remain central to the discussion on agri-credit policies. One scheme that seeks to tackle the objectives of institutionalisation, cheap credit and prevention of defaults is the interest subvention scheme (ISS). Unfortunately, while agri-credit policies in India have been extensively studied from the banks’ perspective, a demand-side analysis remains under-studied. This has led to a mismatch between the present policy paradigm and the needs of the farmers, of which the ISS is poised to be a conspicuous example. It has not only failed to achieve its twin objectives of institutionalisation and incentivising prompt repayment, but, quite apart, also led to some unintended consequences such as diversion of funds towards arbitrage opportunities, the dominance of short-term production loans (as opposed to long term investment loans) in overall credit, and the likely disproportionate benefits to large farmers at the cost of small and marginal farmers. In this paper, we seek to explain how this may happen by creating a model that analyses the behaviour of a farmer in deciding whether to borrow from a formal or informal source. We find that the noninterest costs (transactions costs and losses incurred on account of delays in disbursal of credit) of borrowing from a formal source may be so high that they lead the farmer to borrow from an informal source, such as an APMC agent. The failure of the ISS can at least partly be attributed to the neglect of such demand-side factors. In light of this failure, we conclude it is more effective for the government to invest funds elsewhere in projects that would increase agricultural productivity and incomes in the long run. However, the provision of cheap formal credit is still important. We believe that a microfinance institution (MFI)-like lending mechanism, appropriately tailored to the needs of agriculture, may be best suited to achieving this aim. Drawing on the experience of various MFIs internationally and the existing literature, we outline best practices that reduce the costs of borrowing for farmers while also managing risks and liquidity for MFIs, thereby ensuring their viability.