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293 ~ 121World Bank Discussion Papers
Design Issuesin Rural Finance
Orlando J. SacayBikki K. Randhawa
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(Continued on the inside back cover)
2 93 ~ 1 World Bank Discussion Papers
Design Issuesin Rural Finance
Orlando J. SacayBikki K. Randhawa
The World BankWaslington, D.C.
Copyright c 1995
The International Bank for Reconstruction
and Development/THEWORLD BANK
1818 H Street, N.W
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First printing August 1995
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ISSN: 0259-2 1OX
Orlando J. Sacay is senior rural financial specialist in the World Bank's Financial Sector Development Department. Bikki K.
Randhawa is a consultant to the same departmient.
Library of Congress Cataloging-in-Publication Data
Sacay, Orlando J.
Design issues in rural finance / Orlando J. Sacay, Bikki K.
Randhawa.
p. cm.-(World Bank discussion papers, ISSN 0259-21OX
293)
Includes bibliographical references (p. ).ISBN 0-8213-3395-X
1. Rural credit. 2. Agricultural credit. 3. Rural development
projects. 4. World Bank. 1. Randhawa, Bikki K., 1959-
11. International Bank for Reconstruction and Development.
111. Title. IV. Series.
HG2041.S23 1995
332.7' 1-dc2O 95-31498
CIP
Contents
Foreword ............................................................... vAbstract ............................................................... vi
I. INTRODUCTION ................................................................ 1
II. STUDY FRAMEWORK ............................................................... 1Concept of Rural Financial Market Development ................................................................ 1Features of Operational Directive 8.30 ................................................................ 2
III. SCOPE OF THE STUDY ............................................................... 3
IV. DESIGN FEATURES AND ISSUES ............................................................... 5Issues Related to the Objective and Scope of Rural Finance Projects ..........................................5Issues Related to the Sustainability of the Financial Intermediary ............................................ 13Financial Viability of Institutions ............................................................... 19
V. GENERAL OBSERVATIONS AND CONCLUSIONS ............................................................... 20General Observations ............................................................... 20Determining the Objectives and Scope of Rural Finance Projects ........................ ..................... 20Factors Affecting Sustainability of Finance Intermediaries ........................................................ 23
VI. GUIDELINES IN DESIGNING SUCCESSFUL RURAL FINANCE PROJECTS ...................... 25Features Which Contribute to the Effectiveness of Rural Finance Projects ............. ................. 25Measures to Strengthen Rural Financial Intermediation ............................................................ 27
Notes ............................................................... 31Annex: List of Projects Studied ............................................................... 33
iii
I
FOREWORD
The World Bank is entering a new era of developing strategies in microenterprisefinance for banking with the poor. The issues in attaining sustainable banking with thepoor find common ground with rural finance. The poverty pyramid is primarilycomposed of the rural poor. Urban poverty is the result of the rural poor moving to urbancenters in search of better opportunities.
Bank policies as embedded in Operational Directive 8.30 have shifted from thefund transfer objectives of traditional agricultural credit projects to those of buildingviable financial institutions which operate within the purview of the rural financialmarket. However, this has presented a significant challenge and has had a decidedlynegative impact on the volume of agricultural credit lending. This study was inspired bythe need to learn how to design and implement realistic projects consistent with thesepolicies.
The Financial Sector Development Departnent is continuing its research effortswith case studies of financial institutions in different parts of the world which havesucceeded in providing access to credit to small farmers, women and the landless poor.We are also conducting country case studies to identify lessons to be leamed andopportunities to demonstrate that viable rural finance and sustainable banking with thepoor are in fact attainable objectives.
We hope that this study, and follow-up studies which it has triggered, will re-ignite the interest and rebuild the confidence of Bank staff working in the field of ruralfinance. We also hope that the finding of these studies will serve as a guide to those whoface the challenges of the new world of banking with the poor.
GARY PERLINDirector
Financial Sector Development Department
v
ABSTRACT
The World Bank's policies as embedded in Operational Directive 8.30 have shifted fromthe fund transfer objectives of traditional agricultural credit projects to those of buildingviable financial institutions which operate within the purview of the rural financialmarket. However, this has presented a significant challenge and has had a negativeimpact on the volume of agricultural credit lending. The study was inspired by the needto learn how to design and implement realistic rural finance projects consistent with thesepolicies. This study analyzes all of the World Bank's on-going rural finance projects toarrive at best practices in project design, particularly with reference to the provisions ofOperational Directive 8.30. Design features of on-going rural finance projects werecompared to pinpoint best practices. In addition, design issues were identified andconclusions reached on these issues. On the basis of these conclusions, guidelines havebeen proposed to assist Bank staff in designing sound rural finance projects.
vi
I. INTRODUCTION
1. The agricultural credit portfolio of the World Bank has declined sharply during the pastfive years. This decline coincides with the time period that the Task Force Report on FinancialSector Operations was circulated and subsequently followed by the issuance of OperationalDirective 8.30 (OD 8.30). In its review of the Bank's agricultural credit portfolio, the OperationsEvaluation Department (OED) traced the decline in lending to the adverse reaction to theoperational directive. The OED report considered OD 8.30 to be too restrictive and the declinein lending unwarranted because agricultural credit projects had performed comparatively well.In addition, the OED report stated that agricultural credit projects had a positive impact onagricultural production. Therefore, the OED report recommended that the OD be revised.'
2. Bank management, on the other hand, took the position that the decline in lending wasjustified in lieu of the poor performance of agricultural credit projects and that OD 8.30 in itspresent form was sound as well as adequately flexible. Management was of the view that ruralfinance projects can be properly designed if task managers were given guidelines on how todesign projects based on best practices. It is the premise of this study that OD 8.30 in and byitself is not the source of the problem. Rather, the problem lies in the interpretation of theprovisions of the OD and in translating such provisions into effective project design.
3. This study analyzes all of the Bank's on-going rural finance projects to arrive at bestpractices in project design, particularly with reference to the provisions of the OD. Almost all ofthese on-going projects were approved from 1988 onwards, the period in which agriculturalcredit lending took a sharp downward decline. These projects were most likely to reflect theimplications of OD 8.30 on design features. Design features of on-going rural finance projectswere compared to pinpoint best practices. In addition, design issues were identified andconclusions reached on these issues. On the basis of these conclusions, guidelines have beenproposed to assist in designing sound rural finance projects.
4. As a continuing effort on research on design issues, case studies are being carried out onsuccessful rural finance institutions to resolve some outstanding issues in the field and toreinforce the conclusions of this study. One such study has recently been completed and is citedin this report. It is envisioned that interest in the shrinking field of rural finance will bereignited with examples of successful institutions and the presentation of guidelines on theeffective design of projects.
II. STUDY FRAMEWORK
5. OD 8.30 was used as the policy frame of this study. The extent to which provisions of theOD were complied with and how specific provisions were translated to project design wereexamined. Design issues were also identified on the basis of commonly held concepts on ruralfinancial market development. In addition, design features which appeared to have a directbearing on project performance were singled out.
Concept of Rural Financial Market Development
6. The concept of rural financial market development views rural finance as a process ofintermediation whereby rural deposits are mobilized and channeled into productive ruralenterprises. In this concept the institutional capability and financial viability of the financial
1
intermediaries is a prime objective. This is in sharp contrast to the objective of traditional creditprojects which transfer funds to identified beneficiaries with little regard to the welfare of thefinancial institutions.
7. The concept is premised on the observation that a significant proportion of the depositsgenerated by the financial system come from the rural sector. Commercial banks are primarilydeposit takers in the rural areas but are hesitant to lend to agriculture. Commercial banks do nothave the institutional capacity to reach small farmers and manage risk in agricultural lending.Furthermore, transaction costs are significantly higher in agricultural loans than loans commercialbanks normally provide. In the process of intermediating rural deposits to urban investment, capitalis invariably moved out of the rural sector. While a net outflow of capital from the sector may be anormal phenomenon of economic development, the hesitation of commercial banks to lend toagriculture has motivated governments to reverse this outflow and rechannel funds to agricultureby establishing specialized rural credit institutions. Consequently, a common feature of thecountries studied is the existence of government-owned specialized agricultural credit institutions.In some cases, governments compel commercial banks to lend to agriculture or to deposit fundswith the specialized agricultural credit institutions.
8. On the other hand, it is conceivable to have a situation whereby commercial banks specializein deposit taking while agricultural banks specialize in retail lending and credit. In some countries,agriculture banks do not take deposits and depend entirely on external sources of funds. Thissystem is not a preferable one as it increases government intervention and has given rise to many ofthe problems common to specialized agricultural banks in developing countries.
9. The preferred strategy is to strengthen the process of rural financial intermediation, takinginto account that commercial banks are averse to lending to agriculture and an unimpededaccelerated flow of resources out of the rural sector would have negative effects on the sector. Theapproach is to transform specialized agricultural credit institutions into competitive market-based,diversified, financially viable rural financial intermediaries which can mobilize resources andchannel these into productive rural enterprises. The strategy supports developing local deposit-based rural financial institutions and the linking of the informal credit system with the formalfinancial sector. This strategy should not result in market segmentation as long as institutions arecompetitive and market-based. This conceptual framework proposes a strategy of shifting fromagricultural credit to ruralfinance. 2
Features of Operational Directive 8.30
10. The operational directive recognizes that financial systems provide services vital to economicgrowth and development. The speed and efficiency of growth of the real sectors are ultimatelylinked to the efficient development of the financial sector. The major objective of the Bank'sassistance is the promotion of efficient financial systems.
11. A full range of Bank instruments are available to support financial sector development such asstructural adjustment loans, sector adjustment loans, financial intermediary loans (FILs), technicalassistance loans and country economic and sector work. OD 8.30 states that these instrumentsshould be mutually supportive in financial sector operations in specific country circumstances.When a financial sector adjustment loan is used to support general sector reform, the conditionalityof FHLs focuses on the development of intermediary institutions and financial instruments. In theabsence of financial sector reform, FlLs may have to take a broader policy perspective.
2
12. OD 8.30 lays out the objectives of FILs within a broad financial sector developmentstrategy. FILs should conform with financial sector policies and address issues such as interestrates, directed credit and targeted subsidies. The OD also establishes guidelines for institutionalarrangements as well as eligibility requirements of participating financial institutions. It iswithin this policy frame that the design issues in rural finance projects were studied for this review.
III. SCOPE OF THE STUDY
13. The study covered all rural credit projects and projects with rural credit componentswhich were on-going as of the end of 1993. Most of these projects were approved from 1988onwards. This period experienced an abrupt decline in the number and in the volume of Banklending. As shown in the table 1, lending to countries with market economies for credit projectsalmost disappeared, declining from $813.5 rnillion to only $104.7 million with nine projectsapproved in 1988 to only one in 1992. What held up the volume of lending were credit projectsin socialist countries where the full force of OD 8.30 may not have been applied and creditcomponents which may not have been subjected to the scrutiny of OD 8.30.
14. The decline in the lending portfolio is not confined to agricultural credit lending. Smalland medium enterprises (SME) lending suffered a more drastic decline from a volume of $635million in 1989 to only $59 million in 1993. The reasons for the decline in SME lending aresimnilar to those for rural finance. Some reference will, therefore, be made to the experience inSME lending in reaching the conclusions of this study.
15. A computer search using agriculture as the primary sector and agricultural credit as thesecondary sector identified 22 on-going projects. The study included 16 stand-aloneagricultural credit projects and 6 semi-stand-alone projects. The semi-stand-alone projects werecredit components of other projects that constituted 70 percent or more of the Bank loan. Thenumber of projects reviewed in this study did not coincide with the data from the OED reportbecause of a difference in the basis of classification of agricultural credit projects. The list of on-going projects included in the study is presented in Annex 1.
Table 1. Approved Projects with Credit, 1988-92Credit projects
SocialistAll projects Market economies economies Credit corn onents
Volu1ne Volume Volume VolumeFiscal Year Number ($) Number ($) Number ($) Number ($)
1988 22 1,114.50 9 813.5 2 233.5 11 67.51989 19 1,023.60 8 753.4 - - 11 270.21990 13 584.1 6 366.7 2 175 5 42.41991 14 563.9 1 150 2 372.2 11 41.71992 14 514.1 1 104.7 1 100 12 309.4Total 82 3,800.20 25 2,188.30 7 880.7 50 731.2
Source: World Bank. 1993. A Review of Bank Lendingfor Agricultural Credit and Rural Finance (1948-92), Operations Evaluation Department, Washington, D.C.
3
16. The study analyzed staff appraisal reports, loan agreements, supervision mnission reports(Form 590s) and financial statements of participating financial institutions. Interviews with TaskManagers were conducted as necessary to obtain detailed and up-to-date information. Wheneverappropriate, relevant information was also drawn from recent experience in designing rural financeprojects.
17. Table 2 summarizes the availability of financial data for the 22 on-going projects. Data onfinancial performance were usually difficult to obtain. There were some inadequacies on datacontained in staff appraisal reports, but the greatest deficiencies were noted in supervisionmission reports. Vital information which should have been gathered regularly duringsupervision to monitor the performance of financial intermediaries such as the yearly auditedfinancial statements was not always available. Most loan agreements required auditedstatements of project accounts, but not of the participating bank. While information on interestrates appears to be readily available, the nature of the information on recovery rates wasinsufficient both in appraisal reports and supervision reports. Data on the aging of arrears wasalmost always unavailable both during appraisal and supervision. Recovery rates were seldomdesegregated to show recovery of current dues and arrears. It should be noted that this lack offinancial data is inconsistent with the requirements of OD 8.30.
18. Rural finance projects fall under the classification of Financial Intermediary Loans (FILs).OD 8.30 contains specific provisions for these loans. The study identified design issues when:
* Design features did not conform with the provisions of OD 8.30 or the provisions of the ODwere difficult to comply with;
* Design features considered essential in commonly held concepts on rural financial marketdevelopment were not found in credit projects;
* Design features contributed to poor performance of projects or financial intermediaries.
19. The study does not ignore the need for and the impact of rural credit on the real sector. Itwas not designed to measure access to credit of the intended beneficiaries or assess productionimpact of the credit projects. Apart from the difficulty of developing a methodology ofmeasuring production impact, time series data on rural households, which could reveal theimpact of ciedit on technological change, production, employment and income were notavailable. Some rural finance projects have only recently included rural financial marketstudies, which include rural household surveys, in project design. The study, therefore, focusedon the problems of the performance of financial intermediaries.
Table 2. Availability of Finaticial DataAvailability of data
Typ ofinformation Sourcofinformation Available Not availableFinancial statements Staff appraisal report 15 7
Audited financial statement 7 15Interest rates Staff appraisal report 22 --
Form 590 16 6Recovery rates Staff appraisal report 15 7
Form 590 9 13Aging of arrears Staff appraisal report 3 19
Form 590 1 21
4
IV. DESIGN FEATURES AND ISSUES
20. The study identified ten issues commonly found in the design of rural finance projects.The first five issues relate to the objective and scope of rural finance projects vis a vis theobjectives set forth in OD 8.30 and the concept of rural financial market development. Theseinclude issues on lending arrangements, directed credit, market information, policyconditionalities and the basis for support. The next set of five issues relate to the sustainabilityof financial intermediaries. These include issues on compliance with eligibility requirements,deposit mobilization, autonomy, subsidies and financial viability.
Issues Related to the Objective and Scope of Rural Finance Projects
Single participating institution versus apex lending arrangement
21. Policy. Rural finance projects are financial intermediary loans (FILs) which have a wide rangeof objectives, from a narrow focus on financial intermediaries to a broad sectorwide objective. OD8.30 states that FILs should be "selectively used: (a) to promote the development of the participatingintermediary institutions; (b) to introduce or strengthen sectorwide reforms; and (c) to catalyze thebroadening of financial markets". The OD further states that "apex or two-tier lendingarrangements may be useful for reaching a larger number and greater diversity of end borrowers, aswell as of FIs, particularly private intermediaries, and for promoting policy change and competitionwithin the financial sector."3 OD 8.30 does not make it a hard and fast rule that apex arrangementsshould be adopted. The OD does note that "experience provides little ground for preferring a prioriuniversal or specialized financial institutions."4
22. Experience. The Bank has traditionally supported specialized rural finance institutionswhich are usually government owned and controlled. However, there is a growing trend inrural finance projects to expand participation to include other banks in addition to thespecialized rural finance institution. In fact, there have been recent cases of project staff beingrequired by senior management to devise apex arrangements to include several commercialbanks as participating banks, apparently in line with the objective of broadening financial markets.5
23. Of the 22 on-going projects studied, 10 projects involved single specialized creditinstitutions (table 3). Projects with single participating institutions showed better performancethan projects with apex arrangements. Of the 10 projects with single participating institutions,supervision reports showed that there were comparatively fewer projects meetingimplementation problems. In terms of project disbursement, there were only 2 projects out ofthe 10 projects which had disbursement lags of more than 50%. Box 1 provides an example of aspecialized credit institution in Morocco.
Table 3. Institutional Lending Arrangements/Borrowers of Rural Finance ProjectsLending arrneent Borrower Institution
FinancialRegion Apex Single Government institutionAFRICA 2 3 4 1ASIA 3 2 4 1EMENA 2 4 4 2LAC 5 1 5 1TOTAL 12 10 17 5
5
ASSISTANCE TO EA SPEC7IALIZED .k . :. .:; .24. Twelve projects used apex lendingC:REDiTINSTEITTIION: T[he CaisseNationalei; arrangements. The most commondc Credit Agricole: tnMorocco;: arrangement involved the government as
borrower and the central bank as the apexThe Bank provided assistance to the Caisse sit70 i institution (9 projects). A participating bank
Nationale de credit Agricole (CNCA )through a- was the second-tier institution in the otherseries of agricultural credit projects. Tefirst three projects. Participating banks includedloan of US$10 million was used: to help 0finance; specialized rural credit institutions, publicCNCA's lending program during 1966-69. At:w;: l-:and private commercial banks and ruralseries of follow-up projects improved CNCjA's;03w:; banks. In some projects, several financialinstitutional and financial performance.e This W i.institutions participated, but none werelong-term assistance led to growth in agricultural specialized rural finance institutions. Thecredit and agricultural development, capital for.: number of participating banks included inprivate sector investrnent, improved institutional the apex lending arrangements rangedbuilding capacity and increased availability of from 6 banks to as many as 33 accredited
comrcial banks. Box 2 highlights acredit to small farmers.The recently completed commNational Agricultural Credit Project shows project in Indonesia which has sixhow CNCA has come to play an importantt role. participating banks in its apex lendingin providing financing to the agriculture sector. arrangement.CNCA's financial performance is satisfactory.Total lending grew by 15 percent per year from 25. Of the 12 projects with apex1988 to 1991. In 1987 CNCA began to diversify arrangements, 9 projects were reported tointo new area--agro-industry financing, have met implementation problems duecommercial banking and foreign banking primarily to the lack of interest of theoperations. participating banks. As a result, 7 of the 12
projects with apex arrangements hadThe latest project in implementation disbursement lags of more than 50%. All
(National Rural Finance) will help CNCA to but one of these projects did not have apromote private investment in rural areas. The specialized credit institution serving as theobjective is to develop a sustainable and major channel. The majority of thesefinancially sound rural finance program that projects are located in one region wherecan operate in a liberalized financial system. specialized rural finance institutions haveThe project will fund medium and long-term been abolished or never existed.credit to private farmers and investors for on-farm and off-farm investments. It will 26. The problem of the lack ofstrengthen CNCA's planning, management participation of financial institutions inand drought management. apex lending can be traced to the lack of
BOX 1 interest among commercial banks. Severalreasons were given in supervision reports for this lack of participation, i.e. low interest rates,high intermediation cost, low loan recovery, competition by the apex bank and macroeconomicfactors.
27. Commercial banks normally serve a very limited agricultural clientele. There were onlythree projects which effectively involved commercial banks. In all three cases, a satisfactory rateof disbursement was due to loans being granted to large borrowers. For example, in one projectthere were only 29 projects approved for $11 million of loans. Most of these loans were foragroindustry. 6
6
28. Apex institutions such as central bankshave limitations in assessing the capability of COMMERCIAL BANK PARTICIPATION:participating banks and in supervising the The Indonesia Agricultural Financingimplementation of rural finance projects. The Proectproblem of monitoring and lack of financialdata was also partly caused by the difficulty of Of the projects with apex lendingtracking down a large number of participating arrangements, this project is one of the fewbanks. to identify'participating banks before
implementation. Six banks (three private29. Outstanding Issues. The argument and three state-owned) were identified atgenerally presented opposing a project with a appraisal to participate in the apex lendingsingle participating financial institution is that arrarigement through Bank Indonesia (theit represents targeted credit. Moreover, it is central'bank). The project became effectiveargued that access to project funds is not equal in 1992-and began with satisfactory .and is therefore contrary to the principle of a participation by most of the co'mmerciallevel playing field. If these are valid premises, banks'.are apex lending arrangements necessaryunder all circumstances or only under specific The'1993 rikid-termreviewnoted that onecircumstances. Under what circumstances is a participating bank accounted for 64 percentsingle participating institution more preferable of the subloan comnmitments. The otherthan an apex lending arrangement? participating batiks did n'ot tp'romote the
project actively.- The review:recomimiendedDirected Credit an increase in the staff assigned to the
project's investment activities. It30. Policy. OD 8.30 observes that credit is recommended op'ernng up the remainingfrequently directed by governments to specific loan fu'nds to 'more participating banks to,.end uses and end users through a variety of increase disbursements. Although themechanisms, such as preferential rediscount- project is experiencing delays, early-ing, credit lines, credit quotas, and guaranteed identification, regular follow-up andaccess to credit. It recognizes that targeted monitoring allow for'timely follow-up ofcredit can act as a catalyst to overcome each bank's lending progress and corrective'problems in open market access to previously actions to minimize delays.excluded groups and sectors, i.e. microenter-
prises, small farmers and women. It states that the success of targeted credit programs dependsheavily on proper design and the implementation capacity of the responsible institutions!
31. Experience. All loans reviewed for the study financed agricultural production as a primaryobjective (crop culture, livestock husbandry and, occasionally, fisheries development). Thirteenprojects had provisions for financing farm inputs, farm machinery, irrigation and equipment. Asmany as 15 projects included financing of agroprocessing, marketing and/or transport. Only 5projects financed non-farm rural enterprises in addition to agriculture. Only these projects can beconsidered diversified (table 4).
32. Farmers and producers were the targeted beneficiaries in almost all projects. About half of theprojects made provisions for financing cooperatives, farmers associations and other legal entities.Only three projects specifically mentioned targeting women; one project mentioned landless in-dividuals. While there is the presumption that small farmers, rural women and the landless are poor,projects were not specifically designed to reach individuals at the lower rung of the poverty pyra-mid. Only two projects involving commercial banks did not specify a targeted group of borrowers.
7
Table 4. Projects with Diversified Purpose of LoansProject Purpose of loan BeneficiariesMalawi (Smallholder Crops, livestock, fisheries, small on- Farmers' clubs,Agricultural Credit Project) farm processing, other on-farm and individual farmers,
off-farm investments womenPhilippines (Rural Finance Crops, poultry, livestock, agro- No targeted group ofProject) processing, other investments in borrowers
agricultural and non-farm ruraloperations
Morocco (National Irrigation, farm equipment, crop and Farmers, non-farmAgricultural Credit Project) livestock development, storage, clients enterprises,
forestry, agro-processing plants, womenfisheries, rural non-farm investments
Poland (Agricultural Marketing, trade, processing, Farmers, entrepreneurs,Development Project) agricultural inputs, handicrafts, cooperatives, private
transport, tourism enterprisesRomania (Private Farmer & Agricultural production and Private sector farmers,Enterprise Support Project) processing, marketing and trade, private enterprises,
transport, agrotourism farmers' associations.
33. Outstanding Issues. The issue at hand is whether rural finance projects should continueto be narrowly targeted to agricultural production. Should the scope of rural finance projectsbe broadened to include all types of non-farm rural enterprises? Is there evidence thatdiversification will alleviate the problems of specialized finance institutions? On the otherhand, is some form of targeting essential, particularly in dealing with the rural poor?
Availability of information on ruralfinancial markets
34. Policy. The major thrust of financial sector reform is the development of market-basedfinancial systems. The willingness of savers to hold domestic financial assets depends onmacroeconomic conditions. Competition in financial markets results in the efficient allocationof financial resources. The decision to invest in rural enterprises is influenced by economicfactors such as interest rates and prices. In carrying out financial sector operations, OD 8.30provides guidelines pertaining to a wide variety of country circumstances. These guidelinespresume an adequate amount of information on macroeconomic conditions and financial markets.
35. Experiece. While market-based lending is the principal thrust of financial sectordevelopment strategies, the rural finance projects reviewed proceeded with very little or noinformation at all on rural financial markets. All rural finance projects have been carried out onthe presumption that there is a demand for medium- to long-term loans for items whichnormally bear a high foreign exchange component. This presumption mirrors more the natureof the Bank's lending instruments rather than a careful assessment of credit demand.
36. The lack of information on rural financial markets is a major deficiency of staff appraisalreports. Information that could serve as a basis for project design was unavailable, i.einvestment opportunities, credit demand, access of rural borrowers to formal credit, capacity ofthe informal market to finance development, household savings, and transaction costs of borrowers.Only recently have some rural credit projects included components for credit studies.
8
37. Eight projects made provisions for credit studies. Three projects were to conductcomprehensive rural financial market studies; one project was to study the informal creditmarket. The other projects were to study credit policy, deposit mobilization and agriculturalinsurance (table 5). Results of the studies in on-going projects are not yet available. Only twostudies on rural financial markets have been completed under the Bank's auspices, both forprojects which were not part of this study's review.8
38. Outstanding Issues. In light of the need for information on rural financial markets, shouldcredit studies be made an essential component of rural finance projects?
Compliance with credit policy conditionalities
39. Policy. While project conditionalities are numerous, interest rate policy is by far the mostimportant credit policy conditionality. As highlighted in OD 8.30, interest rates have apervasive influence on the mobilization and allocation of resources. OD 8.30 states thatmovement toward market-determined rates is an important objective of financial sector reform.Market determination of interest rates is an essential element of competition. Administrativelyfixed interest rates impose barriers to efficient financial intermediation. Thus, the interest ratestructure is a central concern of the Bank's economic dialogue with borrowing countries. 9
40. The minimum requirement set by OD 8.30 is for the rate to be positive in real terms.Furthermore, the spreads between borrowing and lending rates should be sufficient to coveroperating costs, make prudent risk provisioning, and result in adequate profit. Where creditsubsidies exist, the OD is explicit in its objective of reducing and eventually phasing these out.The OD also notes that it is preferable to finance credit subsidies from the fiscal budget in orderto enhance transparency and regular review.
Table 5. RuralI Finance Projects with Provision for Credit StudiesProject Ruralfinancial market studies
Research to be conducted during project implementationGhana (Rural Finance Project) (1) Review of the cooperatives and credit union decrees; (2)
Baseline survey of the status of credit unions and Susu groups(local money dealerships).
Madagascar (Second Agricultural Study on agricultural credit policy, particular emphasis onCredit Project) needs of smallholder farmers.Pakistan (Agricultural Credit (1) Four demand level studies on farm credit, borrowerProject) transaction costs and credit rationing, role of women in the
rural economy, and farm household savings; (2) Three supplyside studies on informal rural financial markets, comparativestudy of banking institutions, and cooperative credit study.
China (Third Rural Credit Agricultural Bank of China to conduct studies on depositProject) mobilization, enterprise financing, etc.Philippines (Rural Finance Policy studies sub-component: (1) comprehensive study toProject) generate formal basic data to determine the role the informal
financial sector plays in credit supply and resourcemobilization, etc.; (2) assessment of the agricultural termlending market.
Hungary (Integrated Agricultural Study on developing a strategy for the agricultural insuranceExport Project) system.Poland (Agricultural (1) Credit research to cover both formal and informal sectorsDevelopment Project) and include a farm credit survey; (2) Studies analyzing the role
of cooperatives in the agricultural subsectors.
9
41. In countries with annual inflation rates of below 10%, OD 8.30 states that interest rateliberalization can be phased in over a short period of time. In countries with projected annualinfl ation rates of above 10% but below 30%, maintenance of a fully administered interest ratesystem may be justified although it is desirable to approximate market levels. For countrieswhere inflation exceeds or is projected to exceed 30 %, financial sector operations would requirea particularly strong justification."'
42. OD 8.30 states that where interest rate distortions are significant, Bank financial sectoroperations should normally be conditioned on an agreed program of adjustment in interestrates towards market rates and the introduction of a satisfactory mechanism where one doesnot already exist.
43. Experience. Of the countries with on-going rural finance projects, annual inflation rangedfrom 1% to more that 3000%. Supervision reports monitored interest rates in 14 out of the 22projects studied. However, lending rates were not adequately monitored. Actual lending rateswere reported in only 5 projects while in 9 projects positivity of interest rates were reportedwithout specifying the actual lending rates. Twelve projects reported negative interest rates.Four of these projects resorted to lending in foreign exchange to overcome the problem ofhaving to charge very high rates on local currency loans as domestic inflation was exceedinglyhigh.
44. The level of interest rates to end-users was the major policy conditionality in rural financeprojects. Out of 22 on-going projects, 14 projects had interest rate covenants while 8 did not.Loan agreements stated that interest rates should be positive in real terms in 10 cases while in 3cases interest rates were to be market determined. Only one project's loan agreement specifiedthat the interest rate should cover all the costs of the financial institution (table 6).
45. Experience shows that interest rate covenants were difficult to enforce. Five projects didnot comply with the interest rate conditionality. Formal suspension or cancellation was resortedto in two cases. These two projects were in countries where the government rather than thefinancial institution set interest rates or where the overall interest rate structure was negativedue to high inflation rates.
46. The degree to which interest rate conditionalities were enforced varied greatly. In somecountries, the existence of a highly subsidized credit line was in direct competition with Bankfinanced lending. In other cases, the Bank took a more rigid stance. For example in one country,the loan covenant called for interest rates for agriculture loans to be positive. While oneagricultural credit line was negative, the weighted average interest rate for all types of lendingwas positive. Violation of the covenant led to the cancellation of a part of the loan.,' Box 3highlights the above mentioned project.
Table 6. NmDber of Projects 7wit1 Interest Rate ConditionalitiesRegion Projects with Projects withJout
interest rate covenants interest rate covenantsAFRICA 4 1ASIA 4 1EMENA 2 4LAC 4 2TOTAL 14 8
10
CREDIT POLICY CONDITIONALITIES: THE THIRD AGRICULTURAL CREDITPROJECTIN TURKEY
The project began in 1989 with a loan of US$250 million. The project objectives were to increasethe availability of agricultural credit and strengthen the agricultural credit institutions. Themain agricultural credit institutions were the Agricultural Bank of Turkey and the AgriculturalCredit Cooperatives. The project agreement included two covenants on interest rates. The firstcovenant stipulated that the weighted average interest rate for agricultural loans was to bepositive in real terms by March 31, 1990. The second covenant stated that all agricultural interestrates were to be positive by March 31, 1991.
The covenant for the weighted average interest rate was met. However, failure to adjust nominalrates in the face of rising inflation prevented the second covenant from being met. Agriculturallending rates were positive for a few months in 1986 when the inflation rate was 28 percent andthe lowest lending rate was 30 percent. Inflation increased and interest rates did not increaseaccordingly. During 1990-91, the Bank stressed to the Gcvernment the need to find ways tomeet the covenant. Progress was further undermined by low recoveries in 1991 becauseborrowers expected remission of agricultural interest rates or principal. In 1992, interest ratesremained negative. It was clear that the Government could not meet the conditions of thecovenant. In June 1992, the Government requested cancellation of part of the loan. However,the technical assistance component remained intact under a trust fund agreement to continueprogress in institutional development. BOX3
47. Oiitstanding Issues. In view of the unsatisfactory experience with compliance, whatshould be the nature of credit policy conditionalities and how rigidly should theseconditionalities be enforced?
Basis for continuing supportfor ruralfinance
48. Policy. A significant proportion of the Bank's rural credit portfolio consisted of follow-upprojects in client countries. The drastic decline in rural credit lending may be attributed to thediscontinuation of these loan series. Management decision favored the discontinuation oftraditional support to rural finance projects on the grounds of the poor financial performance ofparticipating institutions, based on the standards set forth by OD 8.30.
49. Experience. Of the 20 countries studied, 14 countries had follow-up projects. Of these 14countries, 7 had repeater projects involving the same institutions and 7 had successor projectswith different institutional arrangements compared to the previous project. Six countries hadno previous rural finance project (table 7).
50. The study examined project completion reports (PCRs) and project audit reports (PARs)of the projects which were completed prior to the on-going projects being reviewed todetermine the basis for continued support for rural finance. Of these projects, elevencompleted projects were rated as satisfactory by OED. OED assessed the financial performanceof only four projects of these 11. Three projects were reported to have satisfactory financialperformance and one as having unsatisfactory financial performance. The reasons given for thesatisfactory rating of the remaining 7 projects were the attainment of production objectives (5
11
Table 7. Previouis Rural Finance Lending to Countries with On-Going ProjectsRegion Countries with Countries without
previous rural finance projects previous ruralfinance projectsAFRICA 1. Madagascar 1. Malawi
2. Zimbabwe 2. GhanaASIA 1. Pakistan
2. China3. Indonesia4. Philippines
EMENA 1. Morocco 1. Egypt2. Turkey 2. Poland3. Hungary4. Romania
LAC 1. Argentina 1. Belize2. Brazil 2. Uruguay3. Ecuador4. Costa Rica
projects) and policy improvement (2 projects). Three of these seven projects did not meetinstitutional development objectives. It should be noted that continuation of support was notalways based on satisfactory financial performance.
51. During the last 7 years, the Bank ended support for rural finance in 21 countries. Thiscompares with 11 countries that had follow-up projects. Of the 21 terminal projects, 12 wererated satisfactory while 9 were rated unsatisfactory (table 8). Discontinuation of support wasnot always based on unsatisfactory project performance.
52. Outstanding Issues. What were the primary reasons for discontinuing support to ruralfinance if satisfactory project performance was not always the basis for follow-up projects?What should be the basis for continuing support to rural finance projects?
Table 8. Countries Without Follow-Up Credit ProjectsProjects with satisfactory ratings: Projects with unsatisfactory ratings:
Region OED or PCR OED or PCIRAFRICA 1. Kenya 1. Chad
2. Somalia 2. Tanzania3. Sudan
ASIA 1. Thailand 1. Bangladesh2. India3. Korea4. Papua New Guinea
EMENA 1. Yugoslavia 1. Cyprus2. Yemen Arab Rep.
LAC 1. Chile 1. Peru2. Colombia3. Grenada4. Honduras5. Jamaica6. Mexico7. Paraguay
12
Issues Related to tihe Sustainability of the Financial Intermediary
Comnpliance with the eligibility requirements of OD 8.30
53. Policy. A widely discussed provision of OD 8.30 is the one on the eligibility requirementsof participating institutions. The OD states that "in most cases, participating FIs should beindividually appraised by Bank staff, with particular attention to their overall lendingcapabilities and financial and portfolio performance.""2
54. The minimum criteria of financial soundness embodied in OD 8.30 are as follows:
* a positive return on equity, with realistic provisions for potential and identified losses;* an acceptable capital adequacy ratio-8% for a well managed commercial bank, 10% for a
sound mature DFI and 20% for new DFIs or those with poor past performance;* a collection rate which avoids the erosion of capital, taking into account a realistic estimate
of possible portfolio losses, inflation, and the opportunity cost of capital;* not more than 20% of loan portfolio has been rescheduled and less than 5% of the portfolio
has been rescheduled more than once."3
55. If financial intermediaries demonstrate poor performance over a long period, the OD statesthat substantial corrective measures should be taken before they participate. The inclusion of thesefinancial intermediaries requires an agreed upon institutional development plan with monitorabletargets in such areas as financial performance, loan collections, capital adequacy, resourcemobilization, managerial autonomy, data processing systems, credit and financial policies, staffskills, etc. Free standing technical assistance may be provided for this purpose."4
56. Experience. The key financial performance indicators calculated for the projects whenpossible were: income to equity ratio, equity to loan ratio and recovery rate. Of the 22 ruralcredit projects studied, 15 presented financial statements and reported on recovery rates.Financial data were primarily available for specialized credit institutions.
57. Specialized financial institutions reveal weak income performance. Of the 13 projectswhere the return on equity was possible to calculate, only three projects met the criteria ofpositive return to equity. On the other hand, these institutions showed a strong equity base. Allbut one of the 8 institutions reporting had an equity to loan ratio of over 10%.
58. Recovery was reported in 15 projects. The predominant measure reported (11 projects)was the past due ratio. Another four projects reported the rate of recovery based on the amountdue. One project reported the aggregate figure of collection as compared to loans granted overa number of years. A fourth way of reporting recovery was a cash flow measure in whichcollection was compared to disbursement. Due to the inconsistency of financial data, recoveryperformance of participating institutions was difficult to compare.
59. The recovery performance reported during appraisal was not satisfactory in about half ofthe projects on the presumption that a past due ratio of over 10% was unsatisfactory. Of the 11projects reporting on past dues, 6 projects reported unsatisfactory recovery while 5 projects hadsatisfactory performance. Of the 5 projects with satisfactory performance, 3 were specializedcredit institutions and 2 involved apex lending arrangements (table 9).
13
60. It is estimated that out of 10 projects providing complete financial data, four projects havefully met the eligibility criteria of OD 8.30. Three projects involved specialized creditinstitutions and one project involved participating commercial banks in the client country."5
61. Outstanding Issues. Since few specialized finance institutions meet the eligibility criteria of OD8.32 how should these criteria be applied to rural finance projects? For those institutions which donot meet the eligibility criteria, have Bank projects implemented the necessary corrective measures?
Performance in tnobilizing more deposits
62. Policy. The rural financial market development concept adopted in this report is builtaround the objective of increasing the capacity of rural financial institutions to mobilize ruraldeposits. The rural sector has sufficient capital resources which can be mobilized to develop thesector, provided that rural finance intermediaries are strengthened.
63. OD 8.30 supports the objective of deposit mobilization and requires financial institutionsto increase over time the amount of funds mobilized competitively from the capital market. Itgoes further by providing a guideline for appraising financial intermediaries: the prudent limitof loans should be no more than 70% of deposits (or deposit to loan ratio of at least 140%).16
64. Experience. Twelve projects provided information in staff appraisal reports to allowcalculation of loan-to-deposit ratios. The data shows that the financial institutions in fiveprojects were able to finance loans entirely from deposits. These financial institutions werecommercial banks. The 8 specialized rural finance institutions were able to finance loans onlypartially from deposits. The ratio of deposits to loans ranged from as low as 5% to as high as92% with the majority being better than 50%.
Table 9. Recovery Perfornantce of Financial Intermnediaries Reported in Staff AppraisalReportsCotutry Institution Date Performance
Past Due Ratio:
Indonesia Commercial banks 1989/90 0.2%-4.0%Turkey Agricultural Bank of Turkey 1987 5.2%Philippines Land Bank of the Philippines 1990 8.8%Ecuador National Development Bank 1985 9.0%Malawi Small Enterprise Development 1986
Agency of Malawi 13.9%Investment & Development Fund 6.5%
Belize Development Finance Corporation 1986 15.2%Malawi National Rural Development Program 1987 20%-25%Argentina Bank of the Argentine Nation 1986 27.0%Zimbabwe Agricultural Finance Corporation 1988 48.0%Ghana Sample of rural banks 1988 50%Costa Rica National Bank of Costa Rica 1984 53.0%
Collection ofTotal Dues:
Egypt Principal Bank for Development &Agricultural Credit 1983 96.0%
China Agriculture Bank of China 1988 94.3%Morocco Caisse Nationale de Credit Agricole 1992 63.0%Pakistan Agricultural Development Bank of 1990 41.9%
Pakistan
14
65. The poor performance in deposit mobilization was not caused by the unavailability ofrural deposits, but by the lack of capability and willingness of the rural financial institution tomobilize funds. 7 The institution with the highest deposit to loan ratio was a diversified ruralfinancial institution."' It was possible to determine the growth in deposits in only fourinstitutions for which data were available at appraisal as well as during supervision. This datadoes not reveal a definite trend as two institutions showed an increase in deposit-to-loan ratioswhile two others showed no change or a decline.
66. Seven rural finance projects included savings mobilization as a design feature. Projectcomponents called for either increasing the amount of savings of financial institutions,increasing capacity of financial institutions to mobilize deposits, or promoting institutionswhich mobilize savings such as credit cooperatives. Qualitative assessment showed that theperformance of rural finance projects in attaining the savings objective was dismal. Either theagreements were not complied with, interest was lacking, action was not taken on a timelybasis, or the attempt was unsuccessful. Only one case was successful; another was moderatelysuccessful.' 9 Box 4 details the experience in resource mobilization.
67. Outstanding Issues. Considering the experience of the poor performance in depositmobilization, is it possible for specialized rural finance institutions to fully finance loans fromdeposits?
SUCCESSFUL RESOURCE MOBILIZATION
Seven stand-alone and semi-stand-alone rural finance projects incorporated savingsmobilization as part of project design:
Ghana: Rural Finance Project China: Fourth Rural CreditMalawi: Smallholder Agricultural Credit Pakistan: Agricultural CreditThe Philippines: Rural Finance Ecuador. Second Agricultural CreditMorocco: National Rural Finance
Only two projects reported some degree of success with appraisal targets in this area. ThePhilippines Rural Finance project included a special training program for cooperative staffand management. The training program was to improve skills in extending loans andincreasing resource mobilization. Implementation progress reveals that the Land Bank ofthe Philippines has advanced well in increasing resource mobilization.
In the'Morocco project, one project objective is to increase domestic resourcemobilization. The Caisse Nationale de Credit Agricole (CNCA) was to include depositgeneration in its business plan. The implementation progress of this objective has beenmoderately successful as CNCA figures reveal that the relative share of short-termdomestic resources in CNCA's total resources increased from 12% in 1988 to 17% in 1991.In terms of total deposits in the banking system as a whole, CNCA accounts for only 5% ofthe share. The issue of increasing CNCA's potential in savings deposits is being addressedunder the follow-up project. One of the objectives of the National Rural Finance Project isto enhance CNCA's capability in domestic resource mobilization by continuing to developnew clientele such as women farmers, artisans, and Moroccans employed in foreigncountries. BOX 4
15
Autonomy of credit institutions
68. Policy. OD 8.30 aims to strengthen the independence of the decision-making process ofcredit institutions. The OD underlines the importance of the freedom and accountability ofmanagers for assessing credit risk. However, the OD takes the position that autonomy ofmanagerial decision-making may occur under either private or public ownership.2 0 Inassessing the financial institution's autonomy, OD 8.30 states that project documents shouldtake into account: (a) sources of funds, (b) ownership structure, and (c) composition andappointment of board members, among others.2"
69. Experience. The rural financial institutions supported by the Bank are predomninantlygovernment owned and controlled institutions. The root cause of the problems faced by ruralfinancial institutions is that governments have exercised their proprietary rights to meet theirdevelopment goals, often at the expense of the financial viability of credit institutions.
70. Several features of rural credit institutions characterize the lack of management autonomy:
* institutions supervised by government ministries rather than by central banks;* boards chaired by ministers and members who are predominantly functionaries of the
government;* managers appointed by the national government rather than the board; and* exogenous committees which pass credit judgement on loan applications.
71. In addition, some policies and practices weaken the autonomy of credit institutions:
* interest rates set by the government;* special government credit programs targeting high risk or unviable borrowers;* repayment guaranteed by the government;* rural credit used for relief operations when natural calamities occur; and debt
forgiveness measures imposed on credit institutions.
72. Of the projects reviewed, four credit institutions were under a ministry such as theministry of agriculture or finance. The other institutions were under central bank supervision.Financial institutions under central bank supervision are usually more autonomous. Theseinstitutions must comply with banking laws which apply to all banks. In some instances,however, supervision by the central bank did not assure independence because the governmentexercised control of the financial institution through the central bank. Special laws creatingthese institutions also gave the government more control.
73. The most common form of government control is in the determination of interest rates. Of22 projects studied, interest rates were set by the government in 7 projects while restrictionswere imposed by the government through central banks in three projects. Projects with apexlending arrangements experienced less interest rate interventions by the government. Of the 10countries in which the government controlled interest rates, only two were under an apexarrangement. The remaining 8 projects involved a single participating institution, usually aspecialized rural finance institution. Of the projects studied, a total of 12 involved financialinstitutions which had a free hand in determining interest rates. Most of these were under anapex lending arrangement. Box 5 provides examples of two projects with different levels ofmanagerial autonomy--one project in Morocco and the other in Pakistan (table 10).
16
MA.NAGERIAL AUTONOMY: The Morocco National Agricultural Credit and the PakistanAgricultural Credit Project
The staff appraisal report for the National Agricultural Credit Project in Morocco notes that since1987 the Government has taken measures to increase the Caisse Nationale de Credit Agricole's(CNCA) managerial autonomy. CNCA is the borrower for the Bank loan. The CEO is appointedby Royal Decree. The Board of Directors includes representatives from various ministries(Agriculture, Finance, Planning and Interior, etc). Although CNCA is under central banksupervision, it determines interest rates for lending.
The Agrictltural Development Bank of Pakistan has less managerial autonomy. The governmentsets interest rates and makes other key decisions. It appoints the Board of Directors. The lack ofdecision-making power impedes ADBP's institutional development and weakens its financialposition.
These two projects illustrate how managerial autonomy can affect implementation. The Moroccoproject ended successfully in December 1993. A follow-up project (National Rural Finance) is inimplementation. CNCA expects to continue making progress in increasing its managerialautonomy. In contrast, the last supervision mission rated the project in Pakistan poorly. In June1994, the World Bank cancelled the loan amount remaining under funds for onlending.
BOX 5
74. There are at least three known cases in the Bank's recent rural finance experience ofgovernments implementing debt relief measures. Two of these cases occurred in the ruralfinance portfolio being reviewed for this study and one case of a previously financed project inJordan.2 2
75. Outstanding Issues. In government-owned institutions, is it possible to attain managerialautonomy, particularly in establishing an appropriate interest rate policy and allocation ofresources?
Table 10. Determination of Interest RatesInterest rates set Interest rates set
Region by government byfinancial institutionAFRICA Apex 0 Apex 2
Single Institution 3 Single Institution 0Total 3 Total 2
ASIA Apex 2 Apex 1Single Institution 2 Single Institution 0Total 4 Total 0
EMENA Apex 0 Apex 2Single Institution 2 Single Institution 2Total 2 Total 4
LAC Apex 0 Apex 5Single Institution 1 Single Institution 0Total 1 Total 5
ALL REGIONS Apex 2 Apex 10Single Institution 8 Single Institution 2Total 10 Total 12
17
Subsidies to Specialized Finance Institutions
76. Policy. The OD advocates the removal of preferential treatment, protection and subsidy.The OD notes that "Bank support should be conditioned by the removal of any preferentialtreatment or protection that might give the FI an artificial advantage over other financial sectorparticipants, actual or potential, and thereby insulate it from competition." 23 The OD also statesthat "prolonged subsidization could itself create a barrier to sustainability and eventualcommercial access."24
77. Experience. The Subsidy Dependence Index (SDI) was used to determine sustainability.SDI has been calculated for four rural financial institutions participating in on-going projects.Data show that all four financial institutions were dependent on subsidy, with the level varyingfrom 19% to 63% (table 11). The SDI is further explained in box 6.
78. The SDI was reported in another study for 7 financial institutions which are not currentlybeing supported by on-going projects. Only one of these institutions operated without subsidy.This was the case of a commercial bank in which the major lending activity was not inagriculture. The agricultural lending was carried out in this case, to a large extent, for and onbehalf of the government. The SDI was computed for the entire bank.25
79. Two of the financial institutions considered to be better performers (Egypt and Morocco) hada higher absolute level of subsidy dependence, but with the level declining. The two institutionsconsidered to be poorer performers (Pakistan and Turkey) had a lower subsidy, but with anincreasing level. The data seem to indicate that the important factor is not so much the absolutelevel of subsidy but the direction the level is taking. As there are differences in the quality offinancial data used, it is difficult to compare SDI estimates between financial institutions.Observation of trends may, therefore, be more relevant than cross institution comparisons.
80. Outstanding Issues. Can subsidy dependence be expected to be eliminated under allcircumstances?
Table 11. Subsidy Dependence Index of Financial Institutions Participatingin Rural Finance Projects
Subsidy dependence index(SDI)
Rural financial institution Year PercentEgypt: Principal Bank for Development and 1990 54.1Agricultural Credit (PBDAC) 1991 52.7
1992 42.2Morocco: Caisse Nationale de Credit Agricole (CNCA) 1988 62.7
1989 60.21990 52.81991 51.21992 54.4
Pakistan: Agricultural Development Bank of Pakistan 1988 31.4(ADBP) 1989 29.6
1990 25.51991 31.61992 36.2
Turkey: Agricultural Bank of Turkey (TCZB) 1985 19.01986 19.01987 36.0
18
THE SUBSIDY DEPENDENCE INDEXFinance & Development, March 1994, p. 33
According to J. Yaron, the subsidy dependence index as a measurement tool, can bedescribed as follows:
Financial self-sustainability can be viewed as the inverse of subsidy dependence. Asubsidy dependence index (SDI) is suggested for tracking the progress of an RFI in reducingits dependence on subsidies and for comparing the subsidy dependence of different RFIsproviding similar services to a similar clientele. The SDI allows for a sensitivity analysis thatmeasures the percentage increase in the average, on-lending interest rate required tocompensate for complete and immediate subsidy elimination. For example, SDI of zeroindicates that the RFI is fully self-sustainable; SDI of 100 percent means that the average, on-lending rate used by the RFI must be doubled if operations are to continue withoutsubsidies.
For simplicity, this interpretation assumes that an increase in the lending rate is the onlychange made to compensate for the loss of subsidies. However, the index does not implythat adjusting the interest rate is required or even feasible in all cases. The subsidy ismeasured against the interest the RFI earns on its annual average outstanding loan portfolio,since lending to a targeted clientele is the primary activity of a supply-led RFI.
BOX6
Financial Viability of Institutions
81. Policy. OD 8.30 states that resource transfer alone is not a sufficient justification forfinancial intermediary lending.26 As previously mentioned, one of the stated objectives of theOD in financial intermediary lending is to promote the development of the participatingintermediary institutions. The OD envisions the attainment of full financial viability.
82. Experience. This study attempted to determine if the financial performance of institutionsimproved over the course of the project. Only a few specialized credit institutions participatingin on-going projects provided adequate information during appraisal as well as duringsupervision to serve as the basis for comparison. The time period elapsed between appraisaland the last supervision varied from three to six years.
83. The impact of rural finance projects on the financial performance of financial institutionswas mixed. Of five financial institutions with data available, two institutions showed animprovement in the equity to loan ratio while three experienced a decline. Three institutionsimproved in income and two declined. In only one known case did the government regularlyreceive dividends from its investment in the institution. However, this institution was heavilydependent on grants from external sources.27
84. Recovery performance is the major determinant of financial performance. Two financialinstitutions improved their recovery performance; two did not change or declined. It should benoted that the recovery performance of rural credit institutions was severely affected by naturalcalamities.28 In several countries, land titling has not been completed so that loans are not fullysecured. Thus, there is little recourse in cases of default. In countries where loans are fully
19
secured, government controlled credit institutions find it difficult to carry out widespreadforeclosure proceedings in natural calamity cases. It has been a practice in some countries toreschedule loans or forgive loans. Either the debt burden increased or credit discipline eroded.In both cases, recovery was affected negatively.
85. Outstanding Issues. The ultimate objective of rural finance projects is the attainment offinancial viability of the institutions. Can specialized rural finance institutions attain financialviability and sustainability?
V. GENERAL OBSERVATIONS AND CONCLUSIONS
86. This section summarizes the findings of the study and draws the report's conclusions. Thestudy identifies features of appropriately designed rural finance projects. It proposes how Bankpolicy, particularly the provisions of OD 8.30, should be interpreted and translated into projectdesign. These conclusions then serve as the basis for guidelines proposed in the next section. Inarriving at the conclusions of the study, reference is made to similar studies where findings shedmore light on the issues and where conclusions are mutually supportive. A Bank study on lendingfor small enterprises is cited in this report.29 A case study of the Bank for Agriculture andAgricultural Cooperatives (BAAC) in Thailand is the first of a series of case studies to resolve someoutstanding issues or to reinforce the conclusions of this study.30 Although BAAC discontinuedborrowing from the Bank, it may be considered to be one of the best, if not the best, specializedcredit institution the Bank has supported. Since BAAC became successful on its own, someconclusions can be drawn from its experience.
General Observations
87. The experience gained in conducting the study invariably leads to the observation that theproblem of weak supervision overshadows the deficiencies in project design. The inadequacy offinancial data needed to monitor the performance of financial intermediaries is a reflection of thepoor quality of supervision. Yearly audited statements were rarely included in supervision reports.Where yearly audited statements were obtained, these were not analyzed adequately to provideguidance to financial institutions. Recovery rates crucial to institutional capability and financialviability were not reported regularly in supervision reports. The performance of project componentstook precedence over the more important goal of improving the financial viabilitty of participatingintermediaries.
88. Based on the conclusions of this report, guidelines based on best practices were prepared andare presented in the next section to assist task managers in the preparation of future rural financeprojects. The problem of supervision highlights the need for clear guidelines on assessing thefinancial performance of intermediaries. Improvement in the professional expertise of taskmanagers is called for. Bank staff with the necessary acadenmic background and field experienceshould be employed to guide the development of rural financial institutions. Moreover, staff shouldbe provided training and technical backstopping as needed.
Detennining the Objectives and Scope of Rutral Finance Projects
89. In reaching the conclusions on the issues related to the objectives and scope of rural financeprojects, it is necessary to view rural finance from a broad perspective in terms of the nature of
20
clientele served. The client base can be viewed as an economic ladder in which the size of theenterprises are larger at the upper end of the economic ladder and declines towards the lower endof the economic ladder. At the bottom of this economic ladder, below the poverty line, is a "povertypyramid". The top of the pyramid comprises the entrepreneurial poor, followed by the self-employed poor, the laboring poor and finally the vulnerable poor at the very bottom.
90. Bank projects for SMEs serve clients at the upper end of the economic ladder. These arecomprised of larger enterprises which engage in non-agricultural business. The review of SMElending reveals that the average loan size is about $40,000 with average asset ceilings of almost$1,000,000 for the Bank portfolio as a whole.3 ' The mniddle level is served by rural financeprojects where the concentration of loans is in the $1,000 to $5,000 range. The bottom level isserved by microenterprise projects with an average loan size of less than $500, with few loansbeing more than $1,000. There is a wide gap between the client base of SME and rural financelending. However, there is a significant overlap between rural finance and microenterpriselending since most microenterprise finance projects are located in rural areas. Subsistencefarmers are considered as the laboring poor because they do not produce for the market.
91. Financial intermediaries for SME lending are usually commercial banks, government-owned specialized institutions for rural finance activities, and non-governmental organizations(NGOs) for microenterprise lending. Commercial banks are driven by the profit motive,specialized rural finance institutions are mandated by government to serve the rural sector,while NGOs have a mission to help the poor. As the size of enterprises and loans becomesmaller, competition in lending declines, credit projects become narrowly targeted,intermediaries become more specialized, dependence on subsidies is greater, and viability oflending takes a longer time to achieve.
92. Projects which cater to relatively large enterprises and in which the participation ofcommercial banks is expected, an apex arrangement is more appropriate rather than limitingparticipation to a single institution. An advantage of the apex lending arrangement is that it iseasier to establish a market-based interest rate structure. It is feasible to design a general, non-sector specific credit line. Sectorwide objectives of broadening the financial markets andfinancial reform can be incorporated in such projects. There is, however, the possibility ofnegative targeting when agriculture is excluded from availing the general. credit line.
93. As the purpose of on-going rural finance projects is narrowly targeted to financingagricultural production, commercial banks have shown a lack of interest in participating insuch projects. These projects have traditionally resorted to using single participatinginstitutions serving as credit channels. While there is the advantage that project funds aredisbursed faster by specialized institutions, projects have encountered problems in attainingsatisfactory financial performance of the participating institutions. Establishing a market-basedinterest rate policy has also proven to be more difficult due to government control. Sinceimprovement in the performance of rural finance institutions is key to the success of ruralfinance projects, limiting participation to specialized rural finance institutions will allow focuson institutional development. However, when competition in rural lending exists amongformal institutions and the specialized rural finance institution is comparatively efficient, anapex structure is a desirable arrangement in attaining resource transfers and sectorwideobjectives of rural finance projects.
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94. Rural finance projects which are too narrowly targeted have resulted in high risk portfolios.In addition, this has led to the non-farm credit needs in rural areas being unrmet. There is someevidence that farm investment is not in all cases the farmer's priority enterprise, but rather non-farm investments which are expected to yield additional sources of income. In addition, ruralenterprises among non-farmn rural households also have a demand for formal credit. Some projectsinvolving specialized rural finance institutions have lent for non-farm enterprises, but theproportion of the loan portfolio devoted for such lending activities is still negligible. Agriculturalbanks need to diversify their portfolio in order to improve risk management. Prudent riskmanagement calls for the diversification of lending from solely to agricultural production to thebroader objective of financing the full range of the rural sector's needs.
95. This study revealed some evidence to show that diversification enhances the financialstability of financial institutions. Out of the 22 projects analyzed, financial institutions of fourprojects met the eligibility criteria of OD 8.30. One project involves a commercial bank whichhas a highly diversified portfolio comprising of only a small proportion of agricultural financeloans. The other example of diversification is a specialized agricultural bank in which rurallending is less than half of the portfolio. In this case the non-agricultural portfolio has kept theagricultural bank afloat. The other two projects are relatively successful specialized ruralfinance institutions which are heading in the direction of portfolio diversification.
96. In microenterprise lending the impact on poverty alleviation is the primary objective.Loans are very narrowly targeted to reach the poorest of the poor. While NGOs have in mostcases overcome the problem of loan recovery, which has plagued rural finance institutions,NGOs are faced with high transaction costs. As a result most NGOs are not financially viable assuLstainability is dependent on grant funds from donors. Assessing microenterprise projects,therefore, calls for a more flexible interpretation of Bank policy particularly on the issue oftargeting and subsidy.
97. SME, rural finance and microenterprise lending all represent targeted lending. Raising theissue of targeting is considered to have caused the decline in the Bank's small enterprise lending."Subsidized lending became confused wvith taigeted lending. Staff faced an steep uphill battle toobtain internal approval to process these projects. One result of this internal split in views is avirtual cessation in lending for SMEs because it represents targeted lending."32
98. While the objective is to develop market-based lending, little is known about the ruralfinancial market. Information that is needed includes credit demand, access to formal credit,transaction costs, nature of the informal market, attitude towards credit, and propensity tosave, etc. Research is also necessary on the indicators of impact on technological change, laboremployment, production and income.
99. Rural finance projects can only be selectively used as an instrument for attaining creditpolicy objectives. The high rate of non-compliance of credit policy conditionalities indicatesthat rural finance projects by themselves are not effective instruments in carrying out majorchanges in credit policy. Experience shows that credit policy, in particular interest rate policy, isdifficult to achieve when the government rather than the financial institution sets the interestrates. The violation of covenants on credit policy has been the consequence of the lack ofgovernment commitment to the project's objectives. Enforcement of conditionalities requiresresiliency without, however, losing sight of long-term viability objectives.
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100. The case study on BAAC reveals an institution's long-term commitment to financialviability. BAAC does although have to be balanced between the development objectives of thegovernment which owns it and its own financial welfare. The Bank took a flexible stand in theenforcement of the interest rate conditionality, recognizing the political realities faced byBAAC. The Bank did contribute to setting the proper course for BAAC, but BAAC eventuallybecame successful on its own.
101. The lack of continuing support for rural finance projects has found a parallel in SMElending. The study on SME lending concluded that "SME lending programs that had achieveda high degree of success were abandoned.. .because they had become inconsistent withprevailing ideology." The decline in rural finance lending was not as drastic as the case in SMElending. Nevertheless, it should be noted that Bank support for rural finance was discontinuedin about half of the countries where projects were rated as satisfactory. Thus, poor projectperformance was not the sole reason for the declining trend in Bank lending for rural finance. Itappears that management decisions to scale down support for rural finance were made duringthe preparation of country economic strategies, as an over-reaction to OD 8.30.
Factors Affecting Sutstainability of Finance Intermediaries
102. Few rural financial institutions have met the eligibility criteria of OD 8.30. This should,however, not be taken as a disqualification nor grounds to completely abandon support forrural finance. The eligibility requirements of the OD should be interpreted as a test for matureand efficient financial institutions. The performance standards set forth are more appropriate ifconsidered as long-term goals in rural finance rather than prequalifying requirements. The ODaccommodates financial institutions which do not make the grade by providing thatparticipation is premised on an agreed institutional development plan with verifiable qualitativeand quantitative performance targets. The eligibility criteria should, therefore, not pose a threat totask managers in justifying well defined rural finance proposals. However, this should not minimizethe need for more effective monitoring of the performance of financial institutions.
103. Self-sustainability of rural financial institutions is based on the ability to mobilizeresources and attain financial viability. The experience shows that rural financial institutionscan generate a significant amount of funds from deposits. The majority of institutions generatemore than 50% of loan funds from deposits. Financing loans entirely from deposits is anattainable goal. In the case of BAAC, financial viability was reached and subsidy dependencealmost totally eliminated when major strides were taken to generate more deposits. BAACfound that deposits proved to be a cheaper source of funds than borrowing.
104. The poor performance of projects in deposit mobilization is related to the narrowtargeting of rural credit projects which limits deposit taking to farmers. Unless the scope ofrural finance projects is broadened to include all segments of the rural population, theobjectives of resource mobilization will be difficult to attain. It is necessary to build depositmobilization capacity and pursue deposit mobilization campaigns aggressively in the entirerural sector. Furthermore, linking Bank lending to the amount of additional depositsgenerated is of utmost importance.
105. The ability of rural finance institutions to move towards self-sustainability depends on theircapacity to adhere to sound credit practices and respond to market signals. This capacity is greatlyweakened when governments rather than financial institutions make credit decisions. Since most
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Bank loans are negotiated with the government rather than directly with the rural financeinstitution, rural finance projects have invariably strengthened the hand of the government toinfluence the affairs of participating institutions. Furthermore, there are few covenants in ruralfinance projects which prescribe measures that will lead towards the institutions' autonomy.
106. Since management autonomy is a pre-condition towards the attainment of sustainability, thedesign of rural finance projects should emphasize the need to provide greater leeway for financialinstitutions to operate within the realm of the rural financial market framework. Identifying areaswhere the government's grip can be loosened as well as measures to strengthen the independenceof rural financial institutions should be an essential feature of project design.
107. The case of BAAC shows that an efficient management system is possible under govermmentownership. BAAC has managed to strike a delicate balance between the development objectives ofthe government which owns it and its financial well-being. However, as there are limitations inworking with government-owned agriculture banks, participation of private financialintermediaries such as deposit-based cooperative rural banks, poverty-oriented financialinstitutions, and other non-bank intermediaries should also be encouraged.
108. The SDI calculation is based on a set of assumptions on market interest rates and returnon equity. While it is recognized that the SDI is not an exact measure, it approximates the levelof subsidization. The difficulty lies, however, in the interpretation of the SDI.
109. There ate contrasting views on how subsidies to financial institutions should be treated.One view takes a rigid interpretation of the provisions of OD 8.30 as stated in paragraph 76.Some proponents of this view consider that targeted credit is a form of subsidy even if theloans are provided at market interest rates.
110. Another view is that subsidies can and have been used to pursue meaningful objectives;that not all subsidies need be eliminated immediately. Subsidy is a social cost; judgement of itsworth should be based on the social benefits derived. Proponents of this view have opposedthe mandatory calculation of the SDI for all financial intermediaries participating in Bankprojects. While recognizing the usefulness of the SDI, it is feared that the SDI could beinterpreted carelessly and lead to the further decline in financial intermediary lending.
111. Based on the analogy of the different types of clientele, this report is of the view that there areno grounds to provide subsidy to commercial banks which are driven by the profit motive and cateronly to larger enterprises (paras. 91-92). In specialized rural finance institutions, the government isusually the owner and the return to investment is not always the primary objective. Therefore, someamount of subsidy is present as the institution fulfills its role as a major provider of credit to therural sector. All specialized rural finance institutions in on-going projects are subsidized by someamount. Interest rates to end users should be market determined, however, subsidy to the financialinstitution is an unavoidable feature during certain stages of development. This is especially thecase in financial institutions which serve the lower end of the economic ladder. The real test of anNGO is its non-profit nature. Subsidies to NGOs will be a permanent feature unless mature NGOsare transformed into formal financial institutions. This transformation concept is consistent with thefour stages of development of microenterprise finance institutions.3 "
112. The major conclusion of the case study of BAAC sheds light on the issue of subsidy.Subsidies were important in BAAC's development. The subsidies are utilized under able
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management in a prudent manner to build institutional capacity for the delivery of services.Subsidy dependence was slowly reduced and has been almost eliminated. It should be notedthat this process has taken 20 years.
113. The attainment of financial viability should be considered an ultimate objective. It shouldbe recognized, however, that financial viability is a long-term process. The impact on financialperformance may not be immediately apparent during one rural finance project. Therefore,follow-up projects are needed to consolidate gains. The BAAC success story shows that aspecialized bank owned by the government, lending exclusively to farmers under a less thanideal interest rate policy, can become successful contrary to general perception. BAAC receivedsupport from the government and external donors such as the World Bank. Eventually, BAACattained success on its own.
VI. GUIDELINES IN DESIGNING SUCCESSFUL RURAL FINANCE PROJECTS
114. The following guidelines are based on the observations and conclusions drawn from theexperience gained in the implementation of on-going rural finance projects and supplementedby observations from other projects. Four guidelines cover features which contribute to theeffectiveness of rural finance projects. Another set of four guidelines include features tostrengthen rural financial intermediaries.
Features Which Contribute to the Effectiveness of Rural Finance Projects
Institutional arrangements should be based on the characteristics of beneficiaries andwillingness offinancial intermediaries to participate in rural lending.
115. There are both advantages and disadvantages in the different types of institutionalarrangements. Apex arrangements allows equal access to Bank funds and broaden the ruralfinancial market. Experience has shown that market-based interest rates are easier to establishin apex lending arrangements because participating institutions are generally free to set rates.This is particularly true in the case of commercial banks. In addition, apex arrangements aregenerally suited to projects in which the objective is to provide funds to a wide variety ofenterprises including large agro-processing enterprises. The narrow targeting of agriculturalproducers in most rural finance projects has discouraged commercial banks to participate insuch projects. Moreover, problems of disbursement are inherent when commercial banks areincluded in the design feature of rural finance projects which target agricultural producers.Apex arrangements are, therefore, best suited to projects which are designed to finance a widerange of enterprises.
116. Specialized rural finance institutions are generally more successful in attaining fundtransfer objectives and are more willing to serve the credit needs of small borrowers.Experience has shown that there are significantly fewer problems of disbursement lags in ruralfinance projects involving these specialized institutions. These rural finance institutions arebetter positioned to finance agricultural production and investments and to serve beneficiariesat the lower end of the economic ladder such as small farmers, small rural enterprises, ruralwomen and landless laborers. However, specialized rural finance institutions generally facedifficulties in attaining a satisfactory level of financial performance. The major reason for thisbeing that these institutions are government-owned and controlled. Establishing market-based
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interest rates has been problematic for these should, therefore, be based on pre-conditions as anassurance that these financial institutions will respond to market signals and move towards anacceptable level of financial viability.
Credit projects should be pre-conditioned on the government's commitment to provideruralfinance institutions an acceptable level of autonomy.
117. The fundamental problem for specialized rural finance institutions is the lack of autonomy toadhere to sound credit practices and respond to market signals. In many instances, this lack ofautonomy has led to financially unviable lending in compliance with the government's mandate tomeet its development objectives. Conditionalities for management autonomy were not included incredit projects despite the provisions of OD 8.30 calling for strengthening the decision-makingprocess of financial institutions.
118. Almost half of the credit institutions in on-going projects were not in a position todetermine their lending rates. A few projects operated as agencies of ministries. Furthermore,dependence on government as an external source of funding contributed to the weakening ofautonomy. Since government control of credit institutions has made financial viability adifficult objective to attain, assurance of an acceptable level of autonomy should be a crucialfeature of rural finance projects.
119. At the design stage, rural credit projects should include an assessment of the level ofautonomy. Statutes of credit institutions should be studied. In addition, the managementstructure should be examined by determining the composition of the board, who appointsmanagers, how staff are recruited and what personnel and management systems are in place. Acommitment by government to allow such institutions management autonomy should be a pre-condition for initiating new projects or follow-up projects. A list of measures to increaseautonomy should be drawn up at an early stage of project consideration.
120. If a minister chairs the board, it is desirable for the minister to step down and the boardelect the chairman. It is also desirable that the board, rather than the government, select thegeneral manager. Whenever possible, introducing private ownership and membership on theboard, even to a limited extent, will contribute to greater autonomy. Transferring thesupervision of the financial institution from a ministry to the central bank should also be aconsideration.
121. Operating policies should be studied to determine the independence of the institutions inmaking credit decisions, setting interest rates and foreclosing on defaulted loans. Special creditprograms implemented for and in behalf of the government should be clearly identified.Government practices for imposing debt forgiveness measures should also be noted. Lastly, anagenda of institutional reform measures to correct existing weaknesses should be agreed uponduring appraisal.
A conducive credit policy should suipport mneasures to strengthen nrralfinance institutions.
122. A conducive credit policy framework is essential for the effective functioning anddevelopment of the rural financial system. These policies include interest rates, subsidizedcredit lines from other donors, credit quotas, directed credit lines, government guarantees anddebt forgiveness measures. The most difficult policy to tackle is the interest rate policy.
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123. Despite the need to rationalize interest rates, the Bank's experience in enforcing theconditionality to increase interest rates has often been unsuccessful. In reaching a decision onthe interest rate conditionality, due consideration should be taken of the interest rate structureof the financial institution as compared to alternative sources of credit, the overall interest ratestructure of the country, and the degree of independence of the participating financialinstitution to set rates.
124. In cases where agricultural interest rates are aligned with a distorted overall structure,other financial instruments instead of rural finance projects are more effective in facilitatinginterest rate policy reform. Where the interest rate structure of the financial institution is notaligned with the overall structure, a commitment to realign the interest structure of thefinancial institution should be obtained.
125. Interest rate reform can be achieved by allowing the financial institution the authority toset interest rates. If the government falls short of providing the institution an acceptable level ofautonomy, particularly in the setting appropriate interest rates, policy reform should be dealt inconjunction with country economic dialogues and broader financial sector operations.
Credit projects should support research on ruralfinancial markets.
126. In countries where adequate information does not exist on rural financial markets,research should be included as a component of rural finance projects. The information collectedcan serve as the basis for the future design of credit projects, supervision of projects, and themeasurement of the impact of these projects on production, employment and income.
127. This research should assess both the demand side and the supply side of the ruralfinancial market. The demand studies should entail household level surveys to determine theuse of credit, sources, terms and conditions, transaction costs, household savings, level ofindebtedness, and impact on technological change, production, employment and income. It ispreferable that household surveys be conducted at the beginning as well as at the end of theproject to obtain an accurate assessment of project impact. In addition, a modestly sizednational random sample would be useful for comparative purposes.
128. The supply side studies should include the branch network of banks, deposit based localfinancial institutions, non-governmental institutions and informal lenders. The detailed termsof reference for these studies should be incorporated in project documents. Modest budgetsshould be provided for these studies. Research institutes, research units of governmentagencies or central banks, international organizations and consulting firms can be engaged incarrying out these studies.
Measures to Strengthen Rural Financial Intermediation
The decision to initiate a new orfollow-up credit project should be based on thefinancialinstitution's commitment to move towards financial viability and institutionalstrengthening.
129. While specialized rural financial institutions are effective channels for rural finance, amajor weakness is financial performance. The study shows that only a few of these institutionscan pass the rigid eligibility criteria embodied in OD 8.30. The impact of credit projects on
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financial viability over the course of a single project is not immediately apparent. It is apparentthat subsidy dependence is a feature of rural finance institutions at the early stages ofdevi elopment and that subsidies can be decreased over time.
130. Attaining financial viability should be regarded as a long-term objective. Experience hasshown that specialized rural financial institutions can achieve financial viability provided thatthere is a long-term commitment matched by strong and innovative leadership of theinstitution. A long-term relationship by the Bank through a series of rural finance projectsmatched by a firm stand on major issues and covenants can produce positive results. On theother hand, decades of support to financial institutions which do not have a commitment tomove towards financial viability has not produced the desired results.
131. The commitment to achieve financial viability and institutional strengthening should betranslated into a pre-agreed action plan. A five-year business plan should be preparedincorporating the measures to be taken to attain plan objectives with verifiable qualitative andquantitative targets. This plan should contain, whenever appropriate, a detailed assessment ofthe financial performance of the institution including the quality of its loan portfolio, study oflending policies and procedures, strategic planning process, organization and managementstudy, and rural financial market studies. A commitment to implement the agreed plan shouldbe incorporated in the project's conditionalities.
132. The factors crucial to financial viability are the interest rate structure, the administrative cost,the recovery rate, provisioning policy, and the adequacy of capital. Management informationsystems and internal controls which are necessary for accurate financial data and monitoringprogress should also be in place. In cases where problems in loan recovery are prevalent, a recoveryplan containing specific measures to be undertaken and planned targets should be prepared. Itshould be noted that commitment to implement the plan should be ascertained. When problems ofexcessively high administrative costs prevail, a plan to down-size operating costs and staff shouldbe agreed upon at an early stage of loan procedures.
133. The interest rate structure is linked to the level of autonomy of the financial institution.There should be a commitment to adopt market rates. While it is not feasible to immediatelyeliminate credit lines with below market rates, the beneficiaries of these lines should be clearlyidentified and the relative proportion of funds should be contained. It is preferable to placethese lines under the account of the government as off-balance sheet items with a commitmentto phase out these lines over a reasonable period of time.
Ruralfinance projects shiould support thte diversification of rural credit institutions.
134. Diversifying the purposes for which loans are granted has several advantages. It wouldmeet the credit needs of farmers for purposes other than agricultural production for which theymay have a higher investment priority. Some evidence reveals that agricultural production isnot always the farmer's investment priority. Creating additional employment and generatingadditional income can be a feature of both off-farm and non-farm rural enterprises. Theexperience in poverty alleviation projects in many countries reveals that the demand for creditwas for purposes other than farm production.
135. Almost all specialized rural financial institutions were initially organized as agriculturalbanks for the purpose of providing credit to agricultural producers. Many of these institutions
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give priority to small farmers. As a result, lending has become narrowly confined to financingagricultural production. Rural finance projects have traditionally strengthened thespecialization of these banks. There also seems to be a natural aversion among agriculturebanks to venture into providing credit for non-farm enterprises among farm households andother rural enterprises among non-farm households.
136. Rural finance projects should encourage specialized financial institutions to cater to theneeds of non-farm enterprises and non-farm households. Part of the problem of narrowspecialization can be traced to the practice of identifying specific purposes for which projectfunds can be used at the design stage and calculating rates of return for selected sub-projects.Invariably, the choice of enterprises becomes limited to agricultural production. Rural financeprojects should, therefore, encourage specialized financial institutions to serve the credit needsof the entire sector. Diversification would allow for the risk to be spread. In addition, higherinterest rates could be charged on non-agricultural loans such as commercial loans resulting inwider interest rate spreads and higher yields. Lending to non-farm enterprises would alsoprovide a greater variety of financial services to rural households. A more diversified lendingprogram would contribute to widening the deposit base of financial institutions.
137. Financing should be made available for upstream enterprises such as suppliers of inputsfor agriculture, manufacturers of farm equipment, marketing enterprises which directly orindirectly serve agriculture, agro-processing enterprises, warehousing, retailing, transporting,agro-tourism, etc. There are also a large number of cottage enterprises which rural women andthe landless poor engage in - food processing, weaving, backyard enterprises, etc. The lattertype of lending represents the link between rural finance and microenterprise finance.
138. It would be difficult for project designers to identify all these enterprises in advance asinformation on investment opportunities and credit demand is not available in the absence ofrural financial market studies. Intermediary banks should be given the leeway to identifyenterprises and clients and develop standards and procedures to assess loan applications. Ruralfinance projects should be designed to provide refinancing to intermediary banks for majorcategories of the loan portfolio. Technical assistance should also be provided to develop thecapacity of financial institutions to cater to a more diversified clientele.
Bank funds should match rather than substitute forfunds generated from deposits.
139. Improvement in deposit mobilization is vital to the realization of self-sustainability ofrural financial institutions. However, in practice deposit mobilization objectives have provendifficult to achieve. The lack of progress is attributed to several factors. The availability of Bankfunds provides a disincentive for financial institutions to raise funds from the more difficultprocess of deposit mobilization. In most cases, rural finance projects have not linked theamount of the Bank loan with the amount of deposits to be generated. Agriculture banks have alimited capability to mobilize deposits as branches of agriculture banks are usually notaccessible to rural depositors. Funds generated from deposits can prove to be more costly if theadministrative costs are factored in or there are other sources of funds at below market rates.Deposits mobilized at commercial rates cannot be loaned profitably when an interest rate cap isimposed by the government. While farmers do save, there is a misconception that the bulk ofsavings will come from farmer-borrowers rather than from the rural population at large. Thereis also the problem of public trust of government-owned agriculture banks.
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140. To encourage rural finance institutions to mobilize deposits, Bank funds should match theamount of funds these institutions generate from deposits. Major attention should be given tostrengthening the capacity of sound institutions to mobilize deposits. This would come in theform of improved physical structures, appropriate equipment to maintain deposit accounts,training of staff, and improvement in the image of the financial institution. While ruralfinancial institutions cannot be expected to finance loans entirely from deposits as envisionedby OD 8.30, experience shows that a significant proportion of loan funds can be obtained fromdeposits. Given the necessary attention and support for deposit mobilization, at least 50% andideally 100% of the loan portfolio should be financed from deposits.
Ruralfinance projects should develop other credit channels.
141. The Bank limits the participation in rural credit projects to formal banking institutions. Itshould be recognized that these formal channels do have limitations. Commercial banks aredeposit based, but are hesitant to finance agriculture and rural enterprises. Effectiveparticipation of commercial banks is limited to large clients. On the other hand, whilespecialized rural credit institutions are committed to agriculture and rural lending, theseinstitutions are not deposit based, are controlled by governments, and may not be financiallyviable in the medium-term.
142. Rural credit project design should be broadened to include private, local financialinstitutions and NGOs with a good track record. Consideration should be made to involvingdeposit basea local financial institutions such as credit unions, savings cooperatives, rotatingsavings and credit associations, and local rural banks which have experience in providingcredit to rural households. The possibility of establishing regional banking structures such asregional cooperative banks should be explored to link these local institutions to the formalfinancial system and expand the process of rural financial intermediation.
143. The informal private money lender has been a reliable source of credit for ruralhouseholds. These lenders provide credit primarily for household needs. Non-governmentalinitiatives such as private organizations have successfully financed microenterprises and havedemonstrated their effectiveness in increasing access to credit for the entrepreneurial poor, thelaboring poor, and rural women who do not meet the collateral requirements of banks. Some ofthese foundations have graduated into special purpose banks. The opportunity to include thesenon-governmental institutions should be explored in the context of expanding the scope ofrural credit projects from agricultural credit to rural lending, including microenterprise finance.
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NOTES:
1. World Bank. 1993. A Review of Bank Lending for Agricultural Credit and Rural Finance(1948-92), Operations Evaluation Department, Washington, D.C.2. Adopted from: World Bank. 1991.World Bank, Agricultural Credit in Europe, Middle Eastand North Africa Region: Characteristics, Issues and Strategy) EMENA Technical Department,Agricultural Division, Washington, D.C.3. OD 8.30, para. 80.4. OD 8.30, para. 60.5. An example of this occurred during the appraisal of the Agricultural Modernization Projectis Egypt when instructions were given by the regional management to include commercialbanks as participating banks although project staff recommended against it.6. Indonesia: Agricultural Financing Project (Ln 3402).7. OD 8.30, paras. 23-25.8. These studies were carried out in Yemen and India.9. OD 8.30, paras. 11-14.10. OD 8.30, paras. 15-22.11. This is the case of Turkey: Third Agricultural Credit (Ln. 3090).12. OD 8.30, para. 63.13. OD 8.30, para. 65.14. OD 8.30, paras. 61-62.15. The specialized rural financial institutions are in the Philippines, Egypt and Morocco. The
commercial banks are in Indonesia.16. OD 8.30, Annex A, para 13-B.17. The institution with the lowest level of deposits is the Agricultural Development Bank of
Pakistan. It pursues the strategy of mobilizing deposits from farmers rather than the from theentire rural population. It prefers the convenience and lower cost of external sources of funds,with the Bank being the major source after a total of 7 credit projects over a period of 30 years.The loan amount for the on-going project is much larger than the deposits. In contrast, thecommercial banking system has generated 29% of its total deposits from rural areas loanedback 7% and moved the rest to the urban centers.18. The institution referred to is the Land Bank of the Philippines. However, it should be
noted that government funds accounted for most of this bank's deposits.19. The Philippines Rural Finance Project (Ln. 3356) was successful in deposit mobilization.
The Morocco National Agricultural Credit Project (Ln. 3088) was only moderately successful.20. OD 8.30, para. 71.21. OD 8.30, para. 72.22. The government of Turkey passed a decree approving the remission of interest for farmersin default of payments where the principal was not greater than TL 5 million. In Morocco,payments were forgiven for loans of no more than DH 1,000 (US $100). The governmentforgave farmers in Jordan for repaying interest the first year and forgave the principalpayment the second year. By the third year, the repayment dropped to 5%. The CooperativeBank collapsed the following year.23. OD 8.30, para. 55.24. OD 8.30, para. 29.25. Until 1993 the National Bank for Agriculture in Tunisia devoted 40% of total portfolio,
including government credit lines, to agriculture. Almost all of the agricultural credit lines wereimplemented on account of the government. Government credit lines were rescheduled in 1994and reduced from 48 programs to 4.
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26. OD 8.30, para. 54.27. The Principal Bank for Agricultural Credit (PBDAC) in Egypt receives payment from thegovernment for the interest rate differential of a subsidized line. However, the governmentcollects annually an amount much larger than it provides to PBDAC. Since PBDAC receivessubstantial amounts of grants from external donors, the income collected by the government isessentially income accruing from such grants.28. In a study carried out in connection with a follow-up project in Morocco, it was reportedthat as much as 3 0% of the entire cereal acreage would not be harvested in an extremely baddrought year. The losses for an insurance program which would guarantee 60% of the averageyield is estimated at 15%. Drought could occur two years in succession as has happenedrecently in Morocco.29. Webster, Leila M., Randall Riopelle and Anne-Marie Chidzero. 1994. World Bank LendingforSmall Enterprises 1989-1993 .Washington, D.C., Private Sector Development Department, (DraftReport)30. Sacay, Orlando J. and Meliza Agabin. 1995. The BAAC Success Story: A SpecializedAgriculture Bank under Government Ownership. Washington, D.C., Financial Sector DevelopmentDepartment (Draft Report)31. Webster, Leila M., Randall Riopelle and Anne-Marie Chidzero. 1994. World BankLendingfor Small Enterprises 1989-1993. Washington, D.C. Private Sector DevelopmentDepartment (Draft Report)32. This is the conclusion reached by Webster et al.33. Otero, Maria and Elisabeth Rhyne, Editors. 1994. The New World of Microenterprise Finance:Building Healthy Financial Institutions For The Poor. West Hartford, CT. Kumarian Press.
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Annex 1
List of Projects StudiedCountry Loan or Project Name Starting Closing Date Loan or Credit
Credit Date (US$ million)Number
Ongoing Stand-Alone ProjectsAfricaGhana Credit 2040 RuralFinance Project 4/26/90 12/ 3 1/93 a. 20.0Madagascar Credit 1804 Second Agricultural Credit 10/8/87 6/30/94 10.0Malawi Credit 1851 Smallholder Agricultural Credit 9/8/88 6/30/95 5.9East AsiaChina Loan 3265 Fourth Rural Credit 3/22/91 12/31/95 75.0
Credit 2182 200.0China Credit 1871 RuralCreditlIH 6/17/88 6/30/94 170.0Indonesia Loan 3402 Agriculture Financing Project 3/27/92 12/31/98 106.1South AsiaPakistan Loan 3226 Agricultural Credit Project 4/12/91 Cancelled 148.5
6/28/94Credit 2153 1.5
Philippines Loan 3356 Rural Finance Project 11/7/91 3/31/97 a. 150.0MENAMorocco Loan 3088 National Agricultural Credit Project 9/27/89 12/31/93 190.0LACArgentina Loan 2970 Second Agricultural Credit Project 2/1/89 6/30/96 106.5Brazil Loan 2971 Agricultural Credit Project 8/22/89 12/31/93 300.0Ecuador Loan 2752 Second Agricultural Credit Project 8/31/87 6/30/94 48.0ECAHungary Loan 3229 Integrated Agricultural Export 10/1/90 12/31/95 100.0
ProjectPoland Loan 3343 Agricultural Development Project 3/4/92 6/30/95 100.0Romania Loan 3486 Private Farmer and Enterprise 11/5/92 12/31/97 100.0
Support ProjectTurkey Loan 3090 Third Agricultural Credit Project 11/6/89 12/31/93 b. 250.0
Ongoing Semi-Stand-Alone ProjectsMalawi Credit 1966 Agricultural Marketing and Estate 6/9/89 6/30/96 18.3
Development ProjectZimbabwe Loan 3063 Agricultural Credit and Export 8/1/90 12/31/95 36.3
Promotion ProjectBelize Loan 2959 Agricultural Credit & Export 4/6/89 12/31/94 7.8
Development ProjectCosta Rica Loan 2764 Atlantico Agricultural Development 10/4/88 6/30/94 26.0
ProjectUruguay Loan 3131 Second Agricultural Development 5/11/90 5/31/95 65.0
ProjectEgypt Loan 2561 Second Agricultural Development 7/31/87 3/31/94 139.0
ProjectNotes:a. Last disbursement in June 1994.b. Project extended.Source: Database search of Bank reports
33
Ongoing Projects with Cr. ComponentsCredit Component
Loan or as Percentage ofCredit Project Primary Sector and Starting Closing Loan or Credit
Country Number Secondary Sector Date Date AmountAFRICAEthiopia Cr. 1782 Agriculture/Livestock and 1/29/88 12/31/93 IDA not financing
Livestock ProductsGuinea Cr. 1725 Agriculture/Livestock and 7/31/87 12/31/93 9
Livestock ProductsIvory Coast Ln. 2874 Agriculture/Industrial Crops 10/18/88 12/31/93 18Kenya Cr. 1974 Agriculture/Rural Development 9/9/89 12/31/93 17Kenya Cr. 2062 Agriculture/Food Crops 8/1/90 6/30/97 19Mauritania Cr. 2093 Agriculture/Agricultural Sector 5/29/90 12/31/95 6
Program, Area Agric. Develop.Mozambique Cr. 2337 Agriculture 4/30/91 12/31/00 23Sudan Cr. 2011 Agriculture/Irrigation, Flood 7/27/89 10/31/93 13
Control and DrainageTanzania Cr. 2050 Agriculture/Food Crops, 1/22/90 6/30/96 9
Industrial CropsUganda Cr. 2190 Agriculture/Agricultural Sector 1/3/91 6/30/95 Could not separate
Program Cr. componentZaire Cr. 1790 Agriculture/Area, Agric. Dev. 5/2/88 12/31/94 48ASIAIndonesia Ln. 3305 Agriculture/Area, Agric. 6/24/91 12/31/96 Could not separate
Development Cr. componentIndonesia Ln. 2773 Agriculture/Fishery and 5/7/87 12/31/94 33
Fishery IndustriesIndia Ln. 3065 Agriculture/Agroindustry 9/14/89 12/31/96 Bank not financing
Cr. 2022Pakistan Ln. 2973 Agriculture/Food Crops 4/13/89 12/31/96 59
Cr. 1936 Agricultural Extension andResearch Mechanization
MENATunisia Ln. 2605 Agriculture/Irrigation, Flood 6/18/86 9/30/93 Could not give % of
Control and Drainage Ln. amount; 5% ofRep. of Cr. 1886 Agriculture/Area, Agric. Dev. 7/13/89 12/31/95 3Rep. of Cr. 1667 Agriculture/Area, Agric. Dev. 12/7/87 12/31/93 IDA not financingLACBarbados Ln. 2782 Agriculture/Agric. Sector 11/17/87 12/31/93 60
Program, Area Agric. Dev.Brazil Ln. 2860 Agriculture/Rural Development 10/15/87 3/31/96 31Brazil Ln. 2862 Agriculture/Rural Development 12/18/87 3/31/96 30Brazil Ln. 2861 Agriculture/Rural Development 10/20/87 3/31/96 30Brazil Ln. 2523 Agriculture/Rural Development 12/12/85 6/30/94 27Brazil Ln. 2762 Agriculture/Rural Development 11/20/87 3/31/95 37Colombia Ln. 2667 Agriculture/Irrigation, Flood 2/24/87 6/30/95 Bank not financing
Control and DrainageVenezuela Ln.3420 Agriculture/Agricultural Cr. 6/26/92 6/30/96 42ECAPortugal Ln. 3035 Agriculture/Area, Agric. Dev. 2/20/90 6/30/97 39Source: Database search of Bank reports
34
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Recent World Bank Discussion Papers (continued)
No. 258 How Fast is Fertility Declining in Botswana and Zimbabwe? Duncan Thomas and Ityai Muvandi
No. 259 Policies Affeaing Fertility and Contraceptive Use:An Assessment of Twelve Sub-Saharan Countries. Susan Scribner
No. 260 Financial Systems in Sub-Saharan Africa:A Comparative Study. Paul A. Popiel
No. 261 Poverty Alleviation and Social Investment Funds: The Latin American Experience. Philip J. Glaessner, Kye Woo Lee,Anma Maria Sant'Anna, and Jean-Jacques de St. Antoine
No. 262 Public Policyfor the Promotion of Family Farms in Italy: The Experience of the Fundfor the Formation of PeasantProperty. Eric B. Shearer and Giuseppe Barbero
No. 263 Sef-Employmentfor the Unemployed: Experience in OECD and Transitional Economies. Sandra Wilson andArvil V. Adams
No. 264 Schooling and Cognitive Achievements of Children in Morocco: Can the Government Improve Outcomes?Shahidur R. Khandker,Victor Lavy, and Deon Filmer
No. 265 World Bank-Financed Projects with Community Participation:. Procurement and Disbursement Issues.Gita Gopal and Alexandre Marc
No. 266 Seed Systems in Sub-Saharan Africa: Issues and Options. V.Venkatesan
No. 267 Trade Policy Reform in Developing Countries Since 1985: Review of the Evidence. Judith M. Dean, Seema Desai, andJames Riedel
No. 268 Farm Restrucuring and Land Tenure in Reforming Socialist Economies: Comparative Analysis of Eastern and CentralEurope. Euroconsult and Centre for World Food Studies
No. 269 The Evolution of the World Bank's Railway Lending.Alice Galenson and Louis S. Thompson
No. 270 Land Reform and Farm Restructuring in Ukraine. Zvi Lerman, Karen Brooks, and Csaba Csaki
No. 271 Small Enterprises Adjusting to Liberalization in Five African Countries. Ron Parker, Randall Riopelle, andWilliam E Steel
No. 272 Adolescent Health: Reassessing the Passage to Adulthood. Judith Senderowitz
No. 273 Measurement of We!fare Changes Caused by Large Price Shifts: An Issue in the Power Sector. Robert Bacon
No.274 Social Acion Programs and Social Funds: Review of Design and Implementation in Sub-Saharan Africa.Alexandre Marc, Carol Graham, Mark Schacter, and Mary Schmidt
No. 275 Investing in Young Children. Mary EmingYoung
No. 276 Managing Primary Health Care: Implications of the Health Transition. Richard Heaver
No. 277 Energy Demand in Five Major Asian Developing Countries: Structure and Prospects. Masayasu Ishiguroand Takamas Akiyama
No. 278 Preshipment Inspection Services. Patrick Low
No. 279 Restructuring Banks and Enterprises: Recent Lessonsfrom Transition Countries. Michael S. Borish,Millard F. Long, and Michel Noel
No. 280 Agriculture, Poverty, and Policy Reform in Sub-Saharan Africa. Kevin M. Cleaver and W Graeme Donovan
No. 281 The Diffusion of Information Technology: Experience of Industrial Countries and Lessons for Developing Countries.Nagy Hanna, Ken Guy, and Erik Arnold
No. 282 Trade Laws and Institutions: Cood Practices and the World Trade Organization. Bernard M. Hoekman
No. 283 Meeting the Challenge of Chinese Enterprise Reform. Harry G. Broadman
No. 284 Desert Locust Management:A Timefor Change. Steen R.Joffe
No. 285 Sharing the Wealth: Privatization through Broad-Based Ownership Strategies. Stuart W Bell
No. 286 Credit Policies and the Industrialization of Korea. Yoon Je Cho and Joon-Kyung Kim
No. 287 East Asia's Environment: Principles and PrioritiesforAction. Jeffrey S. Hammer and Sudhir Shetty
No. 288 Africa's Experience with StructuralAdjustment: Proceedings of the Harare Seminar, May 23-24, 1994.
Edited by Kapil Kapoor
No. 289 Rethinking Research on Land Degradation in Developing Countries. Yvan Biot, Piers Macleod Blaikie, CecileJackson, and Richard Palmer-Jones
No. 290 Decentralizing Infrastructure:Advantages and Limitations. Edited by Antonio Estache
No. 291 Transforming Payment Systems: Meeting the Needs of Emerging Market Economies. Setsuya Sato and David BurrasHumphrey
No. 292 Regulated Deregulation of the Financial System in Korea. Ismail Dalla and Deena Khatkhate
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