1.2 Traditional Finance Programmes
1.2.1 The Usury Argument
Interest rates charged by informal money lenders were considered immoral by governments and donor agencies (Adams and Graham, 1981; Adams, 1984). However, high nominal interest rates do not necessarily imply large profits. Money lent by informal lenders can often have a high opportunity cost, since capital was scarce in rural economies. In addition, although lenders charged high nominal interest rates (up to 60% per annum), the loans were considered inexpensive by borrowers since the transaction costs in obtaining these loans were
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fairly low while loan use was flexible (Adams, 1984; Larson et aI., 1994). This is further demonstrated by their continued existence and use even though relatively cheap credit was available.
1.2.2 Liquidity and theUse of Creditinthe ProductionProcess
A common argument in support of subsidised credit is that it is necessary to induce the poor to make productive investments and to use new technologies to encourage economic growth and poverty reduction (Adams, 1984). However, research has shown that policies which provide access to productive resources elicit a muted response from low-income households if local institutions do not provide opportunities and incentives to invest (Olson, 1996;
Zander, 1997). Insecure property rights negatively influence investment decisions since the investor cannot internalise the benefits of the investment. Markets produce the objective information that guides economic decisions taken by investors. Poorly developed infrastructure (roads, telecommunications, postal services) and legal uncertainty (ineffective and costly contract enforcement) present in developing regions and economies increase market transaction costs, negatively affecting investment (Lyne, 1996; Yaron et al., 1997).
Securing the full participation of the poorin the economic growth process may thus require policies which improve the employability of the poor, improving the performance of labour markets, and establishing the necessary institutions and appropriate infrastructure that reduce market transaction costs, facilitate tenure security (secure and transferable property rights) and uphold commercial contracts (Gonzalez-Vega, 1994; Olson, 1996). Evidence from SA suggests that where low-income households have had access to additional resources (more
land through improved land rental markets and earned higher off-farm incomes), credit has encouraged investment in productive inputs and led to increased incomes (Coetzee, 1995).
In addition, the separation of business activities from household consumption does not tend to be distinct in poor households, the decision of the amount and allocation of credit is based on all requirements of the household, whether it be for production, consumption or other contingencies. Therefore, use of credit may not only be a demand for funds for productive investment, but may also facilitate consumption smoothing by synchronising income generating and consumption activities. Credit has the properties of divisibility, substitutability and diversion (fungibility of money) and can be used for many purposes, not necessarily for the one it was intended (von Pischke and Adams, 1980).
Credit can thus have an important liquidity value in low-income households, since it prevents the liquidation of valuable assets such as cattle, stored crops and jewellery, which, although relatively liquid, may result in considerable transaction costs to liquidate (Baker and Bhargava, 1974; Gustafson, 1989; Barry et al., 1995: 185 - 210). Loans to subsistence borrowers could provide an important source of liquidity to meet unanticipated negative income shocks and facilitate consumption smoothing such as paying for school fees, food, weddings and funerals, since these may be more important to the borrower at the time. Even where loans are provided in kind, secondary markets for the goods emerge through which liquid funds can be recovered. Hence, credit cannot only be viewed as an input in the production process because a loan is a claim on real resources that provides additional liquidity in any economic activity available in the market (von Pischke and Adams, 1980;
Adams and Graham, 1981; Adams, 1984).
1.2.3 Interest Rate RestrictionsandLending Costs
Interest rates have a very strong influence on lenders' behaviour since they make up a large part of lenders' total revenues. Major increases or decreases in interest rates have an impact on revenues and thus surpluses or deficits of the lender (Adams and Graham, 1981). Hence, loan pricing is a key managerial control variable and is based on factors both external and internal to the lending institution. Translated into costs experienced by the lender, loan pricing entails covering the full set of lending costs which include administrative costs, funding costs, risk-bearing costs, competitive costs and non-loan costs (Barry et al., 1995:
453 - 468).
Administrative costs include personnel salaries, documents, equipment, legal servIces, computers, supplies and other costs involved in running the loan programme. Funding costs cover interest costs on funds purchased in the fmancial market and equity costs (the desired return on the institution's own equity capital). Delinquency and borrower default, and any unanticipated variations in borrower's need for funds are covered by risk-bearing costs.
Competitive costs reflect the level of competition in the institution's loan market, while non- loan costs cover services provided by the lender such as technical production assistance, business training and financial planning (Barryet al., 1995: 453 - 468).
Operating in rural fmancial markets is costly to lenders due to geographic dispersion of clients, collateral insecurity, small size of loans and covariant risks associated with farming (Adams, 1984; Gonzalez-Vega, 1984). Interest rate restrictions make it difficult for formal lenders to cover costs, with the result that the fmancial viability of the lender is undermined.
This may lead to a highly skewed distribution of credit, with formal lenders only lending to wealthy individuals with readily collateralisable assets, leaving many potential smaller borrowers credit-rationed. The presence of government or donor supported MFOs may also reduce the incentives that commercial lenders have to develop innovative financial technologies to provide financial services to the poor (Krafft, 1996). Allowing lenders to charge interest rates that account for the costs and risks of lending to low-income individuals could improve the provision of financial services in these markets by improving lender viability (Adams, 1984; Gonzalez-Vega, 1984).
1.2.4 Borrower Transaction Costs
Although traditional credit programmes assumed that the burden on the poor can be relieved by reducing the nominal interest rate, borrower transaction costs - which together with the interest payment make up total borrowing costs - are seldom considered (Adams and Nehman, 1979; Ladman, 1984). Such transaction costs include direct out-of-pocket costs such as the costs of obtaining documentation, paying bribes, travelling expenses and, in some instances, collateralisation costs. Indirect costs include the opportunity costs of time and pledging collateral (Cuevas, 1988; Ladman, 1984). These costs arise due to the financial technologies employed by lenders, since they need information about prospective borrowers to protect their funds.
Ladman (1984) shows that borrower transaction costs have at least three important impacts on the degree ofintemal credit rationing (decision whether or not, and how much, to borrow) by potential borrowers. First, borrower transaction costs reduce the expected returns from investment. Second, there is a project threshold below which the borrower will not be willing
to borrow - this occurs where the marginal cost of borrowing equals the marginal revenue generated from additional resources purchased with the borrowed funds. Higher borrower transaction costs increase the threshold below which potential borrowers will not borrow.
Thirdly, high initial out-of-pocket costs required to apply for the loan might deter potential borrowers from applying for the loan if the risk of loan rejection is high.
First-time borrowers may have larger borrower transaction costs and out-of-pocket cost thresholds, since they must present information that need not be furnished by repeat borrowers. In addition, fIrst-time borrowers are likely to have smaller profIts and hence a greater possibility of not exceeding the borrowing threshold and, therefore, not applying for credit. Low-income borrowers may also have limited collateralisable wealth, or may regard the opportunity costs of pledging collateral too high where there is a threat of foreclosure (Feder et al., 1988). Borrower transaction costs can thus provide an important means for lenders to ration credit in the presence of interest rate restrictions.
This is achieved by shifting a considerable portion of the non-interest costs onto borrowers, thereby increasing borrower transaction costs (Adams and Vogel, 1986). Since these transaction costs make up the largest portion of total borrowing costs for small loans, this form of rationing is systematically biased against small borrowers. Larger, wealthier borrowers are in a better position to absorb these costs and thus apply for credit. It is also more profItable to the bank to make larger loans since the relatively constant transaction costs are spread over a larger loan amount (Ladman, 1984; Adams and Vogel, 1986).
The above discussion indicates that policies that provide credit at concessionary interest rates to induce the desired production and technology adoption are rendered ineffective, since non-
interest costs play a key role in determining the price of credit to low-income borrowers.
Concessionary interest rates may result in lenders rationing the excess demand for credit by increasing the non-interest costs to borrowers.