Friday, November 30, 2012

Does debt relief to indebted farmers boost investment and productivity?

According to a new WB policy research working paper by Martin Kanz, the debt relief to indebted farmers (given by the Indian government) didn’t increase investment and productivity. In June 2008, the Indian government waived debt owed by poor farmers (US$14.4 billion = 1.6% of GDP) to commercial and cooperative banks between 1997 and 2007. The small and marginal farmers owning less than two hectares of land got 100% debt waiver and farmers owning over two hectares got 35% debt relief if the remaining 75% was settled (in drought-affected districts, 25% or Rs 20,000 relief, whichever is greater, if the remainder is settled).

The three major findings of the study that should be considered while unveiling similar programs in the coming days are:

  • Debt relief failed to reintegrate recipient households into formal lending relationships. Kanz found that the households that had all of their debt cancelled borrowed, on average, 6 percentage points less from formal sector sources than households in the control group.
  • Debt relief doesn’t increase investment or productivity of beneficiary households. The productivity of debt relief households after end of the program declined in absolute terms and lagged up to 14 percentage points behind the productivity of households in the control group.
  • Debt relief strongly affects the expectations of households regarding the reputational consequences, i.e. they get singled out in the market and might face borrowing constraints in the future. It might lead to decline in investment (risk profile of debt relief households goes up).

Below is the abstract from the paper:

This paper studies the impact of a large debt relief program, intended to attenuate investment constraints among highly-indebted households in rural India. It isolates the causal effect of bankruptcy-like debt relief settlements using a natural experiment arising from India's Debt Relief Program for Small and Marginal Farmers -- one of the largest debt relief initiatives in history. The analysis shows that debt relief has a persistent effect on the level of household debt, but does not increase investment and productivity as predicted by theories of debt overhang. Instead, the anticipation of future credit constraints leads to a greater reliance on informal financing, lower investment and a decline in productivity among bailout recipients. The results suggest that one-time settlements may be insufficient to incentivize new investment, but can have significant real effects through their impact on borrower expectations.

Repeated bail out of indebted households could induce moral hazard and deteriorate rural credit markets (plus investments).These debt reliefs are usually politically motivated and serve to boost popular rating and perception while impacting budget balance. Here, I am not saying that there shouldn’t be debt relief at all of heavily indebted farmers. The issue is that if such reliefs are to be repeated or voters expect one from their elected representatives, then it might promote a dangerous trend where households keep on piling up debt beyond their means on expectations that one day it will be waived by a populist leader. Debt relief of indebted farmers has to be highly targeted and it shouldn’t have any whiff of popularity.

In 2008, the then finance minister of Nepal also introduced debt relief (following the Indian example) of poor and indebted farmers. Even though the money is already spent (via the state-backed BFIs), the effectiveness of this one-off intervention is yet to be evaluated.