Policy and legal review of the Micro Finance Institutions (Development & Regulation) Bill: A new working paper

In response to the Second Micro Finance Crisis in Andhra Pradesh, which took place in October 2010, the Ministry of Finance has proposed a new ``Micro Finance Institutions (Development & Regulation)

Bill''. A new working paper by Shubho Roy, Renuka Sane and Susan Thomas analyses this bill from first principles of economics and law.

A great deal of traditional work in India, in the field of finance and public policy, has been poorly grounded in terms of logical thinking. A variety of government interventions are proposed, without fully showing the rationale for why a given intervention is valuable. I have often scented a socialistic impulse to intervene in the economy based on some vague notions of being a do-gooder. In addition, of course, there are interventions which cater to one special interest group after another.

I feel it is useful to work in a systematic way. The first task is to identify market failures (if any). All interventions must be considered guilty until proven innocent: an intervention must demonstrably tackle a manifestly visible problem. A useful classification scheme in finance is that all financial regulation falls under the three heads of consumer protection, prudential regulation and systemic stability. It is useful to pose problems under these three categories, then propose interventions which address them. At both levels, we need to move away from ex cathedra assertions towards logic and evidence that demonstrates that there is a problem, and logic and evidence that shows that the proposed intervention solves the identified problem without inducing collateral damage.

In the years to come, we need much higher quality drafting of law in India. This process will be assisted if independent analysis in the economy will critique draft law as has been done by the Roy, Sane and Thomas paper. We need more universities and think tanks who will subject all draft legislation and draft subordinate legislation to such scrutiny. On the government side, a greater effort on the formal rule-making process is required, whereby government is able to utilise such comments more effectively so as to strengthen the work.

Waiver of Mass Debt (WMD)

This blog entry is by Vijay Mahajan of BASIX.

Iraq was attacked by the US and the UK on the basis of a fictional threat - WMD - weapons of mass destruction. We have seen the results of that lie, with shock and awe. India's WMD is less costly - Rs 60,000 crore, or only $15 billion - but is based on similar half-baked analysis of half-truths, and well designed to benefit those behind it - in our case Pawar-ful large commercial farmers.

As per the National Sample Survey, 59th Round, 2004-05, over half, or 51.4% of the farmer households in the country did not access credit, either from institutional or non-institutional sources. Further, despite the vast network of bank branches, only 27% of total farm households had any loans from formal sources (of which one-third also borrow from informal sources), while 73% did not. Among the marginal farmer category, as many as 80% did not have any borrowing from formal sources.

So the FM and the Agriculture Minister must have known in advance that their generosity will only cover the upper quartile of farmers. Yet, if we go by the details, only those whose bank loans were overdue on Dec 31, would get a waiver. So a big grape farmer in Nasik who had a bumper crop but was politically aware, so did not repay his loan, will get a waiver of Rs 1 lakh while a poor rainfed farmer in Vidarbha who has sold his less than normal yield cotton crop to the state monopoly cotton federation, at a lower than market price, will be deemed to have repaid his Rs 15000 loan from the proceeds that he has yet to receive, and will not get the waiver.

There is no fig leaf to this pro big farmer loan waiver, as can be seen by RBI's clarification that not only crop loans but also term loans for tractors, poultry farms etc will be covered by the waiver. To minimize backlash from those who did not get the waiver, in AP, the Chief Minister has additionally declared a 10% bonus payment to all farmers who sell their produce through regulated market yards - once again, the larger farmers.

Apart from the gross inequity in the name of small farmers, the loan waiver is particularly inept as it completely fails to address the underlying causes of the Indian agrarian crisis, including -

1. Dwindling size of land holdings;
2. Low percentage of irrigation, even protective irrigation; and where there was irrigation, tapering yields due to long years of mis-fertilisation and increasing level of pesticide resistance.
3. In rainfed areas, no measures for coping with recurrent drought, no significant varietal improvements, nor any agricultural guidance to farmers.
4. Increases in input costs, coupled with lower relative prices for produce, and price fluctuation, has meant that agriculture is not very profitable even for commercial farmers. For small farmers, with imputed wages for family labour, farming does not even break even.

The same Rs 60,000 crore could have been used to drought-proof 60 million ha of dryland @ Rs 10000 per ha, which would permanently secure the livelihoods of at least 3 crore of our poorer, farmers in rainfed areas. Dozens of successful examples exist, of the rehabilitation of natural watersheds and traditional water storage structures, by NGOs and government agencies. Part of the funds could also be used to rehabilitate the dilapidated canal irrigation systems, conditional on the states switching to participatory irrigation management (PIM).

Even if one were to accept that the loan waiver was aimed at gaining electoral advantage, it could have been done much more equitably and would have fetched more votes.

Recognising that the debt burden of small and marginal farmers is more from moneylenders and traders, a waiver should have been given for both bank and moneylender/trader loans. Given the difficulty of verifying these, the waiver could have been limited to Rs 5000 per ha for farmers with irrigation, and Rs 2500 per ha to rainfed farmers, with a cap of Rs 10,000 per farmer in both cases. Additional amounts from informal lenders could have been swapped for much lower cost bank loans, as has been tried in Andhra Pradesh by the "total financial inclusion" program of the Indira Kranti Patham project.

Further, to prevent leakage, the money could be credited to the bank accounts of farmers. This would also have incentivised banks to open "no-frills" accounts for 5 crore farmers who don't have bank accounts, as per the recently adopted national financial inclusion plan.

Rough calculations show that this alternate method would have benefited 10 crore farmers, about thrice the number likely to be covered at the moment.

The one mystery is - why did not the Left argue in favour of a more equitable waiver? Have they lost interest in the agrarian vote bank after Nandigram? Or is it a deal which we will understand many years later?

Maharashtra vs. Gujarat on cotton and farmer suicide

I have written earlier about the problem of farmer suicide. Today, Sanjeev Nayyar has a fascinating piece in Business Standard comparing and contrasting Gujarat and Maharashtra on cotton. There appears to be a significant incidence of suicide amongst cotton farmers in Maharashtra, but not in Gujarat. Why?

Both states accounted for roughly the same proportion of the country's production in 1991-92 (Gujarat was 12.7 per cent and Maharashtra was 10.5 per cent). While Maharashtra's share has increased only marginally in the period since, to 14.8 per cent in 2005-06, Gujarat's share is up three times, to 36.5 per cent; Maharashtra's area under cotton has grown just marginally, Gujarat's has nearly doubled; and Gujarat's yield is more than three times that of Maharashtra.

What went wrong is a classic story of how sops do little but bankrupt the exchequer and, at the same time, make the beneficiary so weak, he/she becomes uncompetitive. In 1971, when nationalisation was the flavour, Maharashtra launched the Cotton Monopoly Scheme (CMS) with the avowed aim to capture the whole economic value for the farmer, from growing cotton to selling finished cloth. It proposed to do this by helping farmers get a fair price for their produce, make available unadulterated cotton to consumers at reasonable prices, produce textiles and distribute bonus (profit on operations) to farmers. Therefore, the CMS allowed politicians to control the states cotton industry.

...

Under the scheme, cotton could be procured only by the state-owned Maharashtra State Co-operative Cotton Growers Marketing Federation Ltd (MSC). Farmers were to be given a bonus for the cotton they sold, but cotton produced in the state had to be pressed within the state only. On the face of it a good thing, this had four consequences.

One, since each cotton procurement area was managed by a grader, this functionary became a big power centre, extracting bribes from farmers according to one ex-MSC official, graders commanded the highest dowry in their villages! Second, since the state had to procure the cotton, and bribes had to be paid to the grader, there was no real incentive to produce better cotton. Third, as the state had financial difficulties sustaining over-payments to farmers, the payments were delayed and, a few years ago, just stopped. Four, since till 1999-00, private sector units had to obtain a license to set up ginning and processing, entrepreneurs began setting up units in border towns in adjoining states, such as Burhanpur in Madhya Pradesh cotton began to be sent out of the state illegally and value addition took place outside the state.

...

In neighbouring Gujarat, in contrast, a combination of factors ensured production increased. First, unlike Maharashtra, Gujarat didn't waste money on monopoly procurement and chose to invest it in creating irrigation. Over 40 per cent of cultivable land in Gujarat is irrigated as compared to just 3 per cent in Maharashtra. Also water levels across the state have gone up due to large-scale rain water harvesting by the construction of thousands of check dams. Instead of the Rs 6,000 crore or so that were wasted on CMS, the Maharashtra government could instead have constructed 100 Kolhapur-type Bandhara dam (medium type dam) at a cost of Rs 60 crore each this would have irrigated 25 lakh acres or 33 per cent of area under cotton cultivation. Indeed, in 1999-2000, both NABARD and the ministry of agriculture contributed Rs 100 crore each to create a Watershed Development Fund across the country of the corpus of Rs 579 crore, only Rs 30 crore has been disbursed.

Gujarat also created its own brand, Shanker6, and entrepreneurial farmers took faster to using Bt cotton to reduce costs. While around 40 per cent of Maharashtra's cotton farmers use Bt seeds, according to industry sources, around 80 per cent of the area cultivated in Gujarat is with Bt cotton. According to an IIM Ahmedabad study, this increases yields in irrigated areas by 35 per cent in Gujarat (48 per cent in Maharashtra) and profits by as much as 75 per cent in Gujarat (58 per cent in Maharashtra) Gujarati farmers sell a better variety of Bt cotton and are able to realise a higher price as well. The same study took a sample across Maharashtra, Gujarat and Andhra and found a 24 per cent reduction in pesticide cost. It found that the Gujarati farmer spends Rs 4,649 per hectare on fertilizer versus Rs 7,116 in Maharashtra (with respect to Bt cotton).

There are other critical areas like rural credit where the government needs to act since it is clear the current system is not working (the accumulated losses of all co-operative banks till 2002-03 was Rs 9,277 crore). The state would do well to take lessons from the Cotton Corporation of India (CCI), which is the equivalent of Maharashtras MSC.

CCI administers the Cotton Technology Mission. As part of the mission it provides ginning and processing units a subsidy of 25 per cent of their modernisation cost (upto a maximum of Rs 12.5 lakh). It also conducts demonstrations on production technology whereby it demonstrates to farmers how cotton should be cultivated on one acre plots and holds farmer field schools and kisan melas. It has started contract farming in Vidharbha. An informal association of farmers represented by select farmers sign a tripartite MoU with CCI and the textile mill. While various structures exist, the general model is that the mill provides farmers with inputs, conducts demonstrations and agrees to buy produce at a premium of 5-10 per cent of prevailing market price. This way the farmer focuses on production and quality, and the mill is assured of pure unmixed cotton.

Easing credit constraints

In an ideal world, individuals should be able to smooth consumption across time through a variety of financial devices such as debt. Given the high risk aversion of most households, there is quite a bit of welfare that can be gained by better smoothing of consumption. In India, a large number of households are "credit constrained" - they are unable to have significant debt. This is not necessarily bad - e.g. some of the problem of farmers killing themselves has surely got to do with inappropriate debt-equity ratios.

Every country goes through a transition where the overall borrowing of households goes from roughly nothing, and ends up with a significant amount of leverage. Robert Samuelson has a very nice story about how the US went from household debt of 22% of disposable income in 1946 to 126% in 2006. (I suppose he means PFCE when he says "disposable income"?) William Pesek had a nice article in 2005 on the crisis with household credit in South Korea. It's a great period for the macroeconomy, with high consumption growth, while households are adding leverage. It is a transition that comes only once in the life of a country.

A while ago, I had written about new approaches to solving credit constraints in the form of loans against securities and credit cards. All over the world, when the credit card business works, it effectively serves as small-business financing.

Loans against securities are now quite mainstream thanks to the mass of dematerialised shares that are now in existence. The NSDL data shows they have Rs.18 trillion of equity and roughly Rs.3.5 trillion of debt securities amongst their 7.7 million accounts. The CDSL data shows another Rs.2.1 trillion of demat assets.

What is new about demat securities is that they constitute top quality collateral. The collateral is frictionless for the lender, mark to market is easy, liquidation is easy. This makes it easy to give a loan against such high quality collateral. In contrast, real estate or cars are bad collateral.

One new kind of high quality collateral that is falling into place is dematerialised warehouse receipts which are claims on standardised physical commodities. These aren't quite as good as securities on the issues of valuation and liquidation, but it's another big step forward for easing credit constraints. Today's Indian Express has a story by Suresh P. Iyengar on this.

In my opinion, another frontier on easing credit constraints is obtaining a loan using the accumulated balance in your DC pension account as collateral. The size of credit required to tide over small problems like health or unemployment are small compared with the size of pension wealth that needs to be built up over life, so for most decades of the working life, it is possible to solve the consumption smoothing required owing to ill-health and unemployment by having access to loans against the DC pension account. I have talked about this a bit in my submission to PRS about the PFRDA Bill.

Farmer suicide continued

A short while ago, I had written about the farmer suicide problem. Now Business World has an excellent editorial on the farmer suicide problem:

Four weeks ago, the Prime Minister visited villages in Vidarbha where farmers had committed suicide. After hearing the stories of their distress from those that were left behind, he announced a relief package amounting to Rs 3750 crore : Rs 712 crore in interest to be written off, Rs 1275 crore in fresh credit, and the rest to fund irrigation, water harvesting and seed improvement. This practice of throwing money at problems is so common amongst politicians that it hardly attracts comment. They buy votes with taxpayer's money. Politicians all over the world do it; if they do it somewhat more egregiously in India, that is what Indian democracy is about. But when it is adopted by a Prime Minister who once was a renowned economist, it evokes questions about which turban he is wearing. For he cannot be unaware of the incentive effects of his actions. If some farmers are forgiven their interest liabilities, they will ask why it should not happen again. Others will ask why they do not deserve the same bounty. Many borrowers will stop paying interest, hoping that when they are asked to pay, they will make up some hard-luck story and get by. Giving fresh loans to defaulters has similar incentive effects. Having been rewarded once for defaulting, they will expect further rewards. And borrowers with an impeccable record will ask themselves why they should pay when others do not. The cost is initially borne by banks, and when they cannot bear it any more, the central government pumps taxpayer's money into them. To a soft-hearted politician, the above considerations will seem devoid of pity. How can one just stand by and watch when farmers are committing suicide? For every suicide there are a hundred farmers going through unbearable financial distress. Such crises are what politics is supposed to address. The press is a spoilt, hypercritical brat. It will criticize any meritorious act. But its attention span is short; soon something else will catch its attention, and it will forget the farmers. What is sad and surprising in this affair, is that although the Prime Minister himself once wrote theses and papers analysing economic problems, he has no interest in analyses of the problems he has to deal with. The problem is not confined to Vidarbha, but is endemic in the Deccan trap, consisting of inland Maharashtra, Andhra and Karnataka. The rainfall in this region is insufficient for rice or sugar cane. So farmers in these areas are confined to dry crops. Amongst these crops, the dry foodgrain crops lost out over the years when cheap (some would say subsidized) wheat and rice came to be sold all over the country; today, jowar, bajra and ragi are largely forgotten. When these crops became uneconomic, the farmers of the Deccan Trap turned to cotton. Cotton is subject to the triple risk of rainfall, pests and prices. Pests can be tackled, but pesticides are expensive; and more recently, expensive high-yield seeds have become available. Both require investment. It should ideally come as risk capital. But farmers cannot set up companies or raise equity. So the capital has come as fixed-interest loans. Banks have from time to time been forced to lend; but they do not like lending to cotton farmers on account of the risk; so the lending business has been largely in the hands of private money-lenders. There are laws going back to late nineteenth century against exploiting farmers. But the returns are high enough to cover the risk, so moneylending has continued to flourish. The Maharashtra government has tried to protect farmers against price fluctuations by guaranteed purchases. But it did not want a situation in which it had to buy all the cotton that was offered in years when prices were low, and get none when prices were high. So it has instituted monopoly procurement - with the result that Maharashtra farmers miss out on price booms. Its monopoly procurement scheme is extremely unpopular, not least because of delayed payments and corruption; farmers routinely smuggle cotton out of Maharashtra. Manmohan Singh may be a master of economics, but he is a prisoner of politics. He can do nothing to dismantle Maharashtra's monopoly procurement scheme. He cannot force the Maharashtra government to act against politically powerful moneylenders; an MLA from Buldana is reputed to be Vidarbha's most prominent agricultural moneylender. And the Prime Minister is too conscientious to abandon his job as long as he thinks he has a chance of doing something good for his country - or at any rate of preventing another politician from doing harm. So the only option he sees is to throw money at problems, knowing full well that money nourishes and multiplies problems.

Making sense of farmer suicide

There has been a great deal of bleeding heart treatment of farmer suicides [link, link]. A few sane voices have pointed out that there are enormous problems with the underlying policy framework in agriculture. [link, link]. Many people are peddling more distortions, such as forcible debt write-offs (which will hurt credit access for the living) or a big MSP style system for cotton (which will hurt the cotton market).

In an article Making sense of farmer suicide in Business Standard today, I try to engage in some rational thinking on these issues.

The risk of cotton farming

Cotton cultivation has risen sharply in Andhra Pradesh, and two regularities about cotton are: (a) A sharp rise in volatility of some grades with (b) Very low correlations across grades. The low correlations seem to suggest a lack of goods arbitrage - if cotton was moving freely across the country, pockets of very high / very low prices (and high price volatility) would not happen. A set of policy responses which will get the cotton market to work properly are well worth emphasising.

The volatility of the cotton price of some grades rose sharply. That got me thinking in terms of corporate finance. If I was a firm, and my cashflow volatility went up, I'd need more equity capital to cope with these shocks. What appears to be going on with farmers is a mixture of high leverage plus an increase in output price volatility - either out of a shift from cereal to cotton, or an increase in in the volatility of cotton. A firm / entrepreneur who plys this trade needs more equity capital on the table.

Modifying the rules of the game of credit

A great deal of the public discussions have emphasised giving out more credit, at lower rates, and with easier debt write-offs. I think the picture is more complex than meets the eye, and there can easily be unexpected effects:

Example: What happens if the government pushes more credit? In the bad old days, there was acute credit rationing, farmers were equity financed and there were no defaults. If the government does a big push to get more credit to farmers - e.g. by giving banks quotas for loans to farmers - then bankers are forced to dole out credit even when the leverage is excessive. Alternatively, improved credit access could help households jump from a low-risk business like wheat to a high-risk business like cotton. So giving out more access to easy credit could lead to wrong results, giving us more farm households with acutely high leverage and/or a more risky cashflow, i.e. more farm households which are under a high probability of default.

Example: What happens if lenders are forced to take losses and forgive debt that borrowers "cannot" repay? A government that emphasises writing off debt gives lenders strong incentives to not give out debt. The debt relief initiatives that are being bandied about in response to farmer suicides look worrisome in terms of the future of credit access for poor people. I am all for a carefully thought out "Chapter 11" procedure for the treatment of personal bankruptcy. But knee-jerk responses owing to 4000 people who killed themselves shouldn't reduce the credit market access and thus the welfare of 40 million people who didn't.

The man-bites-dog syndrome of democracy

Farmer suicide is a bit of a man-bites-dog story in terms of getting heightened focus from the media and the political system. There is something disproportionate in State expenditure of Rs.4,000 crore for a problem where 4,000 people kill themselves a year, while bigger crises like 150,000 mothers who die in pregnancy every year are burning unabated, with no juicy stories to attract the attention of the media.

The nature of the agricultural firm

How are farmers going to bring equity capital, scientific knowledge, risk management using futures markets, etc. to bear on the problem of agriculture? I suspect such bulking up will just not happen as long as an individual entrepreneur holds an acre or two of land. The growing complexity of agriculture requires a shift from small farmer-entrepreneurs to sophisticated organisation structures.

As I say in the article, asking a lay farmer to be a full-fledged entrepreneur - with skills spanning across biology and futures trading, and requiring substantial equity capital - is as daunting as taking a typical industrial or office worker and asking him to become a full-fledged entrepreneur. We are trying to put square pegs into round holes. It would be like taking a small mom-and-pop retailer and asking him to become a modern retailing business. I suspect a lot of today's entrepreneurial farmers could be better off being employees of firms engaged in agriculture.

This is about building modern firms, not about collectives or cooperatives. A merger between 10 mom-and-pop stores does not make a modern retailer. If there are 2 small farmers with little equity capital, low knowledge, and 1 acre of land each, putting them together into a cooperative or a collective which now controls 2 acres of land achieves little. The merged entity continues to have a deficit of equity capital and of knowledge; in addition it has the decision making problems and meddling by politicians that afflict a cooperative.