The Economics of

Rural Organization
Theory,Practice,and Policy
.........
. . . . . . . .. .. . . . . . . .. . . . . . . .. . . . . . . . . . .. . . .

Editedby
Karla Hoff, Avishay Braverman, and
Joseph E. Stiglitz

Publishedfor the WorldBank

OxfordUniversityPress
 2
ImperfectInformation
and RuralCreditMarkets:
PuzzlesarndPolicyPerspectives
KarlaHoff andJosephE. Stiglitz
, ~~~~~~~~~~~~. . . . . . . . . ...

RURAL CREDIT MARKETS have been at the center of policy intervention in

developing countries over the past forty years. Many governments, sup-
ported by multilateral and bilateral aid agencies, have devoted considerable
resources to supplying cheap credit to farmers in a myriad of institutional
settings. The results of many of these interventions have been disappointing.
Despite high levels of subsidy to rural credit in the Asian countries surveyed
in this part of the book, many farmers-especially small farmers-depend for
credit on moneylenders whose interest rates remain extremely high. (See
table 2-1.) One explanation for the failure of public credit institutions to
drive out the traditional moneylender or drive down the interest rates
charged must be that public policies were based on an inadequate under-
standing of the workings of rural credit markets.
There typically exists a dual rural credit market in developing countries.
In the formal credit market, institutions provide intermediation between
depositors (or the government) and lenders and charge relatively low rates of
interest that usually are government-subsidized. In informal credit markets,
money is lent by private individuals-professional moneylenders, traders,
commission agents, landlords, friends, and relatives-generally out of their
own equity. The objective of this chapter is to provide a framework for
assessing the relationship between the formal and informal sectors of rural
credit markets and the consequences of government interventions in formal
credit markets.

33
34 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

Table 2-1. Characteristicsof SelectedRuralCredit Markets

Surveyedin This Volume

Share of Mean interestrate. Average transaction

formnalsector (percent) (dollars)
intotalcredit Formal Informal Formal Informal
Surveyregion/period (percent) sector sector sector sector
Zaria,Nigeria,1987-88 8 -3.6 -7.5 266 51
Nakhon Rachasima
Province,Thailand,
1984-85 44 12-14 9Qh 440 254
India
1951 7 3.5-12.5 7-35 400c 200c
1961 17 n.a. n.a. n.a. n.a.
1971 30 n.a. n.a. n.a. n.a.
1981 61d 10-12 22 n.a. 80-345,
Chambar,Pakistan,
1980-81 25 12 79b n.a. 284
n.a. Not applicable.
a. Interestrates for Nigeriaare real realizedmonthly rates. Interestrates for Thailand and
India are nominal and annual. Interest rates for Pakistan are real annual rates charged.See
chaptersin part I for detailson the calculationof theserates.
b. Figuresincludeonlycommerciallending;they excludeloansfrom friendsand relatives.
c. Annual borrowingsper borrowinghousehold.
d. Basedon officialsources,but much higherthan more plausibleestimatesfrom unofficial
sources.Seechapter 9.
e. Lowfigurefor Bihar;high figurefor Punjab.
Sources: Nigeria:chapter 5;Thailand: chapter 8; India:chapter 9 (table9-1),plusadditional
data providedby Bell drawn from the RBI (1954,vol. 1, part 2, chapter 21, "RegionalData"
tables),Belland Srinivasan(1989,table 2) and Bell,Srinivasan,and Udry (1990);Pakistan:
chapter7.

This chapter also provides an overview, based on the case studies in part 1,
of the modus operandi of informal credit markets in five developing coun-
tries and Israel. Contracts and institutions that appear to be pervasive are
usufruct loans, kinship- and village-based credit systems, trade-credit inter-
linkages, and rotating savings and credit associations. These contracts and
institutions help to solve the information and enforcement problems in
lending. The fact that they are available to some potential lenders and
borrowers and not to others helps to explain why informal credit markets
are segmented, and why financial intermediation between formal and infor-
mal sectors is very imperfect, so that low formal interest rates coexist with
high informal interest rates. I
The body of this chapter presents four competing theories of rural credit
markets: (a) the view that the village moneylender is a usurious monopolist;
 KARLA HOFF AND JOSEPH E. STIGLITZ 35

(b) the view that credit markets are (approximately) perfectly competitive
and characterized by market clearing, with high interest rates reflecting only
high risks of default and high costs of information; (c) the view that empha-
sizes the use of indirect screening mechanisms, such as the interest rate, with
the result that there may be credit rationing; and (d) the view that empha-
sizes the use of direct mechanisms to solve the problems of information and
enforcement, with the result that credit markets may be monopolistically
competitive. Evidence from the case studies suggests that the last view is the
most useful in understanding the informal sector of rural credit markets. We
will therefore describe these direct mechanisms in some detail.
The end of this chapter considers policy implications. Our principal con-
clusion is that the most successful government interventions in the formal
credit markets are those that draw on the ability of the informal sector to
solve the selection, monitoring, and enforcement problems of lending.

Traditional Views and Puzzles

There are two early views of rural credit markets, each providing a different
explanation for the typically high interest rates in the informal sector.

The Monopolistic Moneylender

In this view, the village moneylender is a monopolist. Without competition,
he is free to charge a "usurious" interest rate. The traditional view is cap-
tured in India's landmark study of the rural credit system in the early 19 50s:
agricultural credit presented a "two-fold problem of inadequacy and
unsuitability" (RBI 1954, vol. 2, p. 151, cited by Bell in chapter 9). Introduc-
tion of government lending agencies and promotion of rural cooperatives
were needed to "provide a positive institutional alternative to the money-
lender himself, something which will compete with him, remove him from
the forefront and put him in his place" (RBI, pp. 481-82).
From the perspective of recent research, that official view overstates the
problems of rural capital markets because it ignores the thriving informal
credit markets that often exist. It seems to assume that there is no competi-
tion among moneylenders. But in another way it understates the problems.
The past forty years' experience of government intervention in India,
Pakistan, Thailand, and other developing countries shows that the creation
of a positive institutional alternative-rural banks and credit cooperatives-
has failed to drive the traditional moneylender out of the market ("to put
him in his place"). The case study of Thailand (chapter 8) goes further-it
suggests that government intervention has not even lowered interest rates
charged by moneylenders.
36 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

Perfect Markets
A second view of credit markets, which is associated with George Stigler of
the Chicago school, is that imperfections in credit markets are not likely to
be important. In general, high interest rates reflect not monopoly power but
high default rates and high information costs. Moreover, Stigler argued in
his 1967paper on credit markets (p. 291) that "there is no 'imperfection' in a
market possessing incomplete knowledge if it would not be (privately] remu-
nerative to acquire (produce) complete knowledge." But this statement is
true only if private and social benefits from increasing information are the
same. In general they are not the same, either for information about technol-
ogy (see Hirschliefer 1971, regarding inventions), or for information in labor
markets (see Spence 1974 and Stiglitz 1975), or, as we will argue in this
chapter, for information in credit markets. This view also fails to take into
consideration the fact that imperfect information may limit the effective
degree of competition within a market, a point to which we return in a later
section.
In the "perfect markets" view, there is a presumption that credit markets
are approximately Pareto-efficient. The only ground for government inter-
vention in credit markets is to redistribute income to the poor (at some cost
in efficiency).

The Inadequacy of the "Monopoly" and "Perfect Markets"

Views of Rural Credit Markets
Neither the traditional "monopoly" nor the "perfect markets" view can
explain other features of rural credit markets that are at least as important
and equally puzzling as high interest rates:
* The formal and informal sectors coexist, despite the fact that formal
interest rates are substantially below those charged in the informal
sector.
* Interest rates may not equilibrate credit supply and demand: there may
be credit rationing, and in periods of bad harvests lending may be
unavailable at any price.
* Credit markets are segmented. Interest rates of lenders in different areas
vary by more than can plausibly be accounted for by differences in the
likelihood of default. Local events-a failure of a harvest in one area-
seem to have significant impacts on the availability of credit in local
markets.
* There are a limited number of commercial lenders in the informal
sector, despite the high rates charged.
* In the informal sector, interlinkages between credit transactions and
transactions in other markets are common.
 KARLAHOFF AND JOSEPHE. STIGLITZ 37
* Formal lenders tend to specialize in areas where farmers have land
titles.
Neither the monopoly view nor the perfect markets view can account for
these features taken as a whole. An alternative approach is required-one
that is better able to help us understand the workings of rural credit markets
and, thus, help us design appropriate policy interventions.

The "Imperfect Information" Paradigm

In the past decade there have been major advances in our theoretical under-
standing of the workings of credit markets. These advances have evolved
from a paradigm that emphasizes the problems of imperfect information and
imperfect enforcement. Lenders exchange money today for a promise of
money in the future and take actions to make it more likely that those
promises are fulfilled. Lending activity thus entails (a) the exchange of con-
sumption today for consumption in a later period, (b) insurance against
default risk, (c) information acquisition regarding the characteristics of loan
applicants (this is the screeningproblem); (d) measures to ensure that bor-
rowers take those actions that make repayment most likely (this is the
incentivesproblem); and (e) enforcement actions to increase the likelihood of
repayment by borrowers who are able to do so.
It is this broadening of the perspective of what is entailed by lending
activity that provides the background for the new theories of rural credit
markets. This framework guides the case studies in part I and the theoretical
analysis of peer monitoring in chapter 4.
It is useful to distinguish two types of mechanisms for resolving the prob-
lems of screening, incentives, and enforcement. Indirect mechanismsrely on
the design of contracts by lenders such that, when a borrower responds to
these contracts in his own best interests, the lender obtains information
about the riskiness of the borrower, and induces him to take actions to
reduce the likelihood of default and to repay the loan whenever he has the
resources to do so. These mechanisms may be in the credit market itself (in
loan terms such as the interest rate and loan size), or they may rely on
contracts in related markets (in rental agreements, for example) that will
influence a borrower's behavior in credit markets. In the first case, the
interest rate serves the dual function of a price and an indirect screening or
incentive mechanism. As we discuss further below, this means that the
equilibrium interest rate need not clear the market-there may be credit
rationing. Notice, however, that these indirect mechanisms are equally
applicable whether there is competition or monopoly in the market.
Direct mechanisms entail lenders' (a) expending resources in actively
38 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

screening applicants and enforcing loans and (b) limiting the range of their
lending activity to members of a particular kinship group, residents of a
given region, or individuals with whom they trade. These direct mechanisms
(through personal relationship, trade-credit linkages, usufruct loans, and
other means) tend to lead to a monopolistically competitive structure with
interest rate spreads between different segments of the rural credit markets.
We will argue that the entry of institutional credit into a rural credit market
is unlikely to break the power of moneylenders unless the new institutions
themselves find substitutes for the direct mechanisms used by moneylenders
to overcome the problems of screening, incentives, and enforcement.

The Theory of Indirect Mechanisms

Interest Rates as an Indirect Screening Mechanism

For any loan there is a possibility that the project for which it is used will
perform so badly that the borrower defaults. In that contingency, the lender
cannot recover his total outlay, and in fact there are legal provisions in many
societies that severely limit the amount that he can recover. The probability
of default on a loan thus depends on the probability that the gross return on
the project financed by the debt is less than the principal and interest due. It
follows that as projects become riskier, in the sense that the probability of
both very high and very low gross returns increases relative to the proba-
bility of moderate returns, the likelihood of default increases. The lender is
hurt by an increase in the riskiness of projects that will be undertaken with
his loans. In contrast, the borrower's expected profits from the project will
rise.
To see how the interest rate can be used as an indirect screen of the
riskiness of projects, it is simplest (but not necessary) to suppose that bor-
rowers are risk neutral. Risk-neutral borrowers will submit loan applications
for projects with a positive expected net return, taking into account default
provisions. For any class of projects with the same mean gross return but
differing risk, the interest rate will determine a marginal project that has an
expected net return to the borrower that is just barely positive. By the above
argument, all projects in this class that give the borrower a higher expected
net return entail a higher probability of default. An increase in the rate of
interest will mean that the old marginal project now gives a negative
expected net return. The new marginal project will be riskier than the
marginal project under the initial, lower interest rate, so that the pool of
projects coming from this class will on average be riskier than it was at the
lower interest rate. The same argument applies for projects with differing
 KARLA HOFF AND JOSEPH E. STIGLITZ 39

risks at any level of mean gross return. Thus as the interest rate increases,
the mix of prospective projects tilts in favor of riskier projects. As Adam
Smith put it some two hundred years ago: "If the legal rate of interest . . . was
fixed so high . . . , the greater part of the money which was to be lent would
be lent to prodigals and projectors, who alone would be willing to give this
high interest" (Smith 1976 [1776], p. 379).
A lender can never fully discern the extent of risk of a particular loan, and
the pool of applicants for loans at any given interest rate will consist of
borrowers with projects in different risk categories. But the lender knows, by
the above reasoning, that the mix of projects to finance changes with the
rate of interest. The interest rate takes on the dual function of rationing
credit and regulating the risk composition of the lender's portfolio. This can
lead to unexpected outcomes (explored in formal models in Stiglitz and
Weiss 1981 and forthcoming, and Stiglitz 1987).For example, when there is
an excess demand for loans at a given interest rate, classical economic
analysis would suggest that this price would rise to choke off the excess
demand. Higher interest rates would raise the lender's returns if they did not
greatly increase his risk by increasing the probability of defaults. But at some
higher interest rate, the greater risk and thus the higher incidence of default
will offset the increased interest income from the loan portfolio. In that case,
the lender will choose to keep the interest rate low enough to obtain a
favorable risk composition of projects, and to ration the available loanable
funds through other means. Thus, contrary to the operation of markets as
they are supposed to work, demand may exceed supply, with no tendency
for the interest rate to rise.
The situation would be even more extreme if lenders did not recognize the
effect of interest rates on the risk of their portfolios. Then we might get a
process whereby, at a given rate of interest, the default rate was so high that
returns to the lender did not cover opportunity costs of funds. This would
put upward pressure on the interest rate, but the increase in the interest rate
would only worsen the risk mix. The process would go on until the interest
rate was so high that only the riskiest projects-those with the highest
probability of default-would be undertaken. It has been argued by some
writers that processes such as these account for the thinness of many mar-
kets (including some types of credit markets) in which the quality (default
risk) of the commodity exchanged depends on the price (interest rate) and
there is asymmetric information between buyers and sellers (Akerlof 1970).
This would suggest that lenders, even in situations of limited competition,
cannot raise interest rates so high as to extract all of the surplus associated
with a particular loan. But the limited competition resulting from imperfect
and costly information may nonetheless allow lenders to charge interest
rates far higher than competitive levels.
40 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

Incentive Effects of Terminations and Market Interlinkages

A lender may employ two other indirect mechanisms to enhance the likeli-
hood that borrowers undertake the actions desired by lenders. First, the
lender may use the threat of cutting off credit to induce desired borrower
behavior (see Stiglitz and Weiss 1983). For this incentive to be effective, of
course, borrowers must enjoy some surplus from obtaining the loans. This
provides another way in which markets with imperfect information are
fundamentally different from markets with perfect information: competition
does not drive rents to zero. Those who are lucky enough to get loans get a
consumer surplus, and that consumer surplus, being denied to the unlucky,
is in effect a rent.
Second, lenders who are landlords or merchants may use the contractual
terms in these other exchanges to affect the probability of default. They may
interlink the terms of transactions in the credit market with those of transac-
tions in the product or rental markets (see Braverman and Stiglitz 1982,
1986). For example, a trader-lender may offer a farmer who borrows from
him lower prices on fertilizers and pesticides, since the probability of default
is reduced when such inputs are used. We shall consider the use of inter-
linkages as a direct mechanism for solving information and enforcement
problems below.

Direct Screening Mechanisms

In addition to indirect screening mechanisms, most lenders will also use

direct screening mechanisms and may monitor borrowers' behavior, with-
drawing credit if the terms of the loan appear to be violated. In developing
countries potential lenders vary greatly in their costs of direct screening,
monitoring, and enforcing loan repayment. For some lenders, such costs are
low. For example, information may be a by-product of living near the bor-
rower or being part of the same kinship group or a party to some other
transaction with him. Thus, village lenders often do considerable monitor-
ing, while banks may find it virtually impossible to do so. Differences across
lenders in the costs of screening, monitoring, and enforcement may lead to
the segmentation of markets.

Geography and Kinship

In the area of northern Nigeria surveyed in chapter 5, credit markets are

almost completely segmented along geographic and kinship lines, and infor-
mation asymmetries between borrower and lender within these markets
appear to be negligible. In this case study the rural credit market was very
 KARLA HOFF AND JOSEPH E. STIGLITZ 41

active, but loans between individuals in the same village or kinship group
accounted for 97 percent of the value of those transactions (see chapter 5,
table 5-3). Collateral was seldom used, and credit terms implicitly provided
for direct risk pooling between creditor and debtor. That in three of the four
villagessurveyed, virtually no loans were observed to cross the boundaries of
an extremely small social and geographic space, in an environment charac-
terized by highly correlated risk and seasonal demands for finance, points to
the high information costs of such transactions and the reliance on kinship
and village sanctions as a mechanism for contract enforcement. Similar
evidence for the informal credit market is reported in the case study of rural
China (chapter 6).
Even in areas where nonresident lenders and institutions provide a large
share of total credit, market segmentation by village and kinship group
remains pronounced with respect to consumption loans. Thus chapter 8
reports on the temporary collapse of local Thai credit markets in the face of a
severe regional shortfall of rain. In such periods, resident lenders' own equity
is depleted, but nonresident lenders and institutions appear not to be able to
form a sufficiently accurate judgment of households' ability to repay to
permit them to operate in the consumption loans market.

Interlinkages with Other Markets

For a given lender, loan applicants with the same wealth and productive
capacity may differ in their ability to assure potential lenders of their credit-
worthiness. Similarly, for a given applicant, lenders may differ in their cost of
screening and enforcing loan performance. Besides geography and kinship
group, a critical source of these differences is the scope of individuals' partici-
pation in other markets. Such participation makes possible the interlinking
of loans with transactions in those markets. Interlinked credit contracts may
provide means to alleviate screening, incentive, and enforcement problems.
Interlinkages may also enable the reputation mechanism to work more effec-
tively. What affects behavior is the total benefits (rent) from a relationship.
When an economic relationship entails transactions in several markets,
there is scope for greater surplus.
The most widespread form of interlinkage is provided by traders. Lenders
who are also nonresident traders and commission agents generally require
that their clients sell all their crops to, or through, them (see chapters 7, 8,
and 9). This trade-credit linkage "makes information on the size of the
borrower's operations . . . available to the creditor and to no one else. This
. . . thus closes the borrower's access to other lenders" (chapter 8). The
trader-lender can easily enforce his claim by deducting it from the value of
the crops sold to, or through, him. In towns with well-organized commodity
markets, there may sometimes be cooperation among traders in enforce-
ment. In chapter 9, Bell reports that:
42 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

In Chittoor ... a commission agent who dealt in gur (a sugar product)

told me that agents frequently know one another's clients. If a farmer
attempted to sell through an agent other than the one with whom he
normally dealt, the former would deduct principal and interest on the
loan, basing his calculations on the usual rule of thumb relating the size of
the loan to the quantity to be delivered, and would hand over the said
sum to the latter.
Under some circumstances, however, such trader-provided credit turns
out to be limited. Cassava, unlike most other crops, has no fixed harvest
period. This makes loan enforcement difficult. Generally, cassava growers in
Thailand obtain funds only by selling outright the standing crop (chapter 8).
For this crop, a spot sale to a trader serves as a substitute for trader-financed
credit.
Chapters 8 and 9 argue that trade-credit interlinkages go a long way to
resolving the information asymmetry between borrower and lender and the
enforcement problem, while they create asymmetries of information across
lenders. Lenders who do not serve as traders for a borrower will know less
about his productivity and will be in a less favorable position to enforce a
loan. In a later section we will discuss the implications of such asymmetries
for market structure.

Devices That Limit the Consequences of Information

Asymmetries and Enforcement Problems
Three devices commonly used in rural credit markets in developing
countries-collateral requirements, usufruct loans, and rotating savings and
credit associations-may be viewed as methods to limit the consequences of
information asymmetries and enforcement problems. Like geography, kin-
ship, and market participation, these devices are available to some borrowers
and lenders and not to others. Hence, they also have consequences for the
sorting of borrowers across lenders and for segmentation in rural credit
markets.

Collateral. In developing countries, banks have found it difficult to screen

and monitor borrowers directly. Banks, but not informal lenders, therefore
rely heavily on collateral, generally in the form of land. For this reason, in
Thailand, "the sphere of operation of commercial banks and cooperatives
... has been almost exclusively in villages where land titles have been
issued" (chapter 8). Because land wealth is correlated with income in rural
areas, this finding helps to explain why borrowers with above-average
income have been found to have greater access to formal sector sources than
those who do not. Chapter 8 reports that average per capita income of Thai
households borrowing from the formal sector was more than 30 percent
 KARLA HOFF AND JOSEPH E. STIGLITZ 43

above the mean, while those borrowing only from the informal sector had
average per capita income close to the survey area's mean.

Usufruct loans. In one form of a usufruct loan, a lender occupies and uses
the borrower's land until the principal is repaid. Such loans are transacted in
Thailand to finance migration for work abroad. They are viewed as low-risk
loans. As the saying goes, "Possession is nine-tenths of the law."
A similar practice that is widespread in Nigeria is procuring loans by
transferring to the lender the right to harvest the borrower's trees. The
harvest provides the lender the interest on his loan. Such transactions are
called tree "pledging" and occur with cocoa, oil palm, and rubber trees
(Adegboye 1983).

Rotating savings and credit associations. Rotating savings and credit associa-
tions (ROSCAS) have a long history in developing countries, even predating
monetization (Bouman 1983), and they continue to be a major source of
credit in African countries (where they are often called tontines). In the
usual case, a small group is formed from a village or family group where
enforcement costs are low because of powerful social sanctions. Each mem-
ber agrees to pay periodically into a common pool a small sum so that each,
in rotation, can receive one large sum. If the formal credit market is charac-
terized by a gap between the savings and borrowing rates of interest, ROSCAS
may be preferred to participation in the formal market (see Edwards 1989,
Besley, Coate, and Loury, 1991). ROSCAsare thus an example of a credit
exchange that improves upon opportunities in the market by drawing on
preestablished social ties. Highly successful tontines in Cameroon were
recently described as follows:

Tontines, built on trust, are generally made up of homogeneous groups-

people from the same ethnic background, the same workplace or the same
neighborhood.
[One Cameroonian reported that] "if you don't make your payment to
the tontine, you are rejected by the community. If you are banned from
one group, you are banned from the others."
Indeed, several years ago, several Bamileke traders committed suicide
because they realized that they could not make their tontine payments.
(New York Times, November 30, 1987)

But in Latin America, ROSCAS have been adapted to a situation where

individuals do not know each other (Edwards 1989). The initiative for form-
ing the group typically comes from a retailer of durable goods-for example,
a car dealer. Suppose the groups is of size N and the durable has a price P.
The group members are required to come together for N monthly meetings
to contribute their share of the price, P/N, into a common pool. At each
44 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

meeting, the individuals draw lots. The winner takes the pool, buys the car,
and becomes ineligible for future drawings, though he must complete his N
monthly payments. If he misses a payment, he loses the car. The same
would, of course, hold true in a conventional car loan market. But by
creating a group of individuals whom the borrower comes to know, and who
would be hurt if he defaulted and (at the least) imposed transaction costs on
them, the borrower performs more reliably than if the cost were borne only
by the lender, with whom the relationship is brief and impersonal.

Direct Screening and Enforcement Costs as the Basis

for Monopolistic Competition
The most important way of limiting information asymmetries is buying
information. In his remarkable survey of the operations of moneylenders in
South Pakistan (chapter 7), Aleem estimates the transaction costs incurred
by moneylenders. He finds, for example, that they devoted an average of one
day per applicant to obtaining information and rejected one applicant out of
every two screened.
The screening process creates relationship-specific capital between lender
and creditor. At any one time, a borrower is likely to have built up such
capital with only one lender. If a borrower tries to shift to another lender,
Aleem found that he needs on average one year to build up creditworthiness
with the new lender.
Chapter 8 reports findings consistent with this view of the lender-creditor
relationship. More than 80 percent of borrowers in a ten-province house-
hold survey of Thailand reported that they borrowed from only one infor-
mal source. Furthermore:
Seventy-two percent of the informal sector borrowers . . . reported that
they had not attempted to borrow from other informal lenders during the
past three years . .. ; the average period of contact involving credit
transactions reported by these 72 percent was close to seven years!
Of course, more evidence is needed before we can infer that lenders
exercise monopoly power over their borrowers. This evidence can be found
in chapter 7. First, the total average costs of surveyed lenders, as a fraction of
the amount of funds recovered, were roughly comparable to the average
interest rate charged in the survey area. Second, mean marginal costs as a
fraction of the amount recovered were much lessthan the average interest
rate charged.
These findings strongly suggest that the informal credit market surveyed
in chapter 7 is characterized by monopolistic competition. Each lender faces
a downward-sloping demand curve from borrowers tied to him, so that he
can price at above marginal cost, but entry of new moneylenders keeps pure
 KARLA HOFF AND JOSEPH E. STIGLITZ 45

profits close to zero by driving price down to average cost. Thus, in the usual
way of monopolistically competitive markets, each lender operates at too
small a scale, spreading his fixed costs over too small a clientele. This view of
the market can lead to dramatic policy conclusions about the effects of cheap
institutional credit on rural interest rates, as we shall see in the next section.
To conclude, we should emphasize the difference between the screening
process in the informal credit market described above and the use of the
interest rate as an indirect screening mechanism, as discussed earlier. The
first is active and may cost resources; the second is passive and works
through a process of self-selection. These two types of screening have
entirely different effects on interest rates and on the structure of the credit
market. Passive screening is consistent with perfect competition and can
reduce interest rates below the level that would exist if information were
perfect.2 The evidence presented in chapters 7 and 8 suggests that active
screening through investment in information raises the interest rate above
the level that would exist under perfect information by increasing the costs
of the lender. More important, active screening makes the credit market
imperfectly competitive.

Policy Perspectives

Economic Development and the Evolution

of Rural Credit Markets

We have argued that observed features of rural credit markets in developing

countries can be understood as responses to the problems of screening,
incentives, and enforcement. Of course, these are problems that arise not
just in developing countries. However, it can be argued that these problems
are more severe for countries at an early stage of development because of
more extensive asymmetries of information and the more limited scope for
legal enforcement (in particular, more limited collateral). We may therefore
ask, Will development by itself remove or reduce the imperfections of rural
credit markets?
Several studies have suggested that as development proceeds and average
income levels increase, the imperfections of rural credit markets should
diminish. This argument is supported by evidence from India that rural
areas with higher-than-average incomes seem to face lower interest rates
from moneylenders:
A high r is the effect of the high-risk premium that the village money-
lenders usually charge for lending to the peasants, who are frequently
without sound collateral. The lack of creditworthiness is really a reflection
46 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

of the peasants' poor income and meager savings. Hence, the growth of
real income . . . should reduce the probability of default and the risk
premium, which in turn will reduce r. (Ghatak 1983, pp. 21-22)3

In a relatively more prosperous district like Burdwan in West Bengal

. . , the average rural interest rate for different classes (such as casual
laborers, tenants, and agricultural laborers) varied between 36 to 84 per-
cent per annum, while in a relatively poorer district like Nadia . . . the
average rural interest rates varied between 72 and 120 percent per annum.
. . [I]n West Bengal during 1975-1976, moneylenders still remained a
major source of agricultural credit. (Ghatak 1983, p. 32)

Agricultural technical change does influence the supply of loans....

Farmers residing in areas characterized by the use and/or provision of
new technology appear to benefit in that they face lower moneylender
interest rates. This result provides an additional point of leverage for
policy-makers: Interest rates can be lowered indirectly through the provi-
sion of technical change and investment opportunities and need not be
lowered directly through costly subsidies to some borrowers in the formal
credit market. (Iqbal 1988, p. 375)
The argument above relies on the observation that as incomes and pro-
ductivity increase, the risk of default decreases. But the chapters in part I of
this book suggest additional critical links between development and credit
markets.
Screening, incentive, and enforcement problems in credit markets are
often mitigated through interlinkages between the credit market and other
markets-for example, for land and for commodities. The creation of a dense
network of market interactions, which we would expect as development
proceeds, lowers screening and enforcement costs. Legal developments such
as land titling, in conjunction with the individualization of land rights as
commercialization proceeds, allow land to be used as collateral, and that in
turn expands the scope of credit markets.
However, as technological change disrupts traditional ties in a developing
economy, the strength of social sanctions in enforcing credit repayments
may decrease. This role of social ties is documented by case studies in
chapters 5-10, in Adams and Fitchett (1992), and elsewhere. Thus, as social
ties break down in the wake of development, but before a dense network of
interactions across markets has been built up, the imperfections in rural
credit markets may well get worse before they get better.
Since development by itself is unlikely to take care of the imperfections in
rural credit markets in the short and medium run, policy intervention may
be called for. In fact, the argument has been that the imperfections in rural
 KARLA HOFF AND JOSEPH E. STIGLITZ 47

credit markets, particularly their characteristically high interest rates, may

themselves be an impediment to development. We will now discuss and
evaluate the policy responses to this problem.

Government Intervention and Credit Subsidies

Enforcement (or lack of it) is one of the problems in rural credit markets.
Thus it might be argued that the government as a lender has advantages the
private sector does not-it has the ability to extend or cut off credit subsidies
(using general revenue), and it has at least a legal monopoly on the use of
force. The experience of many developing countries (and some industrial
ones) suggests that the government is often politically unable to use these
advantages. Thus chapter 9 notes that a widespread view in rural India is
that institutional loans are really grants: "Politicians regularly vie with one
another in promising, if elected, to impose a moratorium on the repayment
of informal and institutional debts alike." Harriss (1983, p. 239) reports that
"during the election campaign of 1972 [in North Arcot] farmers were 'prom-
ised' that a vote cast in the right direction would write off a loan." In
Thailand, Farmers' Associations, groups of 50-100 farmers formed hurriedly
in 1975by the Department of Agricultural Extension, have the worst repay-
ment record: "Because their formation was politically motivated, their mem-
bers tend to be rich and influential and, precisely for that reason, their
repayment rate was poor" (chapter 8).
In Pakistan the political cost of foreclosing on debtors with collateral is
significant. These costs may be part of the explanation for Aleem's finding in
chapter 7 that while default rates in the formal sector were 30 percent, for
the informal lenders the mean delinquency rate (the percentage of loans
repaid after the due date) was 15 percent and the mean cumulative rate of
nonrepayment was only 2.7 percent. The latter figure is the percentage of
due loans that had not been recovered since the moneylender's inception of
lending operations (table 7-3).
In view of this accumulated evidence, the argument for direct credit
supply by the government as a means of relieving enforcement problems
must be questioned. What is left, then, is the fact that the government can
supply cheap credit. What is likely to be the effect of this on the rural
informal credit market? The available evidence, as documented in the case
studies in this part of the book, certainly does not suggest that cheap credit
will drive out informal sector moneylenders, and it may not even drive down
interest rates charged by them. The theoretical framework of the "imperfect
information" paradigm allows us to understand this policy failure.
If some borrowers have direct access to cheap funds from government
institutions and can satisfy all their borrowing needs from this source, there
will of course be less demand for credit in the informal sector. If rural credit
48 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

markets behaved as classical markets are supposed to behave, this would

exert downward pressure on interest rates. But we know that rural credit
markets do not behave in this fashion. If the interest rate plays a screening
role and this leads to credit rationing, it is unlikely that the interest rate will
fall following a small infusion of credit. Conversely, if moneylenders engage
in direct screening, those moneylenders with the highest screening costs may
drop out of the market, and interest rates may be expected to fall.
If borrowers cannot fully satisfy their needs from government institutions,
so that they get only part of their credit needs from that sector, then it
matters whether formal sector loans are treated as senior or junior debt
relative to informal sector loans. If the formal sector has seniority, the
informal sector loans become, in effect, riskier, which may lead to an
increase in the informal sector interest rate. To make matters worse, in
monopolistically competitive settings where there is active screening, the
screening costs have to be allocated among smaller loan sizes,raising average
costs and interest rates (as discussed in chapter 8). By contrast, if the formal
sector loans are treated as junior debt, the effect on informal sector credit is
ambiguous. The greater borrowing that results from access to lower rates
increases (at any given level of informal sector loans and interest rates) the
default risk, but a disproportionate fraction of the default risk is borne by
the formal sector. Unequal access to formal sector funds may have further
implications for the informal sector. If formal sector loans go to larger bor-
rowers with more collateral, and the evidence suggests that is so, then the
mix of applicants among whom the informal sector has to screen changes
adversely, and this might increase the interest rates charged there.
If formal sector loans do not go directly to borrowers, but instead to
moneylenders who act as financial intermediaries, the effects depend on (a)
how the costs of informal lenders change, and (b) how the level of competi-
tion in the informal sector changes. If privileged access to government funds
increases entry, and therefore increases average costs of moneylending
because the costs of screening borrowers are now spread over each money-
lender's smaller clientele, then interest rates in the informal sector need not
decline at all. This is another implication of monopolistic competition in
rural credit markets, and we pursue it in a formal model in Hoff and Stiglitz
(1993).
More generally, the "imperfect information" framework alerts us to the
difficulty of relying on financial intermediation to solve the problems in
rural credit markets. Although the case studies in part I present evidence
that moneylenders do borrow from each other in the same village and across
villages, screening, incentive, and enforcement problems place limits on the
extent of these transactions. Formal sector institutions face the same infor-
mation and enforcement problems in relation to moneylenders. The case
 KARLAHOFF AND JOSEPH E. STIGLITZ 49
studies in chapters 7, 8, and 9 provide evidence of the limited extent of
financial intermediation between the formal and informal sectors.

Institutional Innovation and the Role of Public Policy

We have seen that the "imperfect information"/"costly enforcement" para-
digm stands apart from the traditional "monopoly" versus "perfect markets"
debate. It argues that rural credit markets do not behave as classicalcompeti-
tive markets are supposed to, so there is no presumption that they are
efficient. However, both theory and evidence suggest that high interest rates
are not necessarily, or even primarily, a reflection of the monopoly power of
the village moneylender. Rather, rural credit markets behave the way they
do because of the problems of screening, incentives, and enforcement.
Government credit institutions face these same problems relative to bor-
rowers. In fact, they may be in a worse position in terms of informational
asymmetry, monitoring, and enforcement.
Is there, then, any role at all for public policy? Greenwald and Stiglitz
(1986) have shown that markets with imperfect information give rise to
externality-like effects, and it is here that government intervention may be
most successful. In the context of credit markets, one externality that we
have identified is the reduction of enforcement and information costs
brought about by development in other markets. Land titling, to the extent
it increases the value of land as collateral, and the introduction of cash
crops, which makes possible interlinked trade-credit contracts, will reduce
lenders' costs of enforcement. Government investment in infrastructure that
makes agriculture less risky will reduce the importance of informational
asymmetries between borrower and lender. See figure 1-1on page 18.
Another type of externality may reside in institutions that directly address
informational problems in rural credit markets. One such institution is that
of small-scalepeer monitoring. In chapter 4 Stiglitz analyzes a model of this
activity. Individuals form a small group that is jointly liable for the debts of
each member. The group thus has incentives to undertake the burden of
selection, monitoring, and enforcement that would otherwise fall on the
lender. Of course, this entails an inefficiency,since a small group has a lesser
ability to bear risk than a lender with a large and diversified portfolio.
Stiglitz shows that under certain circumstances the benefits more than out-
weigh the costs. However, there is an externality in this institutional innova-
tion. An individual who bears the initial cost of organizing such an institu-
tion is providing a form of social capital from which all members of the
group will benefit. As is well known, when this type of externality arises
there will be an undersupply of the socially beneficial service, and there is
therefore a role for the government to help organize and act as a catalyst in
50 IMPERFECT INFORMATION AND RURAL CREDIT MARKETS

the formation of such institutions. As Huppi and Feder (1990) have noted in
their review of group lending, and as Braverman and Guasch report in
chapter 3, there are notable successes in the provision of rural credit when
the government has acted in this way.

Conclusions

The chapters in part I and the theoretical literature out of which they have
grown show that we can look into the black box that was once referred to
simply as "imperfect credit markets." We can assess the nature and sources of
those imperfections, and we have a framework for assessing the conse-
quences of alternative government policies. A rich research agenda lies
ahead of us: investigating the extent to which the findings of these studies
generalize to other countries, exploring the effectiveness of the institutions
and mechanisms for screening and monitoring loan applicants that we have
touched on in this chapter, and evaluating the consequences of a variety of
government interventions in credit markets, taking into account the infor-
mation asymmetries and enforcement problems endemic in developing
countries.

Notes

1. Floro and Yotopoulos's 1991 study of informal credit markets in the Philippines
provides further evidence, consistent with much of the data reported here, of the
segmentation in rural credit markets. See also the collection of case studies in Adams
and Fitchett (1992).
2. This result depends sensitively on the nature of the information asymmetry. As
we argued above, a decrease in the interest rate improves the mix of prospective
projects that a lender finances if the expected return of a project is public informa-
tion but its riskiness is not; only the borrower knows it. De Meza and Webb (1987)
consider a different information structure-one in which the set of possible returns of
a project is public information, but its expected return is not. De Meza and Webb
also assume that a prospective borrower has private wealth to invest in the project.
Under these assumptions, an increasein the interest rate improves the mix of projects
that a lender finances by making borrowers more cautious about risking their own
funds in low-return projects. In this case, indirect screening will not reduce interest
rates below the level that would exist under symmetric information.
3. Later in his paper Ghatak qualifies the argument that the growth of income will
lead to a fall in interest rates. He notes, in particular, the independent and complex
role of caste and other social and legal factors.
 KARLA HOFF AND JOSEPH E. STIGLITZ 51

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