CHAPTER-1

RURAL FINANCIAL MARKET

1.1- FINANCE AND RURAL DEVELOPMENT

Economic development has often been defined in terms of reduction or elemination of

poverty, inequality and unemployment. Historical experiences point out that finance and financial

system play an important role in economic development. A system, according to Khan(1988), is

a set of interrelated parts working together to achieve some purpose. The financial system refers

to those institutions and mechanisms which affect the generation of saving and effect its transfer

to those who make productive use of the same. The financial system of a country is like any other

infrastructural set-up. It comprises financial institutions (banks, Co-operative credit institutions,

insurance agencies, financial development institutions) and financial instruments (deposits, bonds,

debentures, shares, insurance etc.) and financial markets (money market and capital market).

With the help of these institutions and instruments, the system provides financial services for

development of various sectors of the economy.

The innovations of money and finance helps increase the size and extent of exchange

relationships or markets by promoting division of labour in saving and investment (Gurley and

Shaw, 1960) which, in turn, lead to increased returns and technical progress.

The possibility of lending and borrowing enables economic units to increase their asset

holding and raise production and consumption beyond their net worth. Loan transactions give

command over resources to produce larger value and allow economic units to rearrange their

consumption plan so as to attain inter-temporal utility maximisation. Thus, it increases real wealth

and income of the community. In theory of finance it is known as the asset trans-mutation effect.

As described by Me Kinon (1973) and Shaw (1973),'financial intermediation can promote

economic development through larger mobilisation of funds and efficient allocation of the same

among investments. Possibility of lending and borrowing and introduction of financial instru

ments induces larger saving and investment by raising full employment ratio of saving and invest

ment to current income of the economy. This increase in the ratio of saving and investment is

called the intermediation effect.

The development of financial intermediation involves increase in the scale, scope, com

plexity and efficiency of the institutions and markets through which funds are transferred from the

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savers to the investors. As a result of this the resource cost of financial intermediation falls

leading to lower transaction costs for savers and investors (Burkett,1988).

According to Me Kinon and Shaw, improved financial intermediation favourably influ

ences growth and productivity of the capital stock by allocating funds to high-return investments

and by using pooled short-term deposits as fund for large long-term loans for physical capital.

Me Kinon attempted to demonstrate that money and physical capital are complements

and money is a part of wealth in an underdeveloped economy due to indivisibility of investment

and self-financing practice in many cases. Monetary accumulation is a complement and a pre

requisite, not a substitute to physical capital. But according to Shaw, accumulation of money and

other financial assets can never be a substitute for the physical ones, the financial sector being a

service sector produces only financial assets and as such, its output (credit) is used as input in the

real sector. Thus the growth of financial sector helps development of the real sector.

Recent empirical studies support the positive impact of improved financial intermediation

on economic growth and development. Jung (1986), for example, analyses time series data for

56 countries (37 developing and 19 developed) and found a significant and positive correlation

between real G.D.P. growth and two measures of financial deepening viz. M2/G.D.P. ratio and the

ratio of M1 to currency in circulation. Fritz (1984) also finds that financial development has a

positive causal effect on economic development in the initial stage while during the second stage

i.e. second half of the sample period (1969-81 in Phiilippines) causality runs the reverse way.

These studies support the earlier hypothesis developed by Patrick (1966) that financial develop

ment induces growth (supply leading) in the early stages of economic development while in the

later stage of economic development the development of financial systems and services is a

continuing consequence of development process (Demand following). It can be concluded that

economic growth may be impeded if financial intermediation is repressed" by government regu

lation. Therefore, government regulation is considered detrimental to the growth of an efficient

financial system and hence to overall economic development-. Findings of Ketkar and Ketkar

(1992) in the Indian context confirm this hypothesis.

The relation between finance and development is already an accepted premise. Now the
/ -

emphasis is on free and flexible financial market. Financial markets play a dynamic role in

market economies than in centrally planned economies. Efficient financial markets are a sine qua

2
non for economic development. The more vibrant and efficient the financial market in a country,

more will be capital formation (Khan, 1988).

Development of the rural sector requires not only capital and cheap credit but also the

adoption of new technology. Mere availability of cheap credit will not guarantee its adoption. If

the cost of technology is high compared to its benefits and risk it may not be adopted. Some

entrepreneurs may adopt a technology out of self finance even when credit is not available

provided it is profitable. In other cases adoption of new technology may not require additional

funds at all as the cost of adoption is small, but rearranging existing production patterns may need

additional credit. Another limitation of credit is its fungibility. This fungibility of credit makes it

difficult to evaluate its proper impact on development programme. So credit alone is neither an

essential nor a sufficient condition to promote rural development, but it can be a strong force to

influence efficient use of scarce capital stock.

In India, the rural population constitute 74.28% of the country's total population. The

rural populace is characterised by ignorance, backwardness and poverty and the rural sector still

remains undeveloped and devoid of basic minimum facilities. According to the Planning

Commissions estimate in 1989-90 about one third (28.20%) of the rural population lived below

the poverty line. Estimates by other renowned economists and organisations put this figure at a

much higher level. Elimination of poverty is one of the objectives of the Five Yeal Plans in the

country. To realise this objective and reduce urban-rural imbalance, the importance of finance in

the rural sector cannot be gainsaid.

During the pre-independence era, development of financial activities and institutions did

not receive proper attention from the British Government. Co-operatives were set up in 1904 as

the institutional mechanism to meet the rural financial requirement. During the long period of

experimentation with financing by the Co-operatives there was little improvement in the situation.

In the immediate post-independence era, not much significant work was done to vitalise the rural

financial sector. But the adoption of the new agricultural strategy in mid 60s increased the de

mand for resources, both real and financial, in the rural sector. Further with emphasis on growth

with justice the development strategy called for acclerated rural development, employment gen

eration and poverty eradication programmes. All these programmes aimed at developing the

rural economy and creating productive assets by generating self and wage employment. Most of

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the programmes being subsidy cum credit intensive, huge amounts of financial as well as real

resources were required in the rural sector and strengthening of the rural financial market became

imperative. The government, realising the enormity of the problem, nationalised major commer

cial banks, created some new financial institutions and introduced schemes to facilitate smooth

flow of financial and real resources into the rural sector.

With the acceptance of the New Economic Policy in 1991, the need to modernise the

rural sector by upgrading skill and technology has assumed greater importance. Otherwise,

marketisation and globalisation will be of no real help to the rural producers in the absence of

increased productivity and greater participation in the market. And the two sectors, institutional

and non-institutional can prove complementary to each other, as regards provision of finance in

the rural sector.

So far only the formal or the institutional agencies were looked up to meet the rural

financial needs. But such a strategy has led not only these institutions but also the economy to

difficulties. The financial institutions are in the red and the economy suffers liquidity crisis. Many

experts in the field of rural finance are of the view that the informal sector is not necessarily

inefficient and exploitative. They can play a meaningful supportive role in the process of eco

nomic development.

1.2-FEATURES OF THE RURAL FINANCIAL MARKET

A'developed financial market, by allocating savings between different types of invest

ment in a competitive way, plays an important role in the process of economic development. It

promotes liquidity and safety of financial assets and ensures elasticity in the flow of funds. But the

rural financial markets in the underdeveloped countries are not adequately developed and are

unable to discharge their functions satisfactorily. The rural financial market exists long since and

exhibits certain peruliarities which distinguish it from its urban counterpart.

The rural financial market is neither sophisticated nor unified as its urban counterpart and

is also heterogenous in character. Market conditins vary between regions having people with

different regional base, customary values and attitudes towards credit participation. Therefore,

the financial intermediaries conditioned by the peculiarities of the locality they serve, vary across

the rural markets, particularly in the developing countries. Besides, the socio-economic condition

of the participants and the work environment make the rural financial market distinct. Further,

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rural economy in many underdeveloped countries is not fully monetised, as a result, functioning of

the rural financial market is inhibited to certain extent. The rural financial markets are very small,

localised and disjuncted. There are large number of small borrowers in the rural financial markets

for which its transactions turn out to be uneconomic. On the other hand, the suppliers of funds

(lenders) are a few, exercising monopoly or near-monopoly power. All these factors contribute to

make the rural financial market imperfect and incomplete. Interest rate in the rural market fail to

bring about equilibrium between demand for and supply of funds. Mostly customarily determined

interest rates are insensitive to demand and supply conditions. The participants in the rural

financial market are engaged in activities characterised by unanticipated changes in prices, in

come and yields. Adversities affect many households simultaneously.

Another distinguishing feature of such a market in underdeveloped countries is the

coexistance of the formal and informal sectors. The formal orthe organised sector consists of the

commercial banks, cooperatives, special financial institutions, project authorities and the govern

mental agencies. The formal sector is subject to government and central bank control. But the

informal or the unorganised sector comprising the moneylenders, traders, commission agents,

friends and relatives, and private saving and credit associations lies in the outreach of the central

bank regulation and control. There is little interaction between the formal and informal sector.

The formal sector tends to specialise in legitimate productive lendings whereas the informal sec

tor satisfies all types of credit needs. The rate of interest charged by the informal sector is not only

high but also differs between persons, places and purposes depending upon the likelihood of

default. The informal sector lenders have very close relation with their clients and have the added

advantage of free information . The informal sector is highly personalised whereas its formal

counterpart is highly bureaucratised. Though the latter constitutes an important segment of the

rural financial market, it is mostly urban oriented institutionalised and well organised. The infor

mal sector is mostly rural orientd, ill organised and non-institutional in character. However, fea

tures, such as, easy accessibility to credit, promptness of sanction of loans, lack of formality,

flexibility of operation and secrecy of financial operations have endeared informal credit to the

rural folks and carved out a permanently prominent place for the informal sector in the rural

financial market. There are several explanations for this dichotomy in the rural financial market.

One explanation traces out its root in intrinsic dualism of the economic and social structure in the

5
underdeveloped countries and rural peoples attachment to traditional values and customs. An

other explanation is improper build-up and repression of the formal sector by way of close regula

tion and restriction by authorities. But empirical evidences show the dualism of the rural financial

market is the combined result of both the factors.

Another feature of the rural financial market is its interlinkage with other markets. The

credit market is closely connected with the commodity market and the labour market. Interlinking

of markets often reduces the risk of default and acts as a limit to high rate of interest.

As regards the demand for and supply of funds, the rural financial market also differs from

its urban counterpart. The latter mainly caters to the demand for funds by industry and com

merce. But the clientele in the rural financial market are small and big farmers, rural artisans,

agricultural labourers, rural entrepreneurs and other rural households who demand credit to meet

the expenses on account of farm and non-farm activities and consumption. The necessary loan

able funds in the urban financial market is mostly supported by the organised or the formal sector

and to certian extent by the constituents of informal sector, viz., moneylenders, indigenous bank

ers, friends and relatives, Rotating Saving and Credit Associations (ROSCAS).

For socially optimal allocation of credit, the lenders should charge higher interest rates for

small loans and lower interest rates for loans of large borrowers. Therefore, when the financal

institutions are required to charge uniform interest rate as in most of the underdeveloped coun

tries, allocation of credit becomes inefficient which they try to rectify by adopting undeclared

credit rationing such as delay in loan sanction, strict scrutiny etc. The share of the large borrowers

increases at the expense of smaller ones. Small regional financial institutions with cost reducing

subsidies have met the demands of small borrowers to some extent, but have failed to expand

their activities due to unremunerative government controlled interest rate policy. Savings in the

rural financial market and the behaviour of savers according to Burkner(1980) are related to

accessibility, yield and liquidity of financial instruments. Small savers are interested to buy de

posit instruments if financial institutions are close to them, and the yield is attractive. Their

response is more to availability of institutions than to interest yield and liquidity.

In the rural financial market the issues, such as, whether to borrow or not and from where

to borrow and how much to borrow depend more upon effective cost of borrowing i.e. the actual

transaction cost rather than on interest cost only. The continuance of informal sector with high

6
interest rates despite massive cheap credit programme by many governments can be partly as

cribed to this phenomenon. In certain circumstances, the formal and informal sources also be

come'complementary and credit is obtained from both the sources, particularly when there is

rationing of credit or fixation of a ceiling on the amount that a borrower can borrow or when the

informal sources take some arbitrary decisions. In some other cases access to one source facili

tates access to other,

1.3-RURAL FINANCIAL MARKET IN INDIA

The rural financial market in the country is as old as the Indian village. It existed long

before the advent of modern financial institutions and activities. In the present century it is ex

panding quite rapidly and its importance has increased. Its growth can be partly ascertained from

the increase in the borrowing per reporting household from Rs 447 in 1951-52 to Rs.2267 in 1981-

82. The progress is spectacular since the late sixties when the major Ccommercial Banks were

brought under public ownership and control. However it continues to be imperfect due to several

deficiencies mentioned above.

In the rural areas agriculture is the most important productive activity in terms of employ

ment, income and all other rural economic activities centre around it. Therefore, the financial

needs of the rural people have been taken to be the same as that of the farmers. But it is not

wholly correct to assume that issues in agricultural finance are synonymous with issues in rural

finance. The study of rural financial problems in India is mainly concerned with the financial

problem of the agriculturists to the exclusion of the rural artisans, agricultural labourers and other

rural enterprises and households. In the present rural scenario the financial needs of these people

cannot be overlooked. However, demand for credit in the rural sector mainly comes from rural

agricultural households. Most of the farmers are small and marginal ones possessing a very

small area of land. They require both short-term production credit as well as medium and long

term investment credit. They also often need credit to meet family consumption expenditures

and expenditure on socio-religious obligations. Sometimes they also borrow for repayment of old

or ancestral debt. Recent spurt for credit demand in the rural sector is due to the introduction of

new agricultural technology.

There is also a growing demand for credit by the rural artisans to carry on their ancestral

occupation. Agricultural labourers require credit for consumption and at times for migration.

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Other rural enterprises in the manufacturing and service sectors also need credit to meet fixed

and working capital requirements.

The various agencies which supply credit to the rural borrowers have been broadly grouped

in two catagories, viz (a) Informal agencies, (b) Formal agencies. The informal agencies have

been the traditional suppliers of credit in the Indian rural financial market and were the most

important source of rural finance until recently (Table 1.1). The informal sector is mostly local and

highly personalised. The operators in this sector are small independent units having little contact

with others within the sector and outside agencies. They have little access to formal sector and lie

outside the control of government and Reserve Bank of India(R.B.I).

The formal sector has grown in size since the late sixties. Though some of the constitu

ents of the sector are regional, Regional Rural Banks (RRBs), their linkages with the other finan

cial institutions and R.B.I. directly or indirectly give them a national character. This sector is

subject to the control and direct supervision of the R.B.I. and government.

The various institutions of the formal sector in the rural areas are the following: (a) gov

ernment, (b) Reserve Bank of India, (c) Scheduled Commercial banks, (d) Regional RuraiBanks,

(e) Co-operatives, (f) Specialised agencies like National Co-operative Development Corporation

(NCDC), Industrial Development Bank of India (IDBI), Small Industry Development Bank of India

(SIDBI). The formal sector of the rural financial market is hierarchical in structure. Each of the

institutions has an apex financial agency at the national level. The NCDC, NABARD, IDBI, SIDBI

and the scheduled commercial banks are national level institutions which refinance rural credit.

They mobilise resources and also get financial assistance from the government and the R.B.I. for

the purpose of financing and refinancing.

The Scheduled Commercial banks, State Co-operative Banks, State Co-operative Agri

cultural and Rural Development Bank and the government of the state are the state level institu

tions in the credit delivery system. At the district level, the Regional Rural Bank, Central Co

operative Banks along with the Lead Banks constitute the conduits. Finally at the Primary level

there are branches of Commercial Banks, branches of the Regional Rural Bank, Primary Agricul

tural Credit Society, Farmers Service Society, Large Size Adivasi Multipurpose Co-operative

Society (LAMP) and Industrial Co-operatives to provide short-term, medium-term and long-term

credit to the rural borrowers. These agencies at the bottom are responsible for granting, supervis-

8
ing and collecting loans and marketing of other financial services directly to the rural folks. On the

whole the formal sector has been a close-knit multi-level, multi-section and multi-agency

programme.

1.4-GROWTH AND STRUCTURE OF THE RURAL FINANCIAL MARKETS IN INDIA

Though the rural financial market has remained dichotomous on the lines of formal and

informal sector over a century, the relative size and structure of the two sectors have undergone

a spectacular change. The size and operation of formal sector has expanded considerably at the

cost of the informal sector. Table 1.1 show the change in their relative importance over the period

from 1951-52 to 1981-82.

In the informal sectorthe importance of moneylender who was the most important source

of credit until recently has declined as its share in credit sanction has fallen from 69.7% in 1951 to

16.1% in 1981. But Bell (1990) is of the view that the moneylender is still very much in business

and operates in disguise. The growing commercialisation of the Indian agriculture has encour

aged the rise of trader-moneylenders. The indigenous bankers, mostly found in the Southern and

Western parts of the country, generally extend loans for trade and commerce and operate in the

rural commercial centres. It is very difficult to estimate their number and amount of capital

employed. Of late their importance has declined due to widespread opening of commercial bank

branches at commercial centres.

Landlords, traders and commision agents also provide loans to the needy cultivators.

The share of landlords increased considerably in 1971-72 (10.7%) compared to 1951-52 (3.3%).

But in 1981-82, it has registered a decline to 8.8%. The share of traders and commision agents is

declining continuously over the years, from 5.5% in 1951-52 to 3.2% in 1981-82.

Funds obtained from friends and relatives are generally interest free and based on reci

procity. The share of friends and relatives in the total credit has declined fron 14.2% in 1951-52

to 8.7% in 1981-82.

Rotating Savings and Credit Associations (ROSCAs) are mutual saving and credit asso

ciations. They mobilise savings of and advance loans to their members. There is no information

on the quantum of resources mobilised and loans advanced by these organisations. These

sources are generally clubbed with other sources.

The inadequacy and drawbacks of the informal sector has necessiated governmental

9
intervention. Developing the formal sector has been the core of governmental policy.

Government as a direct source of formal rural credit came into the picture with introduc

tion of Taccavi loan scheme in 1884 to provide credit to farmers at the time of natural calamities,

distress and emergency. Because of insufficiency of funds, administrative rigidity and indifferent

attitude of government employees government could not make much headway in the field of rural

credit and as such, the scheme has been practically abandoned.

Government also provides indirect finance by contributing to shares of co-operatives,

guaranteeing their debentures and by granting them subsidies. The debt relief scheme announced

by the Government of India and state governments in 1990s is also an one-time indirect financ

ing.

Government as an agency of rural finance is most ill suited as it cannot ensure proper

utilisation of funds, prompt sanction and disbursement of credit, neither it can execute timely

recovery of loans, nor can prevent politicisation of credit programme. The share of government

has remained static between 1951-52 and 1981-82.

The emergence of co-operatives as formal agency of rural credit dates back to the year

1904, when the co-operative societies act was passed. Co-operatives were considered the most

appropriate institutional arrangement for financing agricultural and allied activities in the rural

areas. Till the nationalisation of the major commercial banks in 1969, co-operatives were viewed

as the most important source of institutional credit. The share of co-operatives in the total credit

obtained by farmers is increasing continuously since 1961-62 (Table 1.1).

The co-operative credit set-up in India has two wings : one providing short-term and

medium-term credit and the other providing long-term credit. The short and medium-term co

operative credit structure is a three-tier federal set-up. The Primary Agricultural Credit Society

(PACS) operates at the village level, Central Co-operative Bank (CCB) at the district level and the

State Co-operative Bank at the state level. The long-term co-operative credit is provided by

erstwhile Land Development Banks (LDB) and presently Co-operative Agricultural and Rural

Development (CARD) Bank which are either unitary or federal in character. This banking system

is unitary in the Western states, but federal in the southern states. The State Level Land Devel

opment Bank(SLDB) stands at the apex and Primary Land Development Bank (PLDB) at the base

level.

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 The Farmers Service Societies (FSSs) provide credit as well as non-credit agricultural

inputs to the farmers. The Large Sized Adivasi Multi-purpose Societies (LAMPS) have been

organised mainly in the tribal areas to provide credit and other essential articles to the tribal

people. These are relatively new entrants in the co-operative field.

The co-operative institutions are also linked with the NABARD and RBI for refinancing of

agricultural credit. The co-operative credit has expanded significantly in terms of membership

and the quantum of loans advanced. The number of members has increased from 53,69,000 in

1951-52 to 88,672,000 in 1988-89. During this period the amount of loans and advances has

increased from Rs.7148 crores to Rs.1235457 crores (Table 1.3). Inspite of spectacular expan

sion in the activities, the co-operative movement continues to be weak and has failed to provide

the needed credit in the rural sector. This is attributed to its inherent weaknesses, operational

non-viability, excessive governmental control, over lapping jurisdiction, managerial inefficiency,

traditional security pattern, excessive dependence on external resources and political interfer

ence.

The entry of the commercial banks into the rural financial market is of recent origin. Prior

to the nationalisation in 1969, the banks considered financing agriculture was outside their pur

view and as such, it was adhoc, halting and haphazard for which their share in the total agricul

tural credit was less than 1% (Table 1.1).

During the period 1967 to 1975 banks were engaged in experimenting with various

schemes. They acquired necessary knowledge which helped them to evoke a suitable approach

towards financing agriculture and other rural activities. The process of ruralisation of commercial

banking started during this phase.

During the third phase commencing from 1975, the commercial banks realised the mag

nitude of the task and started financing through Farmers Service Societies, Regional Rural Banks

and Primary Agricultural Co-operative Societies. They also set-up their own Agricultural Devel

opment Branches.

The fourth phase is said to have begun since mid-eighties. During this phase emphasis

was on consolidation of past efforts and qualitative expansion.

With this the commercial banks initiated to provide short and medium-term credit along

with certain amount of long-term credit both directly and indirectly for agriculture and other pro-

11
ductive activities in the rural sector. The banks also mandated to achieve certain targets and sub

targets under the priority sector lending. Forty percent of credit was required to be channelled to

the identified priority sector.

The emerging importance of the commercial banks in the rural areas can be easily ob

served from the increase in the number of their branches from 1833 (22% of total bank branches)

is 1969 to 35179 (58.21 %) in 1991. With this massive branch expansion the share of commercial

banks in the total agricultural credit escalated from 0.9% in 1951 to 29.4% in 1981-82 (Table 1.1).

The Regional Rural Banks were started in 1975 with the objective of improving the flow of

credit to the rural sector at a lower cost. These banks are sponsored by the commercial banks and

assisted by the union and state governments. In order to mobilise rural savings they are also

allowed to pay a higher rate of interest on deposits and to maintain a lower reserve ratio. They

are also eligible for concessional refinancing by the R.B.I., NABARD and IDBl.

The total number of R.R.B. branches in the country touched 14593 by June 1995. By the

end of this period they have advanced Rs.6152 crores mainly to the small and marginal farmers

and rural artisans. For resources these banks are mostly dependent on their respective sponsor

ing banks and the refinancing agencies. These banks are facing many operational problems and

are incurring losses.

The National Bank for Agriculture and Rural Development was established in 1982. It has

emerged as the leader of the entire rural credit system in the country. Though primarily an apex

refinancing agency, it also directly co-finances projects with other banks and institutions like IDBi,

ICICI. In order to qualify for direct assistance from the NABARD, the venture should be one

requiring assistance of more than Rs 5 crores and must be high-value-export oriented and agro-

based.

With the expansion of the formal sector the share of the informal sector in rural finance

has declined no doubt, but the informal sector has not contracted in absolute terms. The relative

size and share of formal sector has changed as it has grown faster.

The pattern of debt and credit of the cultivators have also changed considerably. From a

study of changing pattern of rural credit during 1961-1981, Pradhan and Dinkar (1990) observe

that the proportion of households reporting debt has declined from 66.7% to 22.3% of the total

household during the period. The incidence of debt looking at the ratio of outstanding debt to the

12
value of assets held by the borrowing households has declined from 7.2% in 1961 to 4.7% in 1971

and to 1.8% in 1981. This shows that the burden of debt has also diminished. They ascribe the

changes to probable lessened need to borrow, excess demand in rural credit market and inability

of agencies to meet it, or lack of creditworthy borrowers due to increased overdue.

It has also been found that there is a greater demand for production and investment credit

in the developed areas and for consumption credit in backward and poverty sticken areas. The

small borrowers generally prefer informal agencies inspite of high interest rates where as large

borrowers are found to prefer formal sources. Their study also reveals that the demand for

consumption loans has not changed much and the borrowings for this purpose is mainly from the

informal agencies. Inspite of inter-state variations in the rate of interest the interest rate in the

informal sector has declined in the areas where competition from the formal sector is intense.

Among other notable changes, important ones are : emergence of special agencies in the

formal sector, improvement of Credit-Deposit Ratio in the rural branches from 47.2% in 1973 to

64% in 1985, group lending by formal agencies to exert pressure with regard to repayment, tar

geted priority sector lending and Differential Interest Rate schemes with an element of cross

subsidisation.

1.5-STRATEGIES FOR RURAL FINANCE

A policy statement is basically a statement of principles and rules and adoption of a

specific course of action with regard to operation of an organisation.

In the above sense the policy regarding rural finance in many developing countries was

mainly concerned with agricultural credit as larger part of the population of rural economy is

engaged in agriculture. The policies with regard to rural finance in general and agricultural fi

nance in particular in underdeveloped countries were part and parcel of coloninal economic policy.

Finance for plantations was provided by the urban financial agencies but credit for farm produc

tion for the local markets hardly received any institutional assistance.

In the early fifties, with the achievement of political freedom and hightened awareness,

meeting the basic needs of the rural people became an important consideration of governments

in the underdeveloped countries. A number of operational programmes including rural credit

programme were implemented with zeal. Rural credit was perceived as an instrument which

could break the vicious circle of poverty. The credit supplied by the informal lenders was thought

13
to be expensive and exploitative. Increased emphasis was laid on the supply of formal credit. But

the traditional urban financial institutions were found to be unsuitable for the rural financial market

becuase of their profit motivated objectives, urban-oriented organisational set-up, limited branch

network and demanding lending procedures. Much of their credit was appropriated by the big and

well-to-do farmers who were commercially oriented. Small farmers who constitute the majority of

the rural population of these countries were practically left out and placed at the mercy of informal

operators.

But by the end of the fifties there was a shift in the strategy. Government and foreign

donors started realising the importance of farmers financial needs and made provisions for low

cost credit to the small farmers through financial institutions.

For the purpose, Government often created special institutions to ensure prompt and

adequate delivery of credit in the rural sector. This supply leading" approach was put forth by

Patrick(196). He assumed that establishment of financial institutions and provision of funds in

advance of demand will act as levers to promote growth. This approach supports the traditional

view on rural finance which is based on assumptions like limited capacity of rural people to save,

credit as a major constraint for the adoption of new technology, monopolistic exploitation of the

borrowers by the informal lenders, compulsions of the rural borrowers to pay higher interest rate,

high interest elasticity of demand for credit as interest component of loan cost constitutes a major

cost, liklihood of misuse of credit due to the lack of interest and supervision of the informal

lenders. It was further believed that subsidised interest rate policy can offset the adverse effects

of price and exchange rate policies. In the traditional approach there was no emphasis on

mobilisation of savings, rather it was suggested that funds should come from the Government and

Central Bank of the country to support a cheap credit policy.

In view of the failure of the approach experimented in the different countries the validity

of this approach was questioned by Penny (1966) and Adams (1971). In their view, adoption of

new technology is not necessarily dependant upon availability of credit. The low interest rate

policy generates excess demand and consequent rationing of credit and leads to political interfer

ence and corruption. Credit is mostly whisked away by the rich because of their vertical and

horizontal socio-political linkages. As a result of low-interest on lending and consequential low

interest rate on deposits leaves a low margin of the banks for which they are unable to provide

14
some much needed services to rural customers.

The exponents of the modem approach contend that farmers are capable of taking effi

cient and rational decisions as regards borrowing and hiring other resources. In their view, inter

est cost constitutes a small part of total cost and major cost comprises expenditure on inputs like

fertilisers and insecticides. Therefore, cheap interest is very unlikely to induce investment by the

farmers if their other costs are rising and high. Further, cheap credit may allure the farmers to

undertake unprofitable activity and thereby undermining their economic condition permanently.

Further, the so called cheap credit actually may not be so when the effective transaction cost of

borrowing is taken into account.

It is further held that cheap credit policy stiffles the normal growth of the financial institu

tions. The rural folk prefer to save in terms of real assets as the administered rate of interest on

financial assets make them unattractive. So, the financial institutions are unable to mobilise

resources and are mostly dependent on government funds and central bank refinancing. The

advocates of the new approach hold that high interest rate not only attracts saving on a large-

scale, but also provides the financial institutions a higher margin such that they can meet a part

of the high transaction cost of lending to small borrowers out of their profit. The revival of market

forces will cause credit to flow automatically undisrupted. The modern approach stipulates a

working arrangement for the co-existance of the formal and informal sectors because of proven

efficiency, flexibility and easy accessibility of the latter.

Another non-traditional approach held by Bharadwaj (1973,1974) views the whole credit

relation in agriculture as a part and parcel of production and exchange relations. The relationship

between informal lenders and farmers resemble that of interlinked markets. But the market fail

ures and high transaction costs are manifestation of unequal power relations between poor farm

ers and rich creditors (moneylenders, landlords, traders). According to this opinion, informal

markets may be efficient but they aggravate inequality in rural areas.

Many also attack both formal and informal credit as they support a technology not consis

tent with farmers needs. They increase farmers sufferings by making them more dependant on

monopoly capital for industrial inputs. Such credits change production relations and increase

extraction of surplus from farmers via debt nexus.

The policy of the government of India and state governments with regard to rural financial

15
market is largely shaped after the traditional theoritical approach. Policies in respect of the formal

and informal sectors differ with a distinct bias against the latter.

Government policy with regard to co-operative credit in India has passed through three

distinct phases. In the first phase upto 1950 the funds for the co-operative sector came mainly

from the thrift of the members of society. Government neither loaned nor interfered in their

working. The impact of co-operatives on the supply of rural credit was insignificant during this

phase. During the second phase starting from 1950, the policy was to help the farmer to increase

production by using more inputs. Co-operatives were chosen as the instrument to provide the real

and financial resources to the farmers. For this purpose government provided not only the

necessary funds but also administrative support. This policy continued upto 1970. During this

phase the number of co-operative societies and the volume of co-operative credit expanded

enormously. In the third phase beginning from 1970-71, the multi-agency approach was adopted.

It was intended to provide alternative sources of credit as co-operatives failed to satisfy the credit

requirements in the rural sector. The main thrust of the policy towards co-operatives has been to

make them self reliant and financially viable. But it is an irony that due to over patronage and

excessive political interference, the co-operatives have just become a funnel for flowing down of

more and more money.

In view of the negligible share of the commercial banks in rural credit, the study group

setup by National Credit Council (1967) recommended expansion of branch banking base in rural

areas. Nariman Committee (1969) evolved a national policy with regard to development of bank

branch network. Setting up of new bank branches in unbanked areas was recommended. Be

tween 1969 (bank nationalisation) and 1985 (end of Sixth Five Year Plan), Reserve Bank of India

followed a liberal branch expansion policy in consultation with the respective state governments,

Lead Bank of the district and District Consultative Committee. During the period 1985-90, a

modified branch expansion policy emphasized on opening of-branches in the rural and semi-

urban areas and sparsely populated hilly regions. The Lead Bank scheme adopted in 1969 is a

powerful medium to provide integrated credit in a district. The Lead Bank is expected to play a

lead role in the expansion of the banking facilities and act as a leader in co-ordinating the activi

ties of co-operatives, commercial banks and other financial institutions of the district. It is as

signed with the task of preparing the District Credit Plan, supply of inputs and other services, and

16
effecting coordination among development and financing agencies operating in the district. The

Lead Bank scheme has resulted in understanding of rural realities by the banks.

The Service Area Apporoach(SAA) to rural lending was introduced in 1989. Under the

scheme, the area to be served by each bank branch is identified and potential borrowers and t

activities are specified. A credit plan is prepared by the bank in consultation with different devel

opment agencies and credit organisations in the area.

Another development in the credit allocation policy of the commercial banks is the con

cept of priority sector lending. It started in 1968 with the social control on banks. The priority

sector now comprises agriculture, small-scale industries, small transport operation, retail trade,

small business, education and seif employment. Commercial banks are required to achieve

targets and Sub-targets under the scheme. A differential rate of interest scheme was also intro

duced in 1972 to provide financial assistance to the weaker sections at concessional interest rate.

A specific percentage of credit has been earmarked for different target groups. The emphasis on

priority sector and weaker sections has brought interlinkages between the banks and poverty

alleviation programmes of the government.

The Regional Rural Banks were an unique experiment in the field of rural finance. The

authorized capital of each bank has been raised from Rs 1 crore to Rs 5 crores and the issued

capital from Rs. 25 lakhs to Rs 1 Crore. Fifty per cent of the issued capital is subscribed by the

Reserve Bank of India, fifteen per cent by the state government concerned and thirty five per cent

by the sponsoring commercial bank.

The Reserve Bank of India helps the Regional Rural Banks by providing refinance facili

ties. In addition, it permits these banks to maintain lower cash reserve and statutory liquidity

ratios compared to the commercial banks. Presently, National Bank for Agriculture and Rural

Development (NABARD) is responsible for (i) establishment of the Regional Rural Banks, (ii)

Conducting the refinance functions, (iii) formulating operational policies of the Regional Rural

Banks, (iv) monitoring their performance and reliasoning with the RBI as regards branch expan

sion and statutory inspection of the regional rural banks.

The Regional rural banks, in the opinion of Dantwala committee (1978), is an usefull

component in a rural financial market. The Regional rural banks can operate in areas with other

formal financial institutions and informal lenders as these banks are very unlikely to have clash of

17
interest with the latter. These banks extend credit facilities to the weaker section of the rural

societies for productive purpose.

But these banks also suffer from certain weeknesses. First, the growth of these banks

across regions is uneven. Four states (U.P., Bihar, M.P., and Andhra Pradesh) only account for

55% of the total number of bank branches of the country. Secondly, many of these banks are not

economically viable as they have been incurring losses continuously. Thirdly, the problem of over

dues is alarming and getting worse over the years.

The government policy in respect of informal sector is essentially a no policy". This

sector has grown on its own without any support from the government. Rather the operation of the

informal sector agencies has been subject to severe restrictions and controls. In the past, the

Reserve Bank of India tried to link the organised sector with the unorganised one by laying down

conditions for indigenous financial agencies. In 1972, the Banking Commission recommended

indirect control of the indigenous bankers by the RBI through commercial banks. But such pro

posals have not been tried. The avowed objective of the government is to supplant the agencies

of informal sector so far treated as untouchables by the formal ones. But in reality the informal

sector is very vital for raising productivity in the rural sector. Therefore, their knowledge, talent

and services and experience should be fully utilised for overall development of the rural financial

market.

In the changed economic environment characterised by liberalisation and deregulation,

private sector banks recieved a great thrust on the recommendations of Narsimham Committee

(1992), government reffrained from further nationalisation of the banks and differential treatment

between public and private sector banks. New vistas were opened up for the private sectors

banks of the country.

To facilitate the private sector banks to operate in the rural areas, Local Area Banks

(LABs) were proposed. The LABs will have focous on the rural areas. The guide lines led for the

LABs are as follows :

(i) the minimum trading capital of the LABs was fixed at Rs 5 Crore,

(ii) the minimum contribution of promoters was not to be less than Rs 2 Crore,

(iii) the operational area of a LAB was confined to three continuous districts at the maximum,

(iv) the LABs were at the same footing as the RRBs in respect of CRR and SLR,

18
(v) the loaning operations of the LABs were deregulated,

(vi) interest rate on deposits with more than one year maturity were deregulated, and

(vii) each new bank were subject to the prudential norms from their very inception.

LABs were expected to function like informal lenders and as such an attempt to bring the ,

informal lenders into ths institutional framework by incorporating their positive aspects. Appro

priate checks and balances are to be applied by the RBI to safeguard the rural borrowers against

the exploitative and usurious practices of the lenders.

1.6-RURAL FINANCIAL MARKET IN ORISSA

. Orissa has the distinction of being one of the most backward states in the country. It has

a high percentage of rural population and agriculture is the main source of employment and

income of the people in the state. Owing to the lack of irrigation facility in most part of the state

agriculture has remained virtually a mono-culture and backward. The state is staggeringly defi

cient in infrastructural facilities like roads .railways, canals, supply of electricity etc. Except for a

few central sector industries, industrial development is yet to be initiated in the state. Due to the

lack of employment opportunities a good number of unskilled labourers migrate to the other states

every year. In the absence of productive activity of a high order it is quite natural that the financial

market particularly the rural financial market is yet to develop.

In the begining of the century there was no institutional financial agency in the state. The

moneylenders and landlords were important suppliers of credit in urban as well as rural areas.

The farmers and other rural households mainly borrowed in kind from the village moneylender to

meet consumption requirements during the time of scarcity. .Cash borrowings were few, generally

to meet social expenditure and expenses for migration to industrial centres or plantation areas in

search of employment. Even today a considerable amount of borrowing is incurred for these

purposes.

Demand for credit increased substantially after independence when developmental

programmes were undertaken. In order to protect the farmers from the cluctches of the money

lenders and landlords, societies were set-up at the beginning of the present century with govern

ment patronage. The co-operative movement in the state gathered momentum after indepen

dence.

The suppliers of credit in the rural informal financial markets of Orissa are the same as

19
those elsewhere. It is difficult to make any accurate estimation of the number and the volume of

credit supplied by these agencies in the informal sector because of their secretive nature as

regards these operations. An estimate provided in the census of India (1961) put their number at

430 in the state. The number of village population per moneylender was estimated to be 38,230

which was the highest in the country. In 1961,56% of credit was supplied by these moneylenders

(Census of India, Vol-I, Part ll-B, General Economic Tables). Their share gradually declined to

39.8% and 7.1% in 1971 and 1981 respectively. Traders and commission agents supplied 5.5%

of total credit in 1961. This also decreased to 1.6% in 1971 and slightly increased to 3.7% in 1981.

The share of landlords which was 1.0% in 1961 increased to 10.3% in 1971, became only 1.3% in

1981. The share of others in the informal sector was 5.5% of the total credit in 1961, 22.9% in

1971 and 4.81% in 1981.

Though the reliability of such data is questionable because of high degree of underreporting,

the fact remains that informal sector lending is inadequate in Orissa forwhich interest rate charged

in this sector continues to be very high.

The formal sector agencies such as government, co-operatives, commercial banks and

Regional Rural Banks have expanded their operations over the years, in 1961 government pro

vided 15.7% of the total credit and their share declined to 9.2% and 8.1% in 1971 and 1981

respectively. The decline in the share of government is attributed to the emergence of alternative

agencies and general disapproval of government's presence in the financial market.

Among other formal agencies the co-operatives are the leading ones. The beginning of

co-operative movement in the state coincides with that in the country i.e. 1904. Despite the

progress made by the Commercial banks and Regional Rural Banks in disbursal of production

and investment credit for agricultural and other allied activities co-operatives have not lost their

pre-emience in the rural market. The short and medium-term c'o-operative credit structure in the

state is a three-tier one with Orissa State Co-operative Bank (OSCB) at the apex, Central Co

operative Banks (CCB) at the district and Primary Agricultural Credit Socity (PACS) at the village

level. At the end of 1993-94 there were 2805 PACS including LAMPS and Farmers Service

Societies (FSSs). These PACS were affiliated to 17 CCBs. The total membership of the PACS

was 33.70 lakhs. The amount of short and medium-term loans advanced by these societies

during 1993-94 was Rs.74.56 crores.

20
 In the field of long-term Co-operative credit, The Orissa State Co-operative Land Mort

gage Bank (later on called Orissa Co-operative Agricultural and Rural Development Bank

(OSCARD)) was started in 1938. It was unitary in structure'at the beginning but became federal

in 1962-63 with the Orissa State Co-operative Land Mortgage Bank (later on Orissa State Coop. #

Agricultural and Rural Development Bank) at the apex and Primary Land Mortgage Banks (later

on CARD Bank) at the lower (sub-divisional) level. In 1984-85 the nomenculture was changed to

Co-operative Land Development Bank and later on OSCARD. In 1995-96 there were 57 Primary

LDBs with a membership of 8.26 lakhs. The long-term loan provided by these LDBs was Rs.3.94

crores in 1995-96.

The share of co-operatives in the total credit was 16% in 1961. This increased to 22.1%

and 47.4% in 1971 and 1981 respectively. Because of high overdues, excessive dependence on

outside funds, low profitability and failure to mobilise internal resources, the co-operatives failed

to recycle their funds as a result of which their financial position dwindled.

Commercial banking in Orissa started almost at the same time as the co-operatives. But

the development of co-operatives was faster in the initial stage as they received government

patronage. Modem commercial banking began in Orissa with the establishment of the Puri Joint

Stock Bank in 1909. Two more commercial banks were also started in 1913 and 1919. The

Imperial Bank of India opened its branches in 1921. In 1938 the Mayurbhanja State Bank was

started in the earstwhile princely state of Mayurbhanja. Except the Mayurbhanja State Bank and

the Cuttack Joint Stock Bank, all other locally started banks were liquidated in 1930. Some

Commercial Banks organised in neighbourly provinces also opened their branch offices mainly in

the urban centres like Cuttack, Puri, Berhampur and Balasore. The rural areas received little

attention from these banks.

Before the nationalisation of the major commercial banks in 1969 the progress and per

formance of commercial banks in the state was far from satisfactory. In respect of population per

bank branch, percapita deposits and advances, share of priority sector in total credit were very

low in the state. The rural population in the state in 1969 was 92% of total population but only 17%

of bank branches were in rural areas. Profit oriented banking policy, lack of infrastructural facili

ties, absence Of bankable projects in the rural areas, and lack of banking habit of the people are

some of the factors behind the neglect of rural areas by the commercial banks during this period.

21
 After the nationalisation in 1969 and introduction of special schemes the rural financial

scenario in Orissa began to change for the better.

Table 1.2 shows the important changes in the commercial banking activities after

nationalisation. Of the total 100 bank branches in the state in 1969, 83 branches were located in

the urban areas of developed districts and only 17 in the rural areas. But, by 1991, there was a

manifold increase in the bank branches in the state and of the total 2084 branches, 77.54% were

in the rural areas.

With the increase in the number of bank branches, rural deposits have also increased in

both absolute terms and percentage of the total deposit in the state. It has increased from

13.85% in 1976 to 28.11% in 1991. Percapita deposit with commercial banks also witnessed an

increase from Rs. 18.00 in 1969 to Rs.837.09 in 1991 for the state as a whole. For the rural areas,

the corresponding figures in 1976 and 1991 were Rs.8.52 and Rs271.86 respectively. During the

period 1969 to 1991 the percapita advance in the state for both the urban and rural areas has

increased form Rs.9.5 to Rs.674.57. For the rural areas alone it has increased from meagre

Rs.3.65 in 1976 to Rs.251.02 in 1991. Credit deposit ratios for the state as a whole and for the

rural areas separately have shown considerable increase. The priority sector lending in the state

has also increased substantially. These progresses have been achieved mainly due to rural

orientation of the banking policies. All these bear testimony to the fact that in the post nationalisation

era the importance of commercial banks in the rural financial market of Orissa has increased

tremendously.

The first Regional Rural Bank of the state, Puri Gramya Bank, sponsored by the Indian

Overseas Bank, was set up on the 25th Feb, 1976 at Pipili in the district of Puri. By 1991 the

number of the RRBs increased to 12 and their branches stood at 819. They covered 12 out of 13

undivided districts of the state. These banks extend priority sector lending at concessional inter

est rates. But because of their excessive dependence on outside borrowing and insufficient

spread, heavy overdue and huge losses, these banks are unable to discharge heir mandated task

efficiently.

The Orissa State Financial Corporation (OSFC) was started in the year 1957-58. It also

provides financial assistance to the small industries in the rural areas. In 1996-97 its financial

support to 11275 rural small scale and cottage industries amounted Rs.5.46 crores only. The

OSFC has an urban bias and conservative approach for which its role in the rural financial market
%
in Orissa has remained limited.

22
 TABLE-1.1

BORROWINGS OF HOUSEHOLDS FROM DIFFERENT SOURCES (in % )

Sources of Borrowings 1951-52 1961-62 1971-72 1981-82

I.Non Institutional Sources

i. Money Lenders 69.7 49.2 36.1 16.1

ii. Tders and Commission Agents 5.5 8.8 8.4 3.2

iii. Friends/Relatives 14.2 8.8 13.1 8.7

iv. Landlords and Others 3.3 4.5 10.7 8.8

Sub-Total (i) to (iv) 92.7 81.3 68.3 36.8

2. Institutional Sources

i Government 3.3 2.6 7.1 3.9

ii. Co-operatives 3.1 15.5 22.0 29.9

iii. Commercial Banks 0.9 0.6 2.6 29.4

Sub-Total (i) to (iii) 7.3 18.7 31.7 63.2

3. Total (1+2) 100.00 100.00 100.00 100.00

Source : AIRCSC, ReporM 951-52, RBI, 1956

AIRDIS, 1961-62, RBI, 1969
AIDIS, 1971-72, RBI, 1978
AIDIS, 1981-82, RBI, 1986

23
 TABLE-1.2

IMPORTANT INDICATORS OF DEVELOPMENT OF COMMERCIAL BANKING IN ORISSA

---------____Year 1969 1976 1991

Indicator " ~~
Number of bank All Orissa -100 Total - 381 Total - 2084
offices Rural -17 (17%) Rural -187 (49.08%) Rural -1616 (77.54%)
Number of bank Over all -1.5 Overall - 6.61
offices per lakh of Rural - 0.85 Rural - 5.92
population
Deposit in lakhs and Rs. 31.13 Total - Rs. 13517 Total - Rs.263785
Rural deposit as Rural - Rs. 1872 Rural - Rs. 74163
percentage of total ... (13.85%) (28.11%)
Percapita deposits Rs. 18.00 Overall - Rs.55.35 Overall - Rs. 837.09
Rural - Rs. 8.52 Rural-Rs. 271.86
Advance in lakh Rs. 16.63 Total-Rs.7427 Total - Rs. 21257
& Rural - Rs. 781 Rural - Rs.
Percapita advances Rs. 9.5 Overall, Rs. 30.41 Overall - Rs. 674.57
Rural - Rs. 3.65 Rural - Rs. 251.02
Credit Deposit Ratio 53.4% Overall - 54,95% overall - 80.59%
Rural-41.725 Rural - 92.33%
Priority Sector ... March 1977 June-89
Lending 42.9% 58.9%

Source T. R.B.I. Banking Statistics, Quarterly Handouts, June 1976-June 1991.

2. Bureau of Statistics, Govt, of Orissa, StatisticalAbstract of Orissa 1976,1986.

24
 TABLE-1.3

MEMBERSHIP AND LOANS BY CO-OPERATIVE CREDIT SOCIETIES IN INDIA

Membership Loans & Advances

SI.No. Year/Period (in 1000) (In Crores)

1 1951-52 5369 7148

2 1st Plan 8835 12398

3 2nd Plan 18959 34232

4 3 rd Plan 28314 65595

5 4th Plan 39682 16349

6 5th Plan 53918 244597

7 . 6th Plan 73485 723645

8 7th Plan 88672 1235457

Source : Statistical Statement Relating to the Co-operative Movement in India, 1988-89,

Credit Societies, NABARD, Mumbai.

25