Views | The farm loan waiver continues to destroy the credit culture in rural India

Views | The farm loan waiver continues to destroy the credit culture in rural India

You reap what you sow.

And so the effects of the massive 76,000 crore farm debt waiver announced by the government during the 2008 budget are now being felt in the countryside.

Critics of the debt waiver had warned when it was announced that it would do great harm in the long run because farmers would begin to anticipate a similar write off come the next general election. They would see value in strategic defaults. That is what seems to be happening now, as bankers complain that farmers are refusing to pay back the money they have borrowed despite a good harvest and high food prices.

Chaudhuri should know. His bank’s latest quarterly results show that the largest problem, as far as problem loans go, was the airline industry, especially one carrier that the bank did not name. But farm loans are the other big worry, accounting for 750 crore of the total 6,000 crore of slippages in asset quality.

The loan waiver announced in February 2008 had a cut-off date of December 2007. The general elections were held about 18 months later. It seems likely that farmers are now anticipating that the next election will be held sometime in the middle of 2014; so it is a good time to begin defaulting.

It’s all about rational expectations.

There have not been any long-term benefits to the rural economy either, as a recent research paper by World Bank economist Martin Kanz argues.

Kanz shows that the debt relief beneficiaries are not more likely to undertake productivity-enhancing investments; there has been only a moderate improvement in overall household debt since beneficiaries have quickly accumulated new debts; clearing of collateral through the debt waiver did not improve access to bank finance; and the waiver has a strong effect on expectations about the reputational consequences of default.

“A one standard deviation increase in the amount of debt relief increases the probability that beneficiaries would default on a formal sector loan before any other claim by 2.3%," says Kanz in his paper. "Perhaps the most serious criticism of large bailout programs is their potential to induce moral hazard by affecting beliefs about the enforceability of debt contracts and the consequences of default."

Respondents were asked if they were to default due to some financial difficulties, which loans they would prefer to default? "We show that debt relief increases the reported probability of default for bank loans, but not for loans obtained from the informal sector," Kanz said.

Not only has the farm loan waiver not had any positive impact on rural India in the long run, it seems to have created incentives for strategic defaults every five years. Not that empirical refutation has ever come in the way of populist enthusiasm.

Close