The government ensures credit to farmers with the best intentions. But they lead to horrible outcomes.
In his budget speech every year, the Finance Minister lays down an indicative target of farm credit to banks. Banks have an explicit target for agriculture lending as part of their overall priority sector lending target. Banks must give at least 18% of their total loans to agriculture (and related activities allowed by the RBI). The underlying, unflinching belief is that farmers need more institutional credit as against credit from money lenders. Loans from formal financial institutions are cheaper and they do not resort to unscrupulous recovery practices. Crop loans are generally available at a four percent interest rate due to a subsidy from the central government, and some states provide a subsidy on top of it, making crop loans effectively interest-free.
Unsurprisingly, institutional credit to Agriculture has expanded. In the last 15 years for which we have data (FY01-FY16), direct institutional credit (which includes that of commercial banks, regional rural banks and cooperative banks) has increased 12 times! As against this, nominal agriculture GDP has expanded less than five times. While some of the increases in agriculture credit could be due to ancillary activities that are not strictly farming, there certainly has been an increase in the institutional flow of credit to farmers, more than the increase in underlying nominal activity. So, while it is the case that a lower cost of borrowing is beneficial to an individual borrower, the assumption that this is necessarily beneficial to agriculture at large is questionable.
Agriculture is essentially a commodity business. Producers produce non-differentiated goods and no single producer has any influence on the price he can charge for his produce. In this regard, it is similar to other commodity businesses such as steel or aluminum or oil. Thus, every commodity businessman takes a price risk — he is not sure of the price he will realise for his produce when he starts his production. Agriculture is probably riskier than other commodity businesses since the production cycle in agriculture is typically a few months and thus the producer here is exposed to price risk for a longer period. In other commodity businesses the production cycle lasts a few days. Further, in addition to price risk, producers in agriculture are exposed to volume risk also given the role weather plays in output. Both these risks – price and volume – are inherent in Agriculture and cannot be eliminated. They can at best be managed.
One of the principal means by which a producer manages the business risk is through the capital structure, by changing the proportion of debt and equity. Other things being equal, a business with uncertain cash flows, like in the case of a commodity business, is financed through lesser quantum of debt as compared with a business with highly predictable cash flows like, a like toll road or an operating power plant. Further, within an industry, low-cost producers have less-volatile cash flows than high-cost producers, who will often keep swinging between profit and loss. Thus, high-cost producers will need to have a more conservative capital structure than low-cost producers within the same industry. Further, within commodity businesses, since agriculture has more volatile cash flows (due to both volume and price risk as discussed above), there is a need for agriculture to be more conservatively financed. Else, the risk is of financial distress if the risk materialises.
This is where economics and the thrust of our policy (of pushing more credit in agriculture) are at loggerheads. More debt, in the absence of commensurate equity, sets up farmers for eventual distress, when the inherent business risks materialise. The 2013 NSSO report on Agriculture, ‘The Situational Assessment of Farmers‘ brings this out nicely. If agriculture households are arranged as per their land holdings, then the households with smaller holdings (which generally suggests lower wealth) on average generate negative savings. This implies that these households do not generate any savings or equity to fund their agriculture business. While that is just one data point, it should be noted that 2013 was a year with a normal monsoon and a year with adverse weather, like the drought years of 2014 or 2015 would be worse in terms of incomes.
The policy of pushing more credit in agriculture thus leads to two perverse outcomes:
One, it encourages farmers to borrow more than what the underlying economics of the business warrants. And irrespective of the cost of credit, borrowed money needs to be repaid. Almost every operation of farming happens on credit in many cases (either because there is no equity or because debt is ridiculously cheap) with the land itself being mortgaged in many cases. Any adverse variation in output or its price relative to initial expectation means a high probability of financial distress.
Second, by allowing farming to continue credit with little or no equity, it keeps people in farming who otherwise ideally ought to quit it. It thus encourages people to remain in farming, and it does so through increased risk for the farmer, rather than by reducing his risk. This eventually sets the stage for next round of farm loan waivers.
The problem in agriculture is not that there is too little credit, but too little equity. Small and marginal farmers (an overwhelming proportion of agriculture households in the country) are currently taking on a risk they are incapable of taking. Policy must recognise this. We need to stop this policy of pushing credit into agriculture, both in terms of quantum and its cost. Let the underlying economics of agriculture determine the right level of credit that should flow into agriculture. While this cannot happen overnight, a gradual reduction should be made. This will make farming unviable for many households. But that is exactly what policy should aim for. For, in the long run, the only way to make farming viable is to reduce the number of farmers and absorb them in other areas of the economy. That is the only way size of the pie will increase for the surviving farmers.
While this plays out in the long run, even in the short run policy should recognise that the only way the cycle of periodic agrarian crises can be broken is if there is a better allocation of risk within agriculture. The two risks in agriculture are price and volume. A well designed and efficiently implemented crop insurance scheme can significantly reduce the volume risk. Unfortunately, none of the crop insurance schemes implemented so far has achieved this. Minimum Support Price (MSP), the current policy intervention to eliminate price risk, does a poor job principally because it distorts the price discovery. Whether more of gram is to be produced or corn or wheat is for the market to signal to the farmer through price movements.
The problem for the farmer is that the price can vary significantly in the months that it takes to harvest the crop from the time of sowing. This risk can be addressed by having an efficient futures market or by allowing forward contracts between traders or corporates and farmers so that the price risk is transferred from the farmer to businesses who can take that risk. My limited interaction with companies suggests that while businesses are open to this idea, one of the reasons this hasn’t worked is the lack of enforceability of contracts. Policy should thus focus on making this work and remove the friction.