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United Nations University, UNU-MERIT, Working paper Series No. 2010-039, Maastricht Sonne, Lina (2010)

The rural financial system in India, in spite of its deep and elaborate nature, provides inadequate support to pro-poor entrepreneur-led innovations, which are essential for growth and development.

The availability of rural credit is crucial for the development of rural areas, and particularly agriculture, in developing countries. The fast expansion of rural credit and accompanying banking policies in India played an important role during the Green revolution in Indian agriculture. In the seventies, significant private investments occurred in agriculture, mostly in productivity-enhancing techniques, much of which was financed by the nationalized banks along with credit cooperatives. With reforms both in agriculture and the financial sectors in the early nineties, there have been fundamental structural changes in rural banking with strong implications for agricultural investments and rural innovations.
           
The paper by Sonne appraises the rural financial system in India from the perspective of poverty alleviation and livelihood generating innovations. The time span for review chosen by the author is the entire post-independent period after 1947, largely using existing studies in the area and secondary banking data from the Reserve bank of India (RBI). The study also probes into the new forms of financial credit institutions that have merged in rural India in recent times and to what extent they have facilitated rural innovations that benefit the poor.
           
A comparison of the Indian financial system with other developing countries reveals the relatively deeper reach of the credit network. The average area per bank branch in India is 44 sq. km. far lower than that in countries like Mexico or Brazil. The population per branch on the contrary was higher but given the large population that the financial sector is required to serve, this figure at 12800 persons was still quite satisfactory. The deepening of the financial structure can be attributed to several banking reforms undertaken early after independence.
           
The 1951 All India Rural Credit Survey pointed out that less than 9 percent of the rural credit was provided by formal institutions and the dominance of moneylenders and private traders, charging usuriously high interest rates, were dominant in the credit market. In order to correct this situation, the government adopted the ‘social banking’ strategy. Expansion of the number of financial intermediaries in rural areas, undertaking ‘priority sector’ lending and provision of subsidized credit to rural areas were some of the measures implemented as part of this strategy. The National Bank for Agriculture and Rural Development (NABARD) was constituted in 1955 to monitor the expansion of rural credit.

The process, however, received fillip only after the nationalization of commercial banks in 1969. The target for priority sector lending to agriculture and weaker section of the society was set at 33 percent and later raised to 40 percent of total lending in 1979. Moreover, the RBI policy in 1970, that 3 new branches (later 4) have to opened in un-served areas for every new branch opened in an already covered area. The number of regional rural banks increased from 1443 in 1976 to 35000 in 1990. The share of institutional credit increased enormously to more than 60 percent by the early nineties as a result of this expansion.

The study observes that following this impressive expansion of rural credit, the objective of ‘social banking’ was largely abandoned in the next round of financial reforms initiated after 1991. The report of the Narasimhan committee noted that a large number of rural bank branches were not profitable, citing the high share of Non-Performing Assets (NPA) that some of them have incurred in the eighties. Following the committee’s recommendations, there was a veritable decline in the absolute number of rural bank branches after 1991. The share of rural credit in total credit also declined. Banks have also diversified their activities to other profitable investments. Interest income on loans formed only 37 percent of their incomes while returns on investments constituted 52 percent.

Based on the trend that the share of rural credit in total outstanding credit was declining faster and was lower than the share of rural deposits in total deposits, the author argues that there is a flow of credit outwards from rural to semi-urban and urban areas. This has severely hampered rural production, mainly agriculture, as well as pro-poor innovations and enterprises in rural areas. Though the paper does not link this trend to the stagnated agricultural productivity and rate of returns since the eighties, it has been pointed out that given the agrarian crisis that has emerged in recent times due to several trade and input sector reforms, banks are not finding it profitable to lend for farming activities currently. This has further exacerbated the problem of indebtedness, overwhelmingly to private moneylenders, and mass farmer suicides in rural India since the late nineties.

In the context of this shrinking rural credit from commercial and cooperative banks, the author assesses the alternative financial sector (including microfinance) that have developed in rural areas in the recent past. While rightly noting that the usual micro-finance institutions (MFI) are not very effective in propelling innovations due to their very small size of loans and the short-term lending practices, the study observes that new institutions in the alternative financial sector are encouraging micro-innovations in rural areas.

Three kinds of institutions have emerged lately, which assist in developing sustainable livelihood generating innovations and enterprises. These are micro venture capitals, grass-root innovators and incubators and small-scale finance organizations. Certain government actors like the Department of Science and Technology are also part of this alternative system and has launched schemes for rural poor women such as the ‘Women in Science and Technology’ to support rural innovations.

The paper concludes that within the alternative financial sector, there is shift in focus from MFIs and Self-help Groups to rural ventures, entrepreneurs and innovation. The new organizations also have complementarities among themselves in terms of networks and financial support. Finally, the author underscores the need for further research on the alternative financial sector to comprehend to what extent the new institutions are facilitating rural innovations and bridging the credit availability gap created by the withdrawal of the old institutions and also the ways to scale up the operations of alternative credit institutions.