Knowledge Bank

Agricultural credit programs in lesser developed countries (LDCs) frequently incorporate low interest rates to benefit small farmers. This paper investigates the role of transaction costs (in addition to interest rate charges) as a logical rationing mechanism in agricultural credit markets in LDCs that in effect creates unanticipated and undesired results among borrowers. Recent research in five LDCs suggest that the intended effect of credit policies to promote uniformly low interest rates to all borrowers is not attained in practice. Instead a skewed, regressive incidence of total costs (interest rates plus transaction costs) on borrowers emerges. A more detailed study of these countries indicates that transaction costs as a percent of loan amount decrease with loan size, decline with increases in the interest rate (reflecting a "trade-off" relationship), are more significant for small than for large loans, and are higher for private than for development bank loans at given loan sizes and interest rates. This trade-off (i.e. the negative elasticity between the interest rate and transaction costs) is larger for private banks than for the development bank, suggesting that private banks are more responsive and flexible in adjusting their loan procedures to a changing regulatory environment. Finally, contrary to conventional wisdom, an increase in the explicit interest rate on loans would have a progressive impact, since it would reduce transaction costs more for small than for large loans.