On Valuing Targeted Loan Subsidies in Rural Credit Markets: An Option Price Analysis
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Date
1991-02
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Publisher
Ohio State University. Department of Agricultural, Environmental, and Development Economics
Abstract
This paper shows that the way in which loan contract conditions are established by development institutions in rural credit markets shifts risks, from one sector (the targeted group of loan beneficiaries) to another (the specialized lender, the government, or an international donor). The paper shows that these risk-shifting properties of rural credit programs create negative incentives, that stimulate targeted borrowers not only to invest in more risky activities than otherwise and to increase the leverage debt financing of their investment projects, but to reduce the effort devoted to their productive activities as well. Those conditions imply free options and subsidies and create incentives for loan default. Thus, rural credit programs in developing countries are characterized by excessive riskiness, excess demands for loans, and low borrowers' productive efforts. The paper uses option pricing in a valuation model designed to examine these issues and it estimates the value of the implicit subsidy received by a sample of borrowers of the Agricultural Development Bank in the Dominican Republic during 1987. Loans granted with funds from more restrictive sources (targeting) experienced higher default rates and thus resulted in higher implicit subsidies.