Loan waiver: contagion, not solution

By announcing a loan waiver, Karnataka has joined the expanding list of states that have done so recently. The current loan waiver cycle, which started with the national debt waiver of 2008, has now engulfed states from Andhra Pradesh to Rajasthan. In a recent research paper, I concluded that the impact of political interventions in debt contracts is contagious. The negative spill-over effects, fuelled by expectation of future interventions, result in higher default rate and lower flow of future credit.

To test the contagion hypothesis, I used the microfinance ordinance issued by the Andhra Pradesh government in October 2010. The ordinance made collection of loans almost impossible and represented one of the strongest political interventions in one segment of the credit market — micro-finance. Using the above event as the economic setting, I asked whether the impact of political intervention spreads to bank loans. To make sure that the sample selection is not impacted by the event itself, I only considered loans that were lent prior to the event.

Another important point to note is that my comparison is between loans lent by bank branches located in border districts of unified Andhra Pradesh and those lent by nearby branches located in the neighbouring states of Karnataka and Maharashtra. By design, these branches are located close to each other and hence, most general factors such as broad economic conditions, culture and others that influence borrower behaviour are similar.

The Andhra Pradesh branches were impacted by the event, whereas branches located in the other two states were not. This distinction gives a reasonable treatment and control group.

I found that the default rate of loans lent by Andhra Pradesh-based branches (“treated loans”) is about 18.6 percentage points higher when compared with the default rate of similar loans lent by branches located in the other two states (“control loans”). Similarly, the NPA rate of treated loans is 30.2 percentage points higher when compared with the NPA rate of control loans.

I then looked at the future flow of credit. I found that the amount of loans lent by the treated branches is lower by 54.8%. In other words, as an unintended consequence of political intervention in the micro-finance segment, the access to formal bank credit declined by over half. Needless to say, genuine small borrowers and farmers were the most affected. Such borrowers are likely to have been pushed into the clutches of money-lenders, who charge exorbitant rates and engage in questionable recovery practices, by a policy action that was designed ostensibly to help small borrowers.

As is the case with most government interventions, the micro-finance event had large negative unintended consequences. Even worse is the fact that it eventually ended up hurting the same constituency which it sought to protect. The fact that more than a dozen careful studies that have looked at the impact of the 2008 debt waiver have found similar results corroborates findings of my study.

Making matters worse

The findings of my paper are directly relevant to the state-level waivers that are being announced one by one. If contagion effects in terms of higher default and lower flow of credit can move between different segments of the credit market, then there is no reason to believe that such impact will not move between states.

It is reasonable to think that farmers in states which have so far not announced waiver are likely to anticipate a waiver and start defaulting strategically. The problem is likely to be worse in states where elections are expected to be held shortly. In turn, rationally anticipating deterioration in the borrowing culture, banks are likely to cut-off funding to poor farmers.

Some of the design issues with the state-level waivers are likely to make matters worse for small farmers. Some states paid waiver amounts in instalments over many years, understandably due to fiscal constraints. Given my findings, it is not unreasonable to think that this move would have kept farmers away from formal credit markets for a protracted period of time. Nudges from state governments to banks to lend incremental loans to waiver beneficiaries through state-level bankers committees are unlikely to work given the balance sheet issues faced by the banks themselves.

As well, most of the state-level waivers are specifically targeted towards small farmers and it is not difficult for banks to anticipate that small farmers are most likely to be infested with moral hazard. Consequently, the access to formal credit may decline disproportionately for small farmers who are most vulnerable to economic shocks.

Given the promise of debt waivers by most political parties, there is a danger that debt waivers could become a staple diet, instead of a treatment to be used during times of extreme distress. The advocates of debt waiver should understand that if the Rs 1 lakh crore debt waiver of 2008 did not alleviate farm distress, no state-level waiver ever will. The solution to farm distress definitely lies somewhere else.

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(The writer is Senior Associate Director, Centre for Analytical Finance, Indian School of Business)