The Hindu Business Line : For farmers, the real issue is access to credit

Credit is the most important resource, which the rural populace lacks. The farmers we have spoken to do not have banks they can borrow from. Despite the priority sector lending of PSU banks, farmers are still borrowing from local moneylenders at high rates. — DR SENDHIL MULLAINATHAN, PROFESSOR OF ECONOMICS, HARVARD UNIVERSITY

Dr Sendhil Mullainathan, Professor of Economics, Harvard University, has done pioneering research in the areas of behavioural economics and micro-finance. He was recently named IFMR's first Distinguished Fellow. Dr Mullainathan will develop course content in behaviour and development finance at both the master's and doctoral level for IFMR, Chennai. He recently spoke to Business Line on a number of issues, including the role of psychology in economics, micro-finance and the national rural employment guarantee scheme.

Excerpts from the interview:

You are one of the founders of behavioural economics where you have used concepts from psychology to explain economic behaviour. How did you hit upon this approach?

When I was an undergraduate at Cornell University, Prof Richard Thaler, who taught me, used concepts from psychology to explain economic behaviour. He was instrumental in making people look at the psychology of the situation.

There seems to be a wedge between how people actually behave and how economists think they behave. This wedge is interesting.

Initially, I spent a lot of time trying to use concepts from psychology to build models. In the last two-three years, I changed my approach — start with an economic phenomena in the real world rather than a psychological one, and then try and explain and understand it through a psychological approach.

At the Centre for Micro Finance at the IFMR, we take a standard financial problem of a micro-finance institution (MFI), where a typical MFI lends to farmers for buying cattle or buffaloes. They tend to take a 12-month loan and repay it in 12 equal instalments. This is not a fixed-income stream.

So, when the income is high, we tend to think that the farmers will put away the money to repay the loan. This may be a rational model but it is not how people tend to behave in the real world. So, there is a need to restructure loans in such a way that will incorporate a concave income stream.

So psychology helps us understand that there is a contract design problem. How do you think about debt when you realise your customer is not a very good planner? Now, what happens when the cattle is less productive; the farmers stretch themselves to make ends meet. So they end up borrowing from moneylenders.

A basic economic model does not explain this the way psychology does. Maybe, the MFIs should bear more transaction costs in figuring out how to write different social contracts to deal with this problem. It maybe more problematic in the operational sense to write a contract where the farmer is allowed to pay a particular amount for nine months and a lower sum for the rest of the months, a repayment schedule which corresponds with his income stream.

We listen to the problem and try looking at it through a psychological lens. We take different samples of, say, 50 farmers each, and try and apply different contracts to each sample group and, at the end of the year, see how they perform economically. This way we not only get an idea of the repayment schedules, which is what the MFIs see, but also the impact on the income of each sample group and the micro-psychological process involved. This learning process is crucial for designing the next project.

We could call this `prescriptive economics'; start with real-life problems, prescribe solutions and test them in real-life situations and see what we learn about people. There is much more interface between the real world and the world of ideas.

This is the kind of research we're involved with the MFIs and also ICICI Bank on their rural products.

So is ICICI funding some of your research projects?

IFMR is funding the research and ICICI the operational part. We are doing a project for EID Parry with sugarcane farmers.

Typically, in such a project, ICICI Bank or any other institution will only look at the repayment. We look at the problem from the consumption angle and how it affects the household; that is where IFMR comes in.

You were one of the founding members of the Poverty Action Lab at MIT along with Profs Esther Dulfo and Abhijit Banerjee. Can you tell us something more about this lab, its objectives and its research?

Poverty Action Lab is related to all the research we do, that is if we have an idea how do we go about testing it. Let's say we want to see the impact of micro-finance, the best way to test it is to use a randomised sample design. It is similar to testing a new drug. We take a thousand people, administer the drug on 500 and see how these sample groups react.

If a company has a financial product, most often it will conduct a pilot project to test its product. The biggest problem with pilot projects is that the one who designed the product will cherry-pick and choose the best place to conduct the project.

So the impact of the product will look much better during the pilot project than it will when it is introduced into the market. Much of the resources gets wasted in the process. The other point, which seems somewhat academic, but nevertheless important, is the sample size. This is the basic part of statistics.

Now, this may seem boring but is still crucial because we may have a well-designed financial product not working in one sample population (say, district) or a badly-designed financial product doing well in a particular sample population (district). This could be the result of choosing the wrong sample size. So the scale of the sample size is important as it prevents cherry-picking; so we explicitly randomise. Because when we give lot of money to NGOs, how do we know which projects work. This rigorous testing process is a big part of the projects we do in the Poverty Action Lab.

As far as the Indian economy is concerned, on the one hand, you have manufacturing and services sector growingand the IT and financial markets booming. But, on the other, there is a crisis in agriculture with rising input costs, rural indebtedness, farmer suicides and so forth. How do you see these two parallels merging?

The stunning fact about India is that it is predominantly rural. l. We're talking about 700 million people living in the rural areas. The growth rates in the manufacturing sector, though impressive, may not be enough to account for the 70 per cent of the population living in the rural areas. Now, on the flip side, there are also enormous opportunities in the rural space. From our research, we have found out that credit is the most important resource, which the rural populace lacks. The farmers we have spoken to do not have banks they can borrow from. Despite the priority sector lending by PSU banks, farmers are still borrowing from local moneylenders at high rates. Why is this happening? The consequence of this is that land and resources are not being utilised for want of finance. So access to capital is the biggest issue here.

A lot of soul-searching needs to be done by banks and the RBI about why this segment of the population is not being served by the financial sector. How do we go about it? I suspect the outcome of this process will determine the shape of the economy. If the key players make the correct calls, we can see a huge transformation in Rural India. The PSU banks, the RBI and the private banks such as ICICI Bank recognise the credit problem,but there is an immediacy of action that is needed on this issue.

What are your views on self-help groups? Do you think they have the potential to transform Rural India?

We have studied the role of self-help groups (SHGs) in micro-finance. People in Rural India have enormous thirst for savings. The fundamental issue is why they borrow at such high rates. We can't solve this problem by regulation alone or by an interest rate cap. The fundamental problem is access to finance. Now, SHGs is one way of circumventing this problem. We have this notion of SHGs being this idyllic, voluntary organisation where there is no conflict.

The basic problem is between group and individual liability and I think people prefer the latter. So SHGs are only a means to an end and not an end in themselves.

Do you think greater devolution of powers to the panchayat bodies would help in spreading micro-finance to the rural areas? And how would institutions such as ICICI Bank, for instance, deal with rural power structures?

To me, the biggest issue is one of corruption. This is an issue that everyone is aware of but chooses to ignore. Just because we devolve powers to the panchayats, it does not mean that it necessarily leads to better allocation of funds.

Of course, there are leakages; they are inevitable. But if private banks and institutions step in, this financial load is taken off the panchayats and they can focus on education, basic health delivery and other important things. The system does not work the way it shouldand farmers are not getting the loans due to them.

On paper, it looks good, but at the ground level, it is different. There is a disjunction between intent and reality. The best example of this is the public distribution system (PDS). On paper, it provides the poor with food security which, unfortunately, does not reach the targeted sectionGovernance is hard, I don't deny that. All I am saying is that when we formulate policies let us factor in the issue of corruption.

What are your views on the National Rural Employment Guarantee Scheme (NREG)? There is a lot of debate on the efficacy of this scheme, with economists and activists vehemently arguing for and against it.

This is an excellent scheme, which needs to be evaluated. There is a similar debate going on in the US. What is the best way for the government to help the poor? Should it give them cash or other incentives? What is the disincentive effect in all this?

Now before implementing the NREG we know that the fundamental problem will be that of misgovernance. We know that the scheme may not reach the people it is intended for. We're aware of the implementation problem and the leakages.

I think the whole debate on the NREG should focus on whether it reaches the people it is meant for. Now whether it should be done through cash transfers or subsidies is a secondary issue.

The fundamental issue is one of governance and better delivery. Usually, when policy-makers are confronted with this issue, their stock reaction is that ``we have an audit system to prevent leakages".

Now that is a facile answer. For instance, the PDS has an excellent audit system in place, full of checks and balances, but leakages still occur on a massive scale. So putting an audit system in place is not enough. We should confront the problem of mis-governance.

So given the implementation problems dogging a macro-level, omnibus project such as the NREG scheme, do you think it would be a good idea to have more decentralised, State-level rural employment guarantee schemes, instead of an omnibus policy from the Centre? Would that lead to better delivery?

In the long run, there are sound arguments for more decentralisation. Why should we formulate one policy for the entire country and risk losing money in leakages?

In the short run, we could try some policies in a few districts over, say, three years and see which of them work and then think of scaling up the successful ones. Another advantage with decentralisation and this learning process is that there are more people thinking seriously about issues and problems . I'd rather have a thousand people thinking about development issues than two people at the top. Of course, the trade-off about having more people involved in policy-making is that each one thinks that his or her solution is the best.

I think one way of getting around this problem is to tell ourselves that we care more about the issues or problems than about the solutions. That is a more humble way of approaching it.

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