A number of successful financial sector reforms have been undertaken in recent years but the access of small farmers and tenants to formal credit is still restricted which is a pre-requisite for rural poverty reduction.

Potential formal suppliers of credit are often reluctant to advance loans to the small farmers because of high transaction costs and perceived high risk. Formal institutions are biased in favour of big farmers. Their political clout facilitates their access to formal credit and thus lending by the formal institutions becomes skewed towards the rich.

Credit plays a pivotal role in development. It helps farmers to undertake new investments and adopt new technologies to increase agricultural yield. Limited access of the rural poor to formal credit has negative implications for rural growth and welfare. Formal loans are normally used for production and investment purposes while informal loans are squandered away on consumption.. Being short-term, informal loans do not contribute to rural growth as these can not be channelled to long-term productive investment.

Non-availability of credit from formal lending institutions compels small farmers and tenants to resort to informal lenders. Informal sources of agricultural credit include friends and relatives, commission agents, arthi, shopkeepers, landlords, employers and inputs suppliers. Out of these sources-- credit from commission agents, shopkeepers and input suppliers has more baneful effects on the rural poor and evidence suggests that such loans further aggravate rural poverty.

Formal lenders are biased towards landlords who can meet the collateral conditions of the lending institutions and as a result the smaller and tenant farmers are left out of the whole scheme of poverty reduction. According to Pakistan Rural Household Survey (PRHS) 2001-02, nearly 80 per cent of cultivator households participate in the credit market, with two-thirds of total rural credit coming from the informal sector, implying thereby that non-institutional agricultural credit is much more widespread in rural areas..

The effective rate of interest on informal credits is exorbitantly high.It is a general practice that the small growers obtain loan in the form of cash or inputs like seed, fertilisers and pesticides. These are tied loans in the sense that farmers obtaining them have to deliver their produce to these commission agents who price their produce much lower than the market price. The World Development report 2006 has quoted following study relating to Pakistan on this issue:

“Chambhar is a market town in Sindh (Pakistan) on the east bank of the Indus. In 1980-81 farmers from the area around Chambhar got most of their credit from about 60 professional moneylenders. Based on detailed data from 14 of the lenders and 60 of their clients, Aleem (1990) calculated the average borrowing interest rate charged as 78.5 per cent. But if these farmers wanted to lend their money banking system will pay them only 10 per cent”.

A study conducted by Punjab Economic Research Institute (PERI) in June 2006 gives similar results. According to the study, the cost of tied loan in case of cotton is 45 per cent and in case of wheat, the cost of borrowing loan from commission agent comes to 47 per cent as evident from the following tabulated data:

This further suggests that the cost of urea credit purchase is 76 per cent and that of DAP credit purchase is 68 per cent. In case of weedicides and pesticides cost of credit purchase is about 83 per cent. It is evident that cost of informal loans is very high as against interest rate charged by the formal lending institutions.

High interest rates on informal agricultural loans adversely affect the small farmers and tenants. These often generate a vicious circle of unending poverty and misery for them. Whatever they have earned, they give to the middleman who flourishes at their expense. The arrangement of tied agricultural informal loans has other serious implications also. Hoarding of essential commodities is a case in point. The middleman purchases the produce at lower price and hoards it to create an artificial supply shortage in the market. This tinkering with the demand and supply forces of the market gives rise to the phenomenon like current wheat and flour shortage..

If we seriously want to reduce poverty in the rural areas, it is imperative that access of the poor and the asset-less people to the formal credit be made easy. The schemes of formal credit should contain the attractive features like collateral free lending, proximity, flexibility in loan transactions and timely delivery. The institutions available to deal with the credit needs of the rural poor have limited outreach, professional and management capacity.

There is a general lack of information, communication and dissemination of information about the availability of micro credit. So it is needed that information regarding these credit institutions is widely disseminated among the rural population. Collateral requirements need to be further relaxed to extend the outreach of formal lending institutions. Promoting use of alternative forms of collateral and more flexible loan repayment may be good policy prescriptions in this regard.

There is a dire need for a paradigm shift in the policies of lending institutions as these credit institutions are formally structured and are reluctant to diversify and extend their lending operations to the rural poor. For the rural poor it is difficult to comply with several stringent loan formalities due to remoteness of villages, illiteracy, and lack of information, corruption and a host of other factors limiting their access to the financial institutions.

To support the communities living in poverty, it is essential to design and implement an effective credit strategy and cost-effective sustainable credit programmes to compensate for the indifference displayed by the ruling elite towards the rural poor. These programmes should include policy planning and design, institutional capacity building and reform in the design of credit.

Besides enhancing the access of the rural poor to the credit, monitoring of loans is also required as presently no effective mechanism is in place to confirm that loans are used for productive purpose rather than consumption.. These institutions need to develop strategies in a way that not only are the rural poor able to obtain loan without unnecessary hassle but they are also given technical assistance to make optimum use of these loans. It will reduce the default rates and will benefit the financial institutions advancing micro credit. It is now an admitted fact that credit channelled in the right direction can have significant anti-poverty effects.