1

Assessing the Performance of the Rural Financial Sector1 Dr. Gilbert M. Llanto2

1. Financing the rural sector: An assessment The rural sector is a critical and important sector of the Philippine economy. This sector caters to almost two-thirds of the population who are mostly dependent on agriculture for livelihood. Hence, financing this sector has been one of the major concerns of the Philippine government. This is clearly evidenced in the various policies adopted by the government to ensure that financial resources are appropriately provided to the sector. In the government’s attempt to seriously meet the financial needs of the rural sector, policies that range from direct government intervention in the credit market to policies that limits government role to the provision of a conducive policy environment for stronger private sector participation in the credit market were implemented. 1.1 Trends in lending to the rural sector.

Since the rural population is mostly dependent on agriculture for livelihood, lending to the rural sector has been equated to lending to agriculture. Lending to the sector basically comes from two sources: the formal (banks and credit cooperatives) and informal sources (moneylenders, family, friends etc.). Surveys conducted by the Agricultural Credit Policy Council (ACPC) and the Social Weather Station (SWS) since 1985 show that on the average, only 38 percent of farm households borrow (Table 1). Of the borrowing farm households, only about one-third (29 percent) borrow from formal sources of credit.

1Paper Presented at the PIDS-DA-BAR 2nd Agricultural Policy Forum on “Credit Policy Improvement,” Romulo Hall, NEDA sa Makati Building, Makati City, February 2, 2000. 2 Senior Research Fellow of Philippine Institute for Development Studies and Consultant of Credit Policy Investment Program, Department of Finance.

2

Table 1 Incidence of Borrowing and Distribution of

Borrowers among Farm Households: Survey Results (In percent)

Period Incidence of Borrowing Formal Informal

1985-85 32 32 65 1986-87 37 28 66 1988-89 44 20 82 1991-92 35 26 85 1992-93 36 32 68 1994-95 33 31 69 1996-97 40 33 67 1997-98 47 24 76

Average 38 29 72

Bank lending to the sector. There are various types of formal financial institutions engaged in lending to the agriculture sector. These include both government banks and private banks comprised mostly of rural banks, private commercial banks and thrift banks. Figure 1 and 2 show that while total loans granted by formal financial institutions to the agriculture sector has nominally been increasing since 1980, the ratio of agricultural loans to total loans granted by the banking sector has dramatically declined from 1980 to 1998. Huge decline in the ratio of agricultural loans to total loans granted was experienced in 1983 (from 22 percent in 1981 to 8 percent in 1983) when the country experienced economic and financial crisis. This further went down to proportions of less than 1 percent in the late 90s indicating declining amount of financial resources going to the agriculture sector.

3

Figure 1

Figure 2

0

10

20

30

40

50

60

70

80

90

1985-85 1986-87 1988-89 1991-92 1992-93 1994-95 1996-97 1997-98

Formal

Informal

Proportion

0

5

10

15

20

25

1980 1981 1983 1984 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Proportion

4

By type of banks, the proportion of loans granted to agriculture has steadily declined from the mid-80s to the late 90s. The decline was most evident in commercial banks (from 6.6 in 1986 to only .4 in 1998). The proportion of agricultural loans granted by rural banks has also been on a downtrend during the period. In terms of volume, however, rural banks have been the major source of loans in the rural areas. While the proportion of loans to agriculture granted by private banks has been on the decline, the Land Bank which is the government bank mandated to serve agrarian reform beneficiaries has increased the share of of agricultural loans in its total loan portfolio from 7 percent in 1987 to about 30 percent in the late nineties.

The foregoing shows that lending by banks to the sector has been on a downtrend in the recent decade. Lim and Esguerra (1996) attributed this to financial liberalization coupled with poor performance of the agriculture sector during these years. The poor performance of the sector prompted banks to shift loan resources from the rural sector to the urban sector. Likewise, rural loan portfolio has shifted away from agricultural production to that of other rural-based enterprises. In view of this, a number of financial institutions (both bank and non-bank) in the rural areas have been engaged in small and micro-enterprise lending in recent years3. Informal lending to the sector. Over the years, the informal sector continued to be a major source of credit in the rural sector. Various studies and credit surveys conducted by various agencies of the government are consistent in their findings that around two-thirds of the borrowing farm households get credit from informal sources. It is interesting to note that the proportion of borrowers in the rural areas borrowing from informal sources has relatively remained the same over the years. Informal sources of credit in the rural sector include the following: moneylenders, trader-lenders, friends, and relatives. Lending by the government non-financial agencies (GNFAs). Aside from banks and informal sources of credit, the government also provides credit to the small borrowers in the agriculture sector . The government, resulting in a supply-led credit policy, has implemented directed credit programs (DCPs).4 DCPs direct the flow of credit resources to targeted sectors of the population for specific purposes.

A recent survey conducted by Llanto et al (1997) reported that in 1996, 86 directed credit programs were implemented by 21 executing agencies. Executing agencies may be government line agencies and their attached bureaus, government non-bank financial institutions (NBFIs), government-owned and controlled corporations (GOCCs), and government financial institutions (GFIs). Some of these programs were

3 A number of institutions have recently engaged themselves in the micro-finance business. Micro-finance is the provision of financial resources to the household. 4 DCPs are credit programs implemented by the government. These are funded from sources external to the implementing institutions, such as budgetary allocation, grants or loan proceeds from bilateral or multilateral donor organizations, and whose interest rates were subsidized.

5

implemented through GFIs. Government line agencies own the most number of DCPs followed by GFIs. Together, they manage almost 80% of the programs, with line agencies overseeing 37 programs and GFIs handing 31 programs. The Department of Agriculture handles 12 programs while the Land Bank of the Philippines handles 21 programs. These programs cater mostly to the agriculture sector.

DCPs were implemented using subsidized interest rates resulting in very low cost

recovery. Also, very low repayment rates were reported for these programs. In view of this, these credit programs entail large fiscal costs on the government.

1.2 Rural Credit Policies implemented Over the years, the government has tinkered on a number of policies attempting to

increase the flow of financial resources to the rural sector. These policies include both direct government intervention in the rural credit market and the use of market mechanism in directing the flow of credit to the rural sector.

In the 70s and the mid-80s, the government implemented a supply-led credit

policy which directs the flow of resources to the rural sector of the population for specific purposes. Financial resources are directed to the rural sector through the provision of credit subsidies, credit allocation and loan targeting. Various policies and programs were implemented to achieve these. These are:

Policies in the 70s and early 80s

Ø Implementation of commodity specific credit programs. These programs were

implemented to meet the government’s objective of attaining self-sufficiency in its food requirements, particularly rice and corn5. Under the program, special time deposits at below market rates were made available to rural banks lending to small farmers. The loans were administered through the Philippine National Bank and the rural banks, which were given cheap funds from the Central Bank through its preferential rediscounting window. The provision of cheap funds was expected to encourage these financial institutions to lend to small farmers.

Ø Imposition of mandated credit quotas. Presidential Decree 717 or the Agri-

Agra Law was issued in 1975. This mandates banks to set aside 25% of their loan portfolios for agricultural lending, 15 percent of which should be allotted to general agricultural lending and 10 percent for agrarian reform beneficiaries.

Ø Use of subsidized interest rates. To direct the flow of credit to the agriculture

sector, the Central Bank opened rediscounting window offering cheap funds for loans going to the agriculture sector. These interest rates were used in the

5 Masagana 99 and Masaganang Maisan are examples of subsidized credit programs implemented in the 70s with the key objective of increasing production of rice and corn.

6

commodity specific programs that were designed and implemented during the period.

Policies in the mid-80s and early 90s Ø Deregulation of interest rates. In 1981, the government initiated a set of

policy reforms which effectively deregulated the financial market. Interest rates were deregulated and subsidies were gradually removed. The Central Bank window, which served as the mechanism for preferential credit allocation, was also closed. The adoption of market-based interest rates was adopted as a policy. In November, 1994, the Bangko Sentral ng Pilipinas (BSP), issued a circular lifting the ceiling on lending rates for rediscounted papers covering agricultural production, cottage and small industries and financing of working capital.

Ø Promotion of savings mobilization as source of loanable funds. With the

adoption of market-based interest rates, banks were expected to reduce their dependence on cheap government loanable funds. Without the competition from cheap government funds, banks intensified their efforts to mobilize savings as source of loanable funds.

Ø Consolidation of directed credit programs in the agriculture sector. In 1986,

the different funds used for commodity-specific agricultural lending were consolidated into the Comprehensive Agricultural Loan Fund (CALF) by virtue of Executive Order 113. Some 19 funds administered by the Ministry of Agriculture and Food (MAF) and the Central Bank were all consolidated into the CALF. The initial investments from the CALF were used to fund the expansion of guarantee operations of the Guarantee Fund for Small and Medium Enterprises (GFSME), the Quedan Guarantee Fund Board (QGFB), the Philippine Crop Insurance Corporation (PCIC) for agricultural production of small farmers and the Bagong Pagkain ng Bayan Program for rural-based projects of local government units. The guarantee program was intended to encourage private sector participation in agricultural lending by reducing the risks associated with agricultural lending.

Ø Implementation of a Rural Bank Rehabilitation Program. The policies and

programs implemented in the 70s and the early 80s resulted in massive repayment problems and huge default problems among banks participating in the implementation of commodity-specific credit programs. Hence, in 1987, with the issuance of Central Bank (CB) Circular 1143 later amended by Circular 1172, a rehabilitation program for rural banks was implemented. The program helped ailing rural banks to recover through a combination of fresh capital infusion and the rescheduling of past-due obligations with the Central Bank. In 1991, the Countryside Financial Institutions Enhancement Program (CFIEP) was instituted through CB Circular 1315. Under the program, counterpart capital infusion by Land Bank of the Philippines was made

7

available to match private capital infusion; common stockholders were exempted from the 20 % ownership ceiling; and penalties and other charges on arrears covered by the program were waived. In 1992, the Rural Banks Act was passed. The act provided for the implementation of a rehabilitation scheme for rural banks which allowed the conversion of a rural bank’s arrears with the CB into government-preferred stocks in the bank; owners were required to infuse an equal amount of capital over 15 years.

Current Policies Ø Phase-out of Directed Credit Programs in the Agriculture Sector. The

Agriculture and Fisheries Modernization Act (AFMA) was signed into law in December 1997. AFMA provides for, among other things, the adoption of market-based interest rates in the implementation of government credit programs in the agriculture sector. AFMA also provides for the phase-out of directed credit programs (DCPs) implemented by government non-financial agencies in the agriculture sector over a four-year period. The proceeds from the phased-out DCPs in the sector will be consolidated into the Agricultural Modernization Credit and Financing Program (AMCFP). AMCFP will serve the credit demand of the agriculture sector using market based interest rates. The program will be implemented through government and private financial institutions.

1.3 Emerging Issues

Policy reforms that changed the nature of government intervention from a highly

supply –led approach in the 70s to one that deregulated the rural credit markets in the mid 80s did not seem to have significant changes in the proportion of agricultural loans to total loans granted by formal financial institutions. From a little bit more than 20 percent in the late 70s to the early 80s, the proportion took a dive in 1983 (8.0) and was not able to recover thereafter. Likewise, the proportion of borrowers borrowing from the informal sector compared to the proportion of borrowers borrowing from the formal sources has not change significantly over the years. It has remained within the range of 65 to around 85 percent over the years. This phenomenon is partly explained by a number of policy inconsistencies during the period:

Ø Inconsitency on interest rate policy. While both the Central Bank and the

other economic agencies of the government (e.g. NEDA and DOF) have made pronouncements to adopt market-based interest rates, this does not seem to be implemented at the operations level. Interest rate subsidies continued to be provided (Lim and Adams, 1998) especially in the credit programs implemented by the government. Likewise, Congress continued to legislate laws that resurrected caps on lending rates. These are the Comprehensive Agrarian Reform Law (RA 6657, 1988) which provides for the provision of preferential loans to small landowners, farmers and farmers’ organizations. The Magna Carta for Small Farmers (RA 7607, 1992) also mandates that

8

lending rates to small farmers should not exceed 75 percent of prevailing market rates, inclusive of service charges. Also, some government agencies including Congress continue to design and implement subsidized credit programs in view of the high visibility of credit programs.

Ø Passage of Cabinet Resolution 29 despite issuance of Executive Order 113.

EO 113 was issued in 1986 consolidating 20 agricultural credit programs into the Comprehensive Agricultural Loan Fund. The EO mandates the use of the fund for guaranteeing agricultural loans. The EO was meant to rationalize government intervention in the rural credit market. In 1988 however, Cabinet Resolution 29 was passed. While the resolution only allowed the Department of Social Welfare and Development (DSWD) to engage in direct lending, it also allowed the other departments to implement livelihood programs. This therefore, created the avenue to undermine the government’s own market-oriented credit and financial policy leading to the proliferation of subsidized credit programs by 1992 (Llanto and Geron, 1997). In 1995, an OECF study reported that there are 111 directed credit programs in the country. Around half of this are credit programs in the agriculture sector. The continued decline in the proportion of agricultural loans granted and the almost steady proportion of borrowers borrowing from formal sector might be explained by the crowding-out effect of DCPs. Private sector participation in the rural credit market was crowded out by DCPs which are provided at subsidized rates to borrowers6.

The foregoing shows the reality and consequence of policy reversals. While the

government has been well meaning in the pursuit of reforms that would deregulate and liberalize the financial market leading to an efficient delivery of financial services, political motivation continue to portray the need to design and implement projects that are highly visible and popular. Implementation of government directed credit programs is usually perceived by politicians to belong in this category.

In view of this, implementation of policy reform in the rural credit market should

be coupled with a strong advocacy to provide both policymakers and stakeholders the right information of the consequences of undue intervention in the rural credit market. Past policy failures also showed that policy reforms should offer alternatives to both policymakers and stakeholders7. Aside from implementing the reform itself, both bureaucrats and policymakers should make sure that the alternative accompanying the reform is effective and implementable.

As mentioned earlier, policy reversals led to continued distortion in the rural

credit market leading to the proliferation of directed credit programs in the sector. In

6 A CPIP study (Lim and Adams, 1997) reported that interest subsidies entail large fiscal costs on the part of the government with very minimal outreach to target beneficiaries. 7 While the consolidation of credit programs in the agriculture sector offered a guarantee mechanism as an alternative to direct lending, several studies showed that the guarantee programs were also ineffective. This probably contributed to the policy reversal.

9

1997, Llanto et al reported that there are about 42 credit programs in the agriculture sector. Several studies were likewise conducted under the auspices of the National Credit Council (NCC)8. These studies reviewed the existing credit programs and the existing delivery system for credit. Learning from the lessons in the past and using the results of the studies as basis, the NCC recommended the issuance of an executive order that effectively phases out the directed credit programs in all sector and terminates the participation of non-financial government agencies in the implementation of credit programs.9 The EO also mandates the adoption of market-based financial and credit policies and the use of government financial institutions as the vehicle for the delivery of credit by the government. EO 138 containing these policy pronouncements was approved and signed by the President on August 10, 1999. As the implementing rules of the EO has been drafted and is being consulted with key stakeholders the following key issues are raised:

Ø As DCPs are phased out and the non-financial government agencies are

directed not to implement credit programs, the role of government financial institutions as vehicles of government credit becomes very crucial. It is imperative for the GFIs (i.e. Land Bank of the Philippines (LBP) and the Development Bank of the Philippines (DBP)) to come up with a plan of action that spells out how they plan to meet the financial needs of the former beneficiaries of DCPs. The concern that the current requirements of the GFIs are too tedious and are not suited to the needs of small borrowers should be considered seriously. Appropriate and sufficient delivery mechanism and channels should be tapped and considered by the GFIs. Innovative lending technologies should also be considered and used by the GFIs in the delivery of credit to their clients in the rural area.

Ø Lessons from the past show that the failures of the supply-led policy

approach to rural finance point to the fact that the problem lies not only on the supply but also on the demand side. Poor credit access of small farmers is attributed to the prospective borrowers’ lack of viable projects, track record, organization, and/or equity or counterpart funding (ACPC, 1992; Caneda and Badiola, 1999). Also, the non-viability of agriculture ventures especially those of small farmers is also attributed to the inadequate technical and social preparation, weak management capability and poor infrastructure support. In view of this, capability building should likewise be provided to the clients themselves.

Ø Hence, provision of credit without providing for the other support services

such as rural roads, irrigation and post harvest facilities among others is not 8 The National Credit Council was created under President Ramos through the issuance of Administrative Order 59. The AO mandates the NCC to rationalize directed credit programs in all sectors and to design an efficient and effective credit delivery system especially for the basic sector. 9 The NCC recommended the issuance of the EO to complement the reforms in the rural credit market espoused in the AFMA. AFMA provides for the phase-out of DCPs over a four year period. The NCC believes that for phase-out of DCPs should be implemented in all sectors to minimize risks of policy reversals as what happened in the mid-80s.

10

enough. Credit is only one of the important factors that would lead to the alleviation of poverty and improved living condition in the rural areas. As explicitly stated in the EO, government non-financial agencies should provide the necessary physical, human and social infrastructure for farming to be profitable and improve the living condition of small farmers. Provision of timely market information is also deemed important.

Ø As the government moves away from directly intervening in the credit market

and as private sector participation increase, government should continue to provide assistance for capability building. Capability building may be provided to new private financial institutions (e.g. adoption of innovative lending technologies) who are willing to provide credit to the rural sector using market-based policies.

Ø Risks in agriculture need to be seriously dealt with to encourage the private

sector to participate in the rural financial market. The need to reduce risks in agriculture is highlighed. Hence, government should seriously consider the following: (a) make the crop insurance program work; (b) resolve agrarian reform-related constraints, including the erosion of the collateral value of land under the Comprehensive Agrarian Reform Program (CARP) and the non-marketability of land ownership certificates (Castillo and Casuga, 1999).

2. Rural Finance as envisaged in the Medium Term Philippine Development Plan

(MTPDP) The current MTPDP states that over the next six years, government will focus its

efforts in achieving sustainable rural development. It envisions a modernized agriculture, fisheries and a diversified rural economy that is responsive to the needs of the population. To achieve this vision, the MTPDP enumerates key policies and strategies that must be implemented. Mobilization of greater financial resources for sector development has been identified as one of the key concern to achieve the objective of sustainable rural development. It is believed that mobilizing greater financial resources for sector development would lead to the small farmers’ increased access to credit. The MTPDP identifies the following specific policies and strategies for rural finance:

Ø Increase the access of small farmers, fisherfolk, upland dwellers and

indigenous peoples (IPs) to credit, including long-term financing Ø Promote a savings-led approach to agricultural and micro-financing to

encourage capital formation among farmer, fisherfolk, upland dwellers and IPs, household micro-enterprises and rural banks;

Ø Prioritize implementation of the Agro-Industry Modernization Credit and

Financing Program (AMCFP), as provided under RA 8435 through the phase-

11

out and consolidation of all directed credit programs no later than December,2001.

The foregoing policies and strategies are all aimed at increasing the flow of

financial resources to the rural areas and in improving the access of the rural population (farmers, fisherfolk, upland dwellers and IPs) to these resources. To monitor and be able to take actions so that the achievement of these objectives are ensured, the following priority indicators are proposed:

Key Result Area Proposed indicators Definition and Source of data

Greater financial resources mobilized for the sector

• Proportion of agricultural loans to total loans granted

• Proportion of rural

savings to total savings deposits

• This is the volume of loans granted by formal financial institutions to the agri sector as percentage of total loans granted. (BSP, ACPC)

• This is the volume of savings from the rural areas as percentage of total savings. (BSP, ACPC)

Access to rural finance expanded

• Incidence of borrowing • Proportion of borrowers

borrowing from formal and informal sources

• This is the no. of borrowing farmers as percentage of total no. of farmers. (ACPC, SWS)

• This the no. of borrowers from formal/informal sources as percentage of total borrowers (ACPC, SWS)

Agriculture directed credit programs phased-out and consolidated into the AMCFP

• Proportion of credit programs phased-out to total DCPs

• Proportion of credit

programs transferred to GFIs

• Proportion of budget

• This is the no. of DCPs phased-out as percentage of total DCPs (ACPC, NCC)

• This is the no. of DCPs transferred to GFIs as percentage of total DCPs (ACPC, NCC, GFIs)

• This is the amount of

12

going to credit programs

• Proportion of donor funds going to credit programs

• Proportion of DCP funds in agriculture phased-out and consolidated into the AMCFP

budget earmarked and released to credit programs as percentage of total budget to the sector. (DBM, NCC)

• This is the amount of donor funds allocated to credit programs as percentage of total ODA to the sector (NEDA, NCC)

• This is the amount of agri credit funds phased-out and consolidated into the AMCFP as percentage of total DCP funds in Agriculture (ACPC, NCC)

AMCFP implemented • Agricultural loans

granted as % of the total funds in the AMCFP

• Average interest rate of

agricultural loans granted

• No. of program

borrowers as % of small farmer-borrowers

• This is the volume of loans released to agri borrowers as percentage of total funds in the AMCFP (ACPC, GFIs)

• This is the average interest rates charged for loans granted under the AMCFP (ACPC, GFIs)

• This is the no. of program borrowers as percentage of total small-farmer borrower (ACPC)

3. Institutionalizing the Indicators

With the current institutional set-up, monitoring the proposed priority indicators in rural finance would not be difficult. The Agricultural Credit Policy Council (ACPC) is currently mandated to oversee agricultural credit policies and programs. In the AFMA and in the draft implementing rules of EO 138, the ACPC in coordination with the National Credit Council is tasked to monitor the implementation of the DCP phase-out program in the agriculture sector. Also, the ACPC commissions the SWS to conduct

13

annual survey to determine incidence of borrowing and proportion of borrowers in the formal and informal sector.

The National Economic and Development Authority (NEDA) can tap the existing

system in the ACPC in generating the proposed indicators. Most of the basic data needed to generate the indicators are already being monitored by the ACPC. The ACPC may be requested by NEDA to include the generation of these indicators in their monitoring system. These indicators are deemed necessary especially in tracking down the effectiveness of policies adopted to achieve the objective of expanding access to rural finance.

The NEDA may also link up with the National Credit Council in generating the

proposed indicators especially those that relate to the phase out of DCPS. The NCC is tasked in EO 138 to monitor the rationalization of DCPs in all sectors. Also, the NCC has the initial database of credit programs to be phased out.