Interest Rate Subvention in Indian Agriculture: A Demand-Side Analysis and Proposed Alternatives

agri-credit policies. One scheme that seeks to tackle the objectives of
institutionalisation, cheap credit and prevention of defaults is the interest subvention scheme (ISS).
Unfortunately, while agri-credit policies in India have been extensively studied from the banks’
perspective, a demand-side analysis remains under-studied. This has led to a mismatch between the
present policy paradigm and the needs of the farmers, of which the ISS is poised to be a conspicuous
example. It has not only failed to achieve its twin objectives of institutionalisation and incentivising
prompt repayment, but, quite apart, also led to some unintended consequences such as diversion of
funds towards arbitrage opportunities, the dominance of short-term production loans (as opposed to
long term investment loans) in overall credit, and the likely disproportionate benefits to large farmers
at the cost of small and marginal farmers.
In this paper, we seek to explain how this may happen by creating a model that analyses the behaviour
of a farmer in deciding whether to borrow from a formal or informal source. We find that the noninterest
costs (transactions costs and losses incurred on account of delays in disbursal of credit) of
borrowing from a formal source may be so high that they lead the farmer to borrow from an informal
source, such as an APMC agent. The failure of the ISS can at least partly be attributed to the neglect of
such demand-side factors.
In light of this failure, we conclude it is more effective for the government to invest funds elsewhere in
projects that would increase agricultural productivity and incomes in the long run. However, the
provision of cheap formal credit is still important. We believe that a microfinance institution (MFI)-
like lending mechanism, appropriately tailored to the needs of agriculture, may be best suited to
achieving this aim. Drawing on the experience of various MFIs internationally and the existing
literature, we outline best practices that reduce the costs of borrowing for farmers while also managing
risks and liquidity for MFIs, thereby ensuring their viability.