INTRODUCTION

1. Background and relevance of the topic

During the 1990’s, the provision of micro-finance has increasingly been acknowledged as an effective means for poverty reduction in many developing countries. For the poor, lack of financial security is one of the critical reasons for their continuing poverty. Despite the merits of a policy providing the rural poor with subsidized credit, the provision of such credit often meets only a small fraction of the total credit needs of poor households. What is not met through official channels is normally met through the informal financial market.

Vietnam is one of the poorest countries in the world. The poverty incidence in Vietnam is still high. Based on the general poverty line determined by the World Bank (WB) and General Statistics Office (GSO), the poor were accounted for 29.7 percent of population (Vietnam Living Standard Survey 1997-1998, VLSS98). Causes of poverty in Vietnam have extensively been examined. It is found that "limited access to available resource, including financial capital, is among the main underlining causes of poverty in Vietnam. Microfinance is a key part of such resources from which the poor can choose and develop better livelihood" (UNDP, 1996).

To date, there have been several studies of general problems faced by the rural poor households in assessing formal credit in Vietnam that the rural households' ability to access formal credit is limited by complicated procedures of formal financial organizations while the informal sector with flexible conditions makes it easier for farmers to borrow, including Tran. T. D. (1998), Tran. V. B. et all (1999), Le. T. T. et all (1999), Do. Q. T. (2000). However, less work has been done on analyzing the factors affecting the rural poor’s accessibility to credit using data from a nation-wide household survey. Therefore, an investigation into the determinants of rural households’ access to credit in the formal and informal credit markets is worth undertaking.

2. Focus and scope of the thesis

The aim of this thesis is to examine the factors affecting the rural poor’s accessibility to credit market. In particular, this research analyzes qualitatively and quantitatively the factors affecting accessibility of the rural poor to credit in Vietnam in 1997/1998. The study concentrates on the rural poor. Data from the rural non-poor is also used for comparing and distinguishing the salient characteristics of rural poor borrowers.

Ø      Primary data: obtained from VLSS98. This survey was implemented by GSO with funding from Swedish International Development Cooperation Agency (SIDA) and UNDP, and technical assistance from WB.

Ø      Secondary data: collected from various sources, including VLSS93, microfinance survey conducted by Master in Development Economics (MDE) team, Department for International Development (DFID) and State Bank of Vietnam (SBV), policy statements, official unofficial reports, various comments and figures from published studies in the field, newspapers, reports of conferences and documents and papers on the Internet

3. Research questions

Research question: "What are the factors affecting the rural poor’s access to (formal/informal) credit in Vietnam?", and sub-questions:

?   What are the characteristics of formal and informal borrowing by the rural poor?

   What is the difference between the rural poor’s access to formal and informal credit?

?   What can be done to improve the rural poor’s access to formal credit in Vietnam?

4. Structure of the thesis

The paper consists of an introduction, four chapters, a bibliography and appendices. Chapter 1 represents a literature review of three main approaches to credit market, then basic model explaining the behavior of borrowers. Chapter 2 provides a detailed descriptive analysis of borrowing by rural poor with an emphasis on characteristics of the poor’s loans with important findings through the analysis of rural credit data. In chapter 3, the simultaneous equation models are used to test hypotheses in the beginning of the study as well as suggested in examination of household credit data. Chapter 4 provides a conclusion and suggests some policy implications for further development of rural finance, and improving rural poor’s accessibility to formal credit.

CHAPTER 1 – FORMAL VERSUS INFORMAL MICROFINANCE -                   A LITERATURE REVIEW

This chapter reviews three theoretical paradigms in contemporary financial economics providing analytical frameworks for explaining how the rural credit market works. This objective is to present a framework that incorporates the realities of the environment in which formal credit institutions and informal credit sector are operating and the rural poor are making decisions.

1. Three theoretical approaches

1.1. Traditional approach

The traditional approach views limited capital fund as the main factor impeding the access of farmer to formal credit institutions in developing countries. It was extension of Keynesian views on the government role formed during 1930s, and other economists such as Wai (1956), Cairncross (1962), Bottomley (1964). The traditional school based on its explanation for the supply of and demand for credit. From the supply side, they assumed that low levels of income limit the savings potential in developing countries. The role of the government in increasing savings, creating credit, and providing incentives for the proper sectoral allocation of the limited loanable funds, as a result becomes crucial.

From the demand side, credit is considered as input. Traditional approach assumed that the borrowers are more sensitive to interest rates than lenders. Low interest rate helps farmers to make productive investment and use new technology (Wai 1956, 1957; Bottomley 1964). In this regard, the traditional school advocated cheap credit policies implemented through interest rate ceiling, anti-using laws and interest rate subsidies. The traditional approach implies a high level of government intervention in the form of targeted credit.

Ø      Weakness of the traditional approach: Subsidized credit programs, in sum, tend to succeed all too well in keeping governments in power through political patronage and in maintaining and even enhancing, the position of rural elite. Contrary to their intent, credit policies have often been biased against the poor. Low return of subsistence food production as insurance in a risky environment is the situation of the poor. That is argument of the Financial Repression Approach, which is discussed in next section.

1.2. Financial Repression Approach

While the traditional and financial repression school perceived credit markets as fragmented and imperfect, the financial repression approach argued that this is more a result of government policies which have repressed the growth of credit markets rather than an inherent characteristic of the market itself. Cheap credit in fact does not favor the poor, but instead allows the rich people to get a disproportionate share of the cheap credit. Faced with these disappointing results, the early 1970s, a large number of evaluation studies were undertaken, which challenged the traditional view, such as Donald (1976), Adams (1971, 1984), Gonzales-Vega (1976), Vogel (1981), Pischke (1981) and Ladman (1981, 1984).

The financial repression hypothesis raises issues of poor policies. Many policy-makers, technicians, writers on development often don't think interest rates as incentives or prices, and they fail to recognize the importance of these prices in affecting the behavior of participants in financial market. Next, the financial repression approach indicates the weakness of formal financial institution. In rural areas, operations of formal financial institution were largely restricted to state owned development banks and officialized cooperatives. Both were "used and abused" to channel priority credit with controlled and subsidized interest rate, to target credit according to political rather than banking criteria, and enjoyed generous credit guarantees to cover anticipated losses.

In addition, the finance repression approach sees the discrimination against the poor in formal finance sector. According to the Iron Law of Interest Rate Restrictions, as the loan portfolios of formal financial institutions usually include both rationed and non-rationed classes of borrowers, interest rate ceilings become more restrictive. The size of the loans granted to the non-rationed borrower classes increases, in contrast to diminish the size of the loans granted to the rationed borrower classes (Vega, p.86).

The fact was that formal lenders were either unable or unwilling to solve the information problems involved in the broad range of rural credit transactions and those high interest rates reflect high information costs, not the scarcity of funds. The critique from Pischke, Adams, and Donald (1983) was enlivened by observations of credit policies in developing countries. They stressed the distortion introduced by government policies and tended to idealize the informal credit markets that did exist or that might have existed in the absence of the massive government intervention in the credit market. There was a presumption that an intervention-free rural financial market would approximate the perfect competition model.

The financial repression approach suggests that financial liberalization would lead to financial deepening; improved efficiency, resulting in lower spreads between borrowing and lending rates, and increased flow of funds between segments, including better access to formal finance for previously marginalized savers and borrowers.

Ø      However, many surveys of formal and informal institutions and borrowers such as in Ghana, Malawi, and Tanzana investigate the hypothesis that reforming financially repressive policies would not be sufficient to overcome fragmentation of financial markets because of structural and institutional barriers to interactions across different market segments. The financial repression approach does not address the issues of incomplete markets and imperfect information in the context of credit market in rural areas. In much recent theoretical literature, the problems of moral hazard and adverse selection are assumed to be decisive for the organization of agrarian institutions. That’s why financial repression approach could not apply their literature to overcome difficulties in rural credit market.

1.3. The New Institutional Economic Approach

The institutional approach based on cost and incentive problems that emerged especially in a contract involving the promise to pay in the future. It argued that other approaches to credit market ignored the transaction costs beyond the interest rate. In the view of the institutional approach, these transaction costs limit the access of the poor to the formal credit market even though interest rate is low. A strand of literature beginning with Spence (1973), Rothschild and Stiglitz (1976) and Wilson (1977) stresses the role of "sorting devices" that facilitate the transmission of information from informed to uninformed agents in the markets. Then, Hoff and Stiglitz (1990) advanced an explanation based on imperfect information causing the issues of credit market.

Firstly, the terms of the loan contract such as collateral requirements may influence the characteristics of those who present themselves for loans and, hence, the distribution of the lenders' returns. If the lender cannot at reasonable cost distinguish good borrowers from bad, he face a potential problem of "hidden information'', to use Arrow's (1985) terminology - or as it is usually called adverse selection. Secondly, characteristics of the borrowers are fully unknown to the lender, the terms of the loan may influence the borrower's activities and performance in ways that affect the lender's returns. This causes moral hazard. Thirdly, transaction costs that the costs associated with the steps that borrowers undertake to complete the requirements of borrowing also lead to credit rationing. For any lender the larger size of transaction costs, assuming a fixed interest rate, the greater will be rationing power of transaction costs.

Transaction costs have an important impact on the structure of financial markets in rural areas where low average returns and high risks associated with many agricultural activities. There are also comparative advantages of finance formal and informal by strengthening the links between them. Remote areas with poor transportation may lack access to formal financial institutions. Meanwhile, informal sector relies on localized, personal information that gives them local monopoly power but constrains their ability to scale up (Stiglitz, 1992). An additional barrier to access is the cumbersome administrative procedures that accompany formal lending, raising borrowers' transaction costs to levels that are not much different from total costs of borrowing in the informal market.

Ø      If structural and institutional constraints are important, reforms in the formal financial sector would have little impact on informal activities, which would respond more to changes in financial demand and supply in the real economy than to change in financial policies. Therefore, we investigate further the demand for credit and rural poor’s borrowing behavior in the next section.

2. The behavior of borrowers and the demand for credit

2.1. Credit rationing and ceiling interest rate

Credit rationing is defined as a "situation in which the demand for commercial loans exceeds the supply of these loans at the commercial loan rate quoted by banks." (Cosci, p.7). Interest rate acts as screening which regulates the risk composition of loan portfolios, and as dual function of price and instrument for regulating risks. When excess demand happened, the price increased and set off excess demand. Thus, interest rates increased, making greater risk then offset banks' income increase from higher interest rate. The banks keep low interest rate and ration available funds, resulting in credit rationing with no-tendency for interest rates to rise.

A lower interest rate than the market equilibrium fixed at ie leads to shift the supply curve. At the ceiling interest rate ir while lenders could provide loans at Q's, potential borrowers would be willing to pay a higher interest rate i' for this limited amount of funds. Borrowers will therefore continue to seek credit equivalent to Q's as long as their transaction costs are less than or equal to margin i'ir. The lower the restricted interest rate, the greater the transaction costs that borrowers will be willing to absorb and vice versa.

2.2. Borrower behavior and the Demand for Credit

Like the first-stage of the two-stage model of Zeller (1994) discussed in details in next part of the thesis, the model that captures the reality that farmer-borrowers concern themselves with the total borrowing costs is suggested by Ladman (1984). Ladman began the model by studying the borrowing costs BC that are imposed by the lender's credit delivery system. Costs include interest costs IC and constant borrower transaction costs BTC . The condition of profit maximization is i = MRR. Therefore, the profit equation of the farmer-borrower is given by Ladman as in this form:

where:              AR = R/L                     is average revenue

                        ABC = i + BTC/L        is the average total borrowing costs.

As Figure 1.2, the farmer would want to borrow L*, where i = MRR and p would be L*.(AR - ABC). The figure shows that T1 is the borrowing threshold below which the borrower would not borrow from a lender.

Ladman's model is extended to two lenders in the market: one is a formal credit institution with a low nominal interest rate but high transaction costs for the farmer; one is an informal moneylender who charges a high interest rate but low transaction costs. The farmer therefore will choose the lender that offers the larger expected profit p given interest rates ii and if, transaction costs BTCi and BTCf, and demand for credit D, subject to the constraints and associated risks of the out-of-pocket expenses T2i and T2f (subscripts i and f are used to denote variables related to the informal and formal lender, correspondingly).

Ø      From this model for case of two lenders, Ladman suggested that offering cheap credit does not necessary induce farmer to borrow from formal lenders. Otherwise, the farmer's decision to borrow from whom is dependent on the total cost of borrowing. The borrowers seeking small loans will often prefer to work with lenders who charge high interest rates but who impose low transaction costs upon borrowers. When seeking larger loans, borrowers may prefer to work with lenders who impose larger transaction cost but charge a lower interest rate. Therefore, the model shows that rural credit market is characteristics of segmentation.

CHAPTER 2 – AN ANALYSIS OF VIETNAMESE RURAL CREDIT MARKET

1. General picture of the rural poor borrowers

This section presents the overview of the rural poor borrowers in terms of the percentage of borrow by the number of households in comparison with rural poor non-borrowers, non-poor borrowers.

Source: Vietnam Living Standard Survey, 1997-1998

The extension of formal banking system to rural Vietnam is most remarkable achievement of microfinance in Vietnam since 1996. By 1997-98, the percentage of rural households in debt had risen to 50 percent (54 percent of rural poor). Figure 2.1 shows that the poor are almost as likely as the non-poor households to borrow. Similarly, the average loan size of the poor is about 1,684 thousands dongs, which is much small in contrast to the average loan size of rural non-poor households 3,743 thousands dongs (see Table 2.2).

2. Formal and Informal funding sources existing in parallel

Even though there have been many official initiatives in the rural banking sector during the past few years, the vast majority of rural credit needs are still not being met by the formal banking sector. This is proved by the high rate of borrowing from informal sector. Table 2.1 shows the source of borrowing by the rural households. The table reveals two interesting points. First, a big gap is obviously shown in the average loan size of the rural poor and the rural households in both formal and informal sector. Government banks appear to be the first source of loans in terms of amount, however, it represents only 25.6 percent of loan sources when we account for number of loans.

Table 2.1 - Loan and the percentage of number of borrowers by sources

Source: Vietnam Living Standard Survey, 1997-1998

Second, for the rural poor, the informal sector supplies smaller loans than the formal sector did. Therefore, the proportion of informal loan values is lower than that of formal loans (accounted for 37.8 percent of the rural poor’s loan values) even though the rate of numbers of informal loans is more than half of the total numbers of loans. Yet, 54.3 percent of all poor borrowers had at least one active loan from the informal sector. We can therefore observe that the informal credit sector is still exist parallel to formal financial sector.

3. Characteristics of loan uses by rural poor: Formal versus Informal loans

As pointed out in Chapter 1, the formal sector institutions provide loans with priority for production in most credit contracts. The development of formal sector services has caused greater segmentation. In Vietnam, the formal lenders, notably the VBA and the VBP, ration under-priced credit to the richest and the poorest farmers and for investment purpose only. The lengthy approval procedures for formal loans also mean that immediate funding needs are met informally. The poor more likely to be victims of usurious lending, as they seek immediate consumption assistance in times of disasters, food or health crisis. Government banks provide loans for investment purpose only and thus lending for consumption purpose is left to the informal sector.

Table 2.2 – Loan uses by the rural borrowers

Source: Vietnam Living Standard Survey, 1997-1998

Table 2.2 contrasts the purposes of loan obtained by the rural poor with the loans obtained by the rural non-poor households. The data shows that the poor can borrow only small loans, especially for investment and working capital in comparison with the non-poor’s loans. It means that the poor have no other activities to diversify their investment to avoid risks. This might be one of reasons for high default of the rural poor’s loans. The proportion of consumption loans, including loans for residential construction, is much higher in informal loans, particularly from relatives and friends. Such variation reflects the differential ability of lenders to access the repayment capacity of borrowers. However, the data from VLSS98 show evidence of a diversion of loans to unapproved uses or called fungibility of credit. But it is not easy for the poor to do like this since they often lack social influence or relationships. That is why many the poor accept usurious interest rates. In particular, the poor may require loans from private moneylenders for consumption in the months immediately before harvests.

4. Characteristics of the rural poor’s loans: Formal vs. Informal lenders’ requirements

a) Collateral requirement:

One of "rationing mechanisms" that most formal institutions use is collateral requirement. To secure loans, formal lenders usually require physical collateral in the form of land, a house, or durable goods. Figure 2.2 brings a brief description of loans borrowed by rural poor under the condition of collateral and non-collateral.

Most formal loans require collateral, accounted for 28 percent of total number of loans borrowed by rural poor (equivalent to 73.2 percent of total number of loans with collateral). In contrast, loans without collateral are mainly provided by the informal sector, represented around 44 percent of total number of loans borrowed by rural poor (equivalent to 71.4 percent of total number of loans without collateral). According to VBA’s report, the bank provides a loan based on estimating capacity to payback loans, that loans is less than 70% of assessed value household assets, which serve as collateral.

Ø      Form of collateral: The most common type of collateral is land. Only about 30 percent of households have "red certificates" of land use rights. For more detail study of loans with collateral, the table gives the picture of how the different sources require different forms of collateral. As Table 2.3 represented, of 512 numbers of loans, 262 loans used house as collateral, 203 loans used land, however, the percentage of loan value in case of mortgaging land is more than half of total loan value (55.6 percent). The government banks supplied the largest proportion of loans with collateral, of those loans they required mostly land as collateral (153 loans over 272 loans). Meanwhile, other sources such as relatives, ROSCA, Poverty programs mainly used house as collateral for their loans.

       Source: Vietnam Living Standard Survey, 1997-1998

b) Interest rate

Figure 2.3 brings a general picture of providing loans to rural poor with and without interest. Interestingly, most loans provided by formal loan required paying interest while a large part of informal loans did not required interest. In microfinance, as elsewhere, the poor always suffer and have less favor. With less capital, less education and less income, they are a greater lending risk and hence, face higher interest rates especially from informal lender. Table 2.4 shows more detail the big different between two sectors: the informal lenders charged high interest rate in contrast to the low interest rate of the formal financial institutions. Easily, the difference can be explained by State Bank of Vietnam's policy on controlling ceiling interest rates and by government subsided credit policy for targeted groups. Interest rates of informal financial sector freely adjusted in credit market while interest rates of formal financial sector are sticky under market clearing rate.

  Source: Vietnam Living Standard Survey, 1997-1998

Table 2.4 - Monthly Interest rates by source of loans (percent)