Agricultural transformation and implications for designing rural financial policies in Romania

Agricultural transformation and implications fordesigning rural financial policies in Romania

FRANZ HEIDHUES*University of Hohenheim, Germany

JUNIOR R. DAVIS*CERT, Heriot-Watt University, UK

GERTRUD SCHRIEDER*University of Hohenheim, Germany

(received September 1997, final version received March 1998)

Summary

The current depth and future development of rural finance in Romania arediscussed in the context of Romania's macroeconomic and agricultural trans-formation. The rural finance system in CEE countries is part of the overallagricultural support system and still serves to transfer implicit subsidies toagriculture. The paper argues that building an efficient rural finance systemto address the financial demands of the private agricultural sector requires amulti-level approach. Innovations are needed: at the finance system level, inparticular to create an effective regulatory and supervisory framework and tofree the Central Bank from government interference; at the level of financialorganisations, to give highest priority to efficiency and credit worthiness whenapproving credit; and at the level of financial services to adapt administrationprocedures and product design to the demands of the rural clientele.

Keywords: rural finance, transition, Romania.

1. Introduction

The successful reform of financial systems in the former centrally plannedeconomies of Central and Eastern European countries (CEECs) is of funda-

* The authors gratefully acknowledge the support of an EU research grant in preparing thispaper on Romania. An earlier version was presented at a workshop in Bucharest held from10-12 April 1997 in connection with the Phare-ACE research project P95-2170-R. Forhelpful comments on this paper, our thanks go to Rudiger Heining.

European Review of Agricultural Economics 0165-1587/0025-035125 (1998) 351-372 © Walter de Gruyter, Berlin

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352 Franz Heidhues et al.

mental importance to the economic transition of these regions. Moreover,their increasing integration into the world economy makes the efficientfunctioning of a domestic financial system even more crucial (EBRD, 1996;Davis and Hare, 1997; Heidhues, 1995b).

The most important functions of a financial system in a market economyare maintaining an efficient medium of exchange, the mobilisation andallocation of resources, risk pooling, exercising financial discipline overenterprises, and providing a framework of policy instruments to stabilise theeconomy.

The financial intermediaries that the CEECs inherited from the centralplanning era were not suited to these tasks. In many CEECs, includingRomania, the development of the financial system continues to suffer froma number of problems: (i) banks still finance loss-making state-owned enter-prises (SOE), most notably in agriculture; and (ii) they still carry forwardlarge bad-loan portfolios and do not effectively control corporate governanceand policy.

The level of financial deepening or depth is recognised as a measure ofthe effectiveness and efficiency with which a formal financial system carriesout its functions. Financial depth indicates the range and diversity of finan-cial instruments and organisations that are available to the domestic clien-tele. Indicators of financial deepening may be characterised by:1. the monetarisation of the economy,2. the density of formal financial organisations (number per 10,000 per-

sons) and3. the quantity, variety, quality and efficiency of the financial instruments

and services available.The 'deeper' the financial system, the larger is its potential contribution toeconomic development. Nevertheless, even with a widespread and densefinancial organisation network offering a well-developed range of financialservices, there may be demand-side access constraints which can hampereconomic development.

Within the context of macroeconomic and agricultural transformation,this paper analyses the extent of rural financial deepening and discusses theimplications for the future development of rural financial markets. Althoughthe analysis focuses on Romania, where the empirical research was con-ducted, we believe that the key conclusions are also relevant to other CEEsfacing similar problems. The next section outlines the process of agriculturaltransformation and its implications for rural finance during Romania's trans-ition. Section 3 describes the Romanian financial system before and afterliberalisation. Section 4 analyses Romania's financial depth, based on themonetarisation of the economy, the density of financial organisations andthe quality, quantity and efficiency of financial services, using primary andsecondary data from Romania. Finally, linkages between agricultural trans-

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Designing rural financial policies in Romania 353

formation and rural finance and the implications for designing rural financialpolicies are discussed, and general conclusions are presented.

2. Agricultural transformation during transition

Following the pattern of growth in most CEECs after the 1989/90 reforms,Romania's GDP in the early years of transition declined, most sharply in1991 by 12.9 per cent. Positive growth resumed in 1993. In 1995 and 1996,Romanian GDP grew by 6.1 and 4.1 per cent per annum, respectively. Theestimated GDP growth in 1997, however, is again negative (EBRD, 1997).

Inflation remains a significant problem in Romania. The average monthlyinflation rate in 1997 for food items was around 22 per cent (NBR, 1997b).1

It appeared that Romania's economy was gradually beginning to stabilisein 1997 with inflation decreasing to average monthly rates of 4.5 per centin the second quarter, as compared to the average monthly rates of 25.5 percent during the first quarter of that year. However, the annual averageinflation rate for 1997, as estimated by EBRD (1997), is still 145 per cent.Also, unemployment at nearly 8 per cent and the budget deficit at 4 percent of GDP remain serious problems.

2.1. Changes in agricultural structure

Throughout the CEECs, privatisation2 was a top priority. In Romania, thedecision to privatise agriculture was first made after the revolution of 1989.Along with privatisation, the restructuring of farm enterprises was consideredcrucial for an efficient agricultural transformation (Davis, 1997). The currentfarm structure in Romania as in other CEECs, includes:1. state farms that were converted into so-called commercial companies

(according to the Law on Restructuring of State-Owned Companies15/1990);

2. farmer associations with legal status and family associations withoutlegal status that own property rights on the land operated. Associationswithout legal status seem to be a transitional phenomenon towardsfarming associations, or individual private farming;

3. individual private farms whose new owners decided to cultivate theirland individually (in addition to the mountain farmers who were notcollectivised or pressed into co-operatives).

In Romania, private sector farms operate 86 per cent of the arable landand contribute around 80 per cent of agricultural production (Heidhues,1995a). The overwhelming majority (86 per cent) of the 2.8 million privateRomanian farmers own less than five ha, on average (EC, 1995). The averagesize of privately owned farm land is 2.2 ha (Table 1). There is also a tendencyfor the more dynamic individual private farmers to enlarge their operational

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Table 1. Agricultural land distribution and average farm size in Romania, 1997

State farmsPrivate farm associationsFamily associationsPrivate individual farmers

'000 ha

1,758.41,732.61,595.98,052.7

Romania

% area

13.413.212.161.3

0 farm in ha.

2,743.2436.1100.3

2.2

Timis country

0 farm in ha.

2,895.9571.881.8

2.4

Source: Toderiu (1997).

farm size by forming associations or buying and leasing land. Nevertheless,small farm sizes will remain a problem so long as the land market isinsufficiently developed. Until the end of 1997, land market developmentwas constrained by legislation that inhibited private farmers from owningmore than 10 ha. Since early 1998, new regulation has been enacted whichallows landowners to hold 50 ha of arable land, 30 ha of forest, and purchaseland up to 200 ha. If landowners do not keep their land under cultivation,they face expropriation after two years. The Land Law 18/1991 reconstitutedthe property rights relatively quickly, but the distribution of legal land titleswas slower than expected, with only 40 per cent of the small private fannershaving a legal title (Heidhues, 1995a; Lucas, 1997; Toderiu, 1997).

The small farm sizes in the private agricultural sector, the uncertaintiesof the land title registration process and the continuing presence of powerfulstate farms are important factors influencing the development of the ruralfinance sector. Furthermore, the return of workers to rural areas and theagricultural marketing intermediaries known as 'integrators' play an impor-tant role in rural finance development.

In 1996, the Romanian labour force comprised around 11.3 million people,of which 28 per cent were employed in agricultural production or relatedenterprises. Overall, the number of people employed in agriculture hasincreased since 1989 because of the voluntary return of urban workers ofrural origin and the role of the agricultural sector as an employment buffer.About 40 per cent of the private farmers will retire within the next five years,yet qualified successors are frequently missing and the land market mecha-nisms do not yet allow the efficient reallocation of uncultivated farmland.

Until 1996, farmers were required to contract their production to economicagents qualified by the state, i.e. 'integrators' or intermediaries. In the agricul-tural sector, the integrator was the former state grain monopsony,'Romcereal'.3 In 1995, the proportion of the total harvest which had to becontracted at controlled prices depended on the product. It was 40 per centfor bread quality wheat and seed wheat, and 90 per cent for seed maize. Thestate farms, also considered as commercial companies, which normally con-tract with integrators, have maintained their fertiliser input at 70 per cent

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of the pre-transition level, while total consumption in 1993 declined to 28per cent of the 1989 level (EC, 1995). Thus, in accessing input marketingstructures, the former state farms enjoy de facto preferential treatment, eventhough private agriculture produces between 70 and 95 per cent of the cropoutput (Davis and Hare, 1997). Similarly, producer associations are, to someextent, preferred to private individual farms by the Romanian integratorsystem. Since the private agricultural input and output market has not yetattained outreach and competitiveness, larger agricultural enterprises enjoycompetitive advantages.

2.2. Agricultural finance

During the period 1993-1996, government-mandated lending was the mainagricultural finance mechanism in Romania.4 The administration used avariety of funds and credit delivery mechanisms to provide the agriculturalsector with low-cost credit, where principal as well as interest rates weresubsidised. The main sources of funds were the state budget, the NationalBank of Romania (NBR), Private Ownership Fund (POF)5 proceeds, anddeposits in commercial banks (Tesliuc, 1996).

A widespread, and probably correct, view maintains that the beneficiariesof these cheap funds were a special class of borrowers, notably state-ownedfarms, large-scale borrowers, and clients with strong lobbying powers andclose ties with the banking system. Credit channelled through the integratorsystem, where access is linked to output marketing through a marketingintegrator, is difficult to quantify. Most funds were channelled into agricul-ture through:

NBR refinancing facilities and the state budget. The NBR lends at preferen-tial rates to commercial banks with profit margins subject to restrictions(around 5 per cent according to decree 440/1992). The final interest ratecarried by the agricultural client was often below market rates and generallynegative in real terms. The borrowers' interest payment was subsidised,either ad valorem, where a certain percentage of the interest cost is coveredby a subsidy, usually 60 per cent or through a variable where the borrower'sinterest is fixed at a certain preferential level, usually 15 per cent, and thesubsidy covers the difference up to the market rate.

State-owned commercial banks. These banks often extend subsidised loansto high-risk borrowers with state guarantees from the Ministry of Finance.The state covers loan defaults and the interest subsidy to these borrowers.

Private Ownership Fund (POF). The proceeds from the fund were lent atzero interest rate to state-owned agricultural enterprises.

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The cost of government-mandated lending has been a heavy burden onthe state budget and also on the NBR's balance sheet, as some lendingmechanisms required the NBR to cover the interest subsidies. Moreover,the administering commercial banks could not maintain their equity becausethey could not apply their usual profit margin. This has led to an erosionof the financial intermediaries' lending portfolio and capital base. Thesemassive quasi-fiscal transfers (QFT)6 to agriculture, amounting to 9 per centof agricultural value added and 1.6 per cent of total GDP in 1996 (seeTable 2), went largely to state-owned enterprises (more than 80 per cent).On average, private agriculture got about 20 per cent of the transfers duringthe period 1993 to 1996 (see Table 3). Small private farmers received only 2per cent of the agricultural credit funds administered by Banca Agricola

Table 2. Quasi-fiscal transfers to agriculture in billion Lei (current prices)

1993 1994 1995 1996

Interest component: 107.5 221.1 499.2 626.7• Preferential interest rates on NBR refinancing facilities 100.0 145.6 85.2 369.7• NBR profits used to cover interest subsidies• NBR interest payments deferred to the next fiscal year• Subsidised POF lending at 0%• Forgiveness of interest like debt by state budget

and SOE

Principal component, Total

Total quasi-fiscal transfers

Source: Tesliuc (1996: 10).

Note: The average annual exchange rate of Lei per US$ from 1993-96 ranged from 760, 1,580,2,037 to 2,752 Lei/US$ (EBRD, 1997).

Table 3. Quasi-fiscal transfers to state-owned and private agricultural enterprises(current prices)

Year Total State Private

0.00.07.5

0.0

0.0

107.5

0.020.555.0

0.0

0.0

221.1

158.086.168.4

101.4

0.0

499.2

0.0178.978.1

0.0

1,127.0

1,753.7

1993199419951996

Din. Lei

107.5221.1499.2

1,753.7

Bin. Lei

66.9175.0454.21447.0

%

62.379.291.082.5

Bin. Lei

40.546.045.0

306.7

%

37.720.89.017.5

Source: Tesliuc (1996: 12).Note: The average annual exchange rate of Lei per US$ from 1993-96 ranged from 760, 1,580,

2,037 to 2,752 Lei/US$ (EBRD, 1997).

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(BA) which has been providing approximately 90 per cent of all agriculturalcredit in Romania.

NBR lending at preferential interest rates, implemented primarily by theBanca Agricola, includes a clear fiscal subsidy. Thus, the government usedthe NBR to channel non-budgeted, non-transparent state subsidies to theagricultural sector, avoiding the more transparent state budget. The practiceof channelling implicit subsidies to the agricultural sector remains a commonfeature of many CEECs. Subsidies in the form of QFT distort resourceallocation, enterprise efficiency and macroeconomic performance (Davis andHare, 1997).

Subsidised credit was a life-support mechanism for the unreformed state-owned farms and marketing systems rather than a growth-inducing realcapital formation mechanism for either the state-owned or private farmenterprises (Perotti and Carare, 1996). On average, total QFTs accountedfor 0.8 per cent of GDP from 1993 to 1996, rising from 0.5 per cent in 1993to 1.5 per cent in 1996.

Quasi-fiscal transfers to agriculture through Romanian lending pro-grammes plus direct state subsidies to agriculture in 1994-96 accounted for2-4 per cent of GDP and 11-21 per cent of gross value added in agriculture(Table 4). The government's pricing policy for basic agricultural commodities(wheat, maize, barley, sugar beet, milk, beef and veal) subsidised Romanianagriculture throughout the 1990-95 period, with perhaps one exception in1992, where the nominal protection rate for agriculture indicates a low levelof taxation (Bonjec and Swinnen, 1997).

Direct government intervention in Romanian agriculture consists of pro-ducer price supports, consumer price subsidies, and subsidised inputs andcredit.7 The government has been unwilling to leave food production anddistribution to market forces and retains control over a substantial share offood production in order to guarantee the country's food security. For this

Table 4. Total support for Romanian agriculture 1994-1996

1994 1995 1996

Direct agricultural subsidies in billion Lei, current prices

QFT, in billion Lei, current pricesTotal agr. subsidies, incl. QFT, in billion Lei, current prices

QFT as % of gross value added in agricultureQFT as % of GDPTotal agr. subsidies as % of gross value added in agricultureTotal agr. subsidies as % of GDP

Source: Excerpt from Table 2 of Davis and Hare (1997: 13).Note: The average annual exchange rate of Lei per US$ from 1993-96 ranged from 760, 1,580,

2,037 to 2,752 Lei/US$ (EBRD, 1997).

835.0221.1

1,056.1

2.30.4

10.82.1

1,333.8499.2

1,887.5

3.50.7

13.32.6

2,357.31,753.74,111.0

8.91.6

21.03.7

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reason, it has resisted all pressures to privatise and demonopolise statefarms, food processing and distribution enterprises, and competitive marketstructures are not yet in place. The fear of rising unemployment may alsoplay a role. As a result, no state enterprises were allowed to go bankruptand loss-making units were kept running with large subsidies. With theCentral Bank under government direction, subsidised and directed creditwas used as the main channel for subsidisation. Under central planning, thebanking sector dealt with large enterprises and farms on the basis of aGovernment Plan. Even today, the NBR cannot execute its duties withoutparliamentary intervention. It has repeatedly issued emergency ordinancesfor subsidised lending to priority sectors. Although the government wantedto abolish its mandated lending programmes in 1997, parliament launchedan emergency ordinance to supply an additional Lei 550 billion of credit toagriculture to support the spring crop preparation.

The system does not reward efficiency, providing instead strong incentivesfor adverse selection and moral hazard. The larger the inefficiencies andlosses, the higher the subsidies needed to keep the enterprise alive. Also,path dependency plays a role. Former powerful relationships between enter-prise management, banks and government officials are reported to be impor-tant in the allocation of credit. This offers considerable scope for corruptionand cronyism. As under central planning, when investment performance andcredit repayment were hardly monitored, state enterprises today still havea relaxed attitude towards both.

In summary, the main effects of public expenditure on agriculture havebeen to sustain inefficiency and to block structural change in Romania'sstate agriculture sector because it was primarily directed towards inefficientstate-owned enterprises. The amount of public expenditure on private agri-culture has remained small.

3. Romanian financial system before and after liberalisation

Under central planning, a single bank carried out the functions of bothcentral and commercial banking. The monobank system was typically sup-plemented by specialised banks, including a national savings bank, a foreignexchange bank, and an agricultural development bank. Thus, the Romanianformal financial market consisted of the following state-owned monobanks:Bank for Agriculture and Food Industry (BAFI), now called Banca Agricola(BA), responsible for the agricultural and agro-industries sector; InvestmentBank, now called the Romanian Development Bank (RDB) responsible forthe state-owned enterprise (SOE) sector; Romanian Bank for Foreign Tradealso known as Bancorex (RBFT), responsible for financing trade; and theNational Bank of Romania (NBR) as central bank.

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The NBR, besides being the central bank, performed a number of quasi-commercial banking functions. It collected deposits of SOEs andco-operatives, whilst making short-term direct loans for working capital,mainly to SOEs. Real interest rates were maintained at a very low level.SOEs had no incentive to repay loans, because future credit was independentof past repayment and no mechanisms were in place to enforce creditcontracts. Under all the post 1948 administrations, the NBR was obligedby Government to finance the agricultural sector.

The banks listed above had little capital, no autonomy in selecting invest-ments and did not monitor investment performance. They provided rudimen-tary and generally limited services to their customers (Davis and Hare,1997). The Government absorbed all risk and did not monitor any of thefinancial intermediaries. At the outset of the transformation, the monobanksystem was dismantled and the former specialised banks now operate asuniversal commercial banks (Davis and Hare, 1997; Giassemi, 1997). A two-tiered banking system was formally established in March 1991 (Law concern-ing the Statute of National Banks of Romania 34/1991), which restrictedthe NBR to the traditional functions of a central bank and transferred thecommercial functions of the NBR to the newly created RomanianCommercial Bank (RCB). Under the Law on Banking Activity 33/1991, thelicensing of new banks became possible.

Romania's banking sector currently consists of five primarily state-ownedbanks - BA, RDB, RBFT, RCB, and the Savings House (CEC) - that, inAugust 1997, had 2200 outlets (CEC, 1997) as well as private banks. Thestate-owned banks, in particular, demonstrate a number of weaknesses dueto the fact that they had previously not functioned as genuine credit interme-diaries. For example, they have significant amounts of bad debts, a lack ofskills often reflected in poor management, and little loan portfolio diversifi-cation (Davis and Hare, 1997; Giassemi, 1997). The new amendment to thelaw on bank privatisation issued in late 1997 now covers (1) the privatisationof state-owned banks, (2) the restructuring of the NBR and (3) the liquida-tion of banks by court order (Romaniabusiness, 1997).

In early 1997, the NBR reported 21 licensed banks. This includes CEC,which has been included in the banking register of the NBR, although ithas not yet received a formal banking license (NBR, 1997a; Pantazescu,1997). Banca Albina, which was originally founded in 1872 as an agriculturalcommercial bank but closed during the socialist era, reopened in January1996 and plans to engage in rural investments. Nevertheless, the majoruniversal bank addressing the agricultural sector is still BA. It was estab-lished in 1948 and transformed into a joint stock company in 1990.Government and the five POFs hold 57 and 26 per cent of the share capitalof the bank, respectively. There are no other shareholders with more thantwo per cent of the capital. During 1996, 80 per cent of Lei 4,000 billioncredit was pumped into the agricultural sector, largely out of NBR money

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creation. This has been the prime cause of inflationary pressures within theeconomy (Davis and Hare, 1997; Heidhues 1995a).

In addition, there are 842 credit co-operatives (CCs) which have survivedthe socialist era. Their savings mobilisation and credit-extension capabilitiesare limited by the extremely constraining co-operative and banking regula-tions. Also, efficient market integration through its union, CreditCOOP, hasnot yet been achieved. Nevertheless, about 8 per cent of the rural creditportfolio is extended by CCs to primarily small private rural enterprises(Davis and Hare, 1997). The CCs, together with the consumer co-operatives,are co-founders and shareholders of the Banca de Credit Cooperatist(Bankcoop). In 1994, together, they held around 45 per cent of the sharecapital. Theoretically, CCs can refinance themselves through loans fromBankcoop, but, in practice, Bankcoop is very reluctant to grant loans tothe CCs.

4. Rural financial deepening in Romania

How well suited is Romania's financial system to the new structure of ruralclients and their demands? The efficiency and effectiveness of a formalfinancial market can be described by financial deepening indicators, suchas: (1) the monetarisation of the economy; (2) the number of formal financialorganisations; and (3) the quantity and quality of financial services. In thefollowing, these indicators are discussed.

4.1. Monetarisation of the economy

The monetarisation of the economy at the macro level, generally measuredby M2/GDP,8 is an indicator of the efficiency of the financial system inmobilising funds to foster economic growth. The indicator M2/GDP showsthat Romania's financial depth is far less (about 28.9 per cent in 1996) thanwould reasonably be expected for countries with a similar level of per capitaGDP (see Table 5). The negative real deposit interest rate that prevaileduntil 1997 provided little incentive to save in the domestic financial system.The tendency was to retain financial savings either as foreign exchange orto invest them in real assets.

However, interest rate policy is an effective instrument to influence thesavings rate and thus the composition of M2. In order to attract savings,the NBR raised the auction rate for banks to 266.7 per cent in March 1997,which significantly reduced currency in circulation by April 1997. The inter-bank interest rate increased subsequently to 112.7 per cent (April 1997) andthe time deposit rate for non-bank clients rose above 100 per cent (NBR,1997c). As a result, savings deposits at banks increased rapidly. By May1997, the population had deposited an amount estimated at US$ 200-500

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1.5760

9.1141.0256.0115.070.0

101.761.5

129.052.0

3.91,655

21.5138.1139.0192.565.9

124.892.983.062.0

7.12,033

25.471.632.396.639.981.648.659.038.0

4.12,752

28.960.039.090.035.052.755.371.047.0


Table 5. Economic and monetary indicators

1993 1994 1995 1996

GDP/capita in US$ 1,159 1,324 1,573 1,437GDP growth in % at constant pricesAverage exchange rate (Lei/US$)M2 in % of GDPPercentage change of M2Inflation rate in % (annual average)Average lombard rate in % p.a.Average discount rate in % p.a.Average auction rate in % p.a.Inter-bank rate in % p.a.Lending rate (1 year) in % p.a. (annual average)Deposit rate (1 year) in % p.a. (annual average)

Source: ERBD (1997) and NBR: Annual Report 1996, Quarterly Bulletin 2/1996, MonthlyBulletin 11/1996, 1/1997, 3/1997 and 7/1997.

million in the Romanian financial market (Embassy of Romania, 1997).Among them were many members of CCs who had shifted their savingsfrom CCs to commercial banks. If this period of high interest rates hadcontinued, the deterioration of the CCs' liabilities through deposit transfersto competing commercial banks, could have had severe consequences forthe financial survival of many CCs. Another factor influencing the monetari-sation level in local currency is the public's trust in the stability and reliabilityof the banking system.

4.2. Financial density in rural areas

The NBR estimates that 135 subsidiaries and 146 agencies, out of a total of921, offer financial services mainly to the rural clientele (see Table 6). These281 rural subsidiaries and agencies operate in locations where the populationis less than 10,000. We estimate (by relating the number of rural bankingoutlets to the labour force employed in agriculture), that there are 1.3financial intermediaries per 10,000 people in Romania. This indicates thatthe rural financial institution network in terms of banking outlets is compara-tively well developed, although there are vast regional differences.

Although their contribution to the rural finance market up to 1997, interms of credit allocation, was below 10 per cent, it should be noted thatCCs are not included in this calculation. Davis and Hare (1997) point outthat with greater financial market liberalisation, BPST and CEC may beexpected also to become major players in rural finance.

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Table 6. Romanian banking enterprises and their rural outlets, March 1997

Banca Agricola (BA)Banca de Credit Cooperatist (BANKCOOP)Banca Comerciala Romana (BCRO)Banca Romana pentru Dezvoltare (BRD)Banca Renasterea Creditului Romanesc

(Credit Bank)c

Bank Post (BPST)Banca Romana pentru Comert Exterior (Bancorex)Banca 'Dacia Felix' (FELX)C

Banca International a Religiilor (BIR)Banca Comerciala 'Ion Tiriac'Banca Transilvania (BT)MINDBANKBanca RomaneascaBanca Bucuresti (BRUC)Banca AlbinaBanca de Credit Industrial si ComercialBanca de Credit si Dezvoltare (ROMEXTERRA)Banca Turco-RomanaBanca Columna (BCOLfASTRA

Total

Branches

41444144

494534291717149876b

53311

418

Sub-branches

Total

18817812368

-22-

1574-—---_-12-

608

Rural

595115s

9

-1-11--_-------

-

135

Agencies

Total

785

4855

67389-214_

11----4-

313

Rural

656

2134

1261---_—------1-

146

Source: NBR, Politica Monetara (1997a) and Pantazescu (1997).a In this figure, 2 rural outlets in the organisational form of a commercial bank branch are

included.b Banca Albina considers 2 of its branches in Constanza and Alexandra, both south of Bucharest,

as rural.c These three banks are currently undergoing bankruptcy procedure or are under control.

4.3. Quality, variety and efficiency of financial services

The range and efficiency of financial services is a key factor in financialmarket development. In the following, we discuss the extent to which accessto financial markets is constrained and the issues that play a determiningrole.

The participation or non-participation of small private enterprises in theformal financial market is determined by both latent and active factors. Alatent factor would be the decision of a potential investor to refrain fromapproaching a financial intermediary because he assumes that the applicationwould be rejected. This potential market segment views financial market entryas blocked, even though the price of capital could be paid. Therefore, an

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estimate of the demand for loans based on actual debt entails a bias in that itdoes not account for the potential gap between actual demand and loan supply.

Active factors determine a potential investor's decision to participate inthe financial market and may be categorised as the characteristics of invest-ors, financial markets and complementary institutions.

Investors. The personal and business characteristics of a potential investorinfluence not only the lender's decision to engage in a contractual arrange-ment but also the investor's decision to participate in the financial market.Empirical research elsewhere has shown that a low level of education canact as a barrier to financial market entry given the complexity of financialtransactions (Schrieder, 1996). Also, only 40 per cent of the small privatefarmers in Romania have a legal document demonstrating their propertyrights on restituted land. Lacking such documents, potential borrowers mayconsider it useless to approach a financial institution. Moreover, it appearsthat even property certificates may not be accepted as loan security. Theonly collaterals currently acceptable to commercial banks are owned andinsured real estate. Romanian banks need to consider alternative collateralschemes, as in Croatia and Poland, where banks are permitted to use assetssuch as stocks and equipment as security, similar to pawnbrokers (WorldBank, 1996). Also, people seeking external finance may estimate their capac-ity to repay a loan as risky, facing insecure market prices for their produce.A debtor's character, collateral and the capacity to repay based on personaland business characteristics (the three Cs) summarise a potential investor'sdecision to forward a financial demand towards a financial intermediary.

In 1993, a Euroconsult survey in five CEECs found that private farmers'perception of their access to the formal credit market is often negative. InRomania, 80 per cent considered access in some form or other as limited.To a lesser extent, this is also true for farm managers. Due to historicalevents, potential investors may also be suspicious of certain organisationalforms of financial intermediaries. This applies in some degree to the CCswhich have in the past been misused as tools of the government apparatus.

Latent and active credit demand, as well as credit rationing in the formalfinancial market, was surveyed in the Timis region of Romania. The decisiontree presented below (Figure 1), as well as the other initial results of ouranalysis, are based on an empirical survey of 66 small private farm enterprisesin Timis in the spring of 1997. The extent of latent credit demand and thesupply-constrained credit demand is surprisingly high, given the density offinancial intermediaries in the rural areas of Romania.

In the Timis survey, each private farmer's loan portfolio was evaluated.It consists of loans from the formal and the informal financial market, thelatter referring to informal financial savings and credit groups (such as theCAR and Roata), extended family members, neighbours and friends. In theTimis county, just 8 (12 per cent) of the 66 private farmers who were

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Sufficientself-financing48%(N = 30)

Too expensive

15%(N = 9)

Variousinhibitions

37%(N = 23)

•

Latent demand37%(N = 23)

yes6%(N=4)

Credit amountreduced/rejected

50%(N = 2)

,

Rationing50%(N = 2)

Debt-financingas demanded50%(N = 2)

Source: Heidhues and Schrieder (1997).

Figure 1. Decision tree of credit demand and supply in the formal financial marketsin Timis/Romania

interviewed received a loan (including informal sector loans not covered inFigure 1) during 1996, despite the fact that the need to invest in the pro-ductive capital base of their farm was obvious and their self-financingcapacity was limited. The median loan in the formal and informal sectorswas slightly below US$100, while the average was US$1,500 and the maxi-mum almost US$10,000. The average is heavily influenced by two largeloans disbursed by BA. The loan portfolio of the individual private fannersshows that they primarily rely on the informal financial market. Also, theTimis data demonstrates that small private farmers do save, preferably inhard foreign currency such as Dollars and DM, but these savings are mostlykept at home. Farmers were reluctant to give any indication of the amountof foreign exchange savings retained. Only 30 per cent (19) reported havingsavings accounts with local financial organisations, mostly with BA (52 percent) and CEC (21 per cent). In this case too, six farmers refused to indicatethe savings balance. For those who provided data, the average and mediansavings were US$907 and US$856, respectively.

Like private farms, non-agricultural rural enterprises in Timis face finan-cial market entry barriers. About 11 per cent of the 74 non-agriculturalenterprises surveyed have approached formal financial intermediaries toapply for a loan. Of these eight enterprises, the credit application of five wasapproved without changes, and the amount of credit requested by threeenterprises was rationed by the formal financial intermediary. For slightlymore than 40 per cent of the non-agricultural enterprises in the survey, adistinct latent demand for formal sector loans may be observed. A compari-son of non-agricultural rural enterprises with liquidity constraints and others

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whose market access was not restricted showed that the credit-contrainedenterprises employ on average just four people, while the others employ fivepeople. Apparently, access to credit and subsequent real capital formationmay have a positive effect on the rural labour market. The average amountof formal sector loans in the agricultural and non-agricultural sector (aroundUS$6,200) is very similar. The picture changes for loans from the informalfinancial sector. There, the average loan size is US$850 and US$4,285 in theagricultural and non-agricultural rural enterprise sector, respectively.

Financial markets. Frequently, the lack of local formal financial intermedi-aries inhibits potential investors from participating in the formal financialmarket, particularly in rural areas. Rural financial intermediaries may dis-courage small private entrepreneurs from becoming their customers becauseof information asymmetries between client and agent, lack of suitable collat-eral and high transaction costs (TCs). Innovative forms of contractualarrangements and organisations adapted to clients' demands can circumventor ease these financial intermediation constraints.

Imperfect information at the financial agent level about the ability orwillingness of potential borrowers to honour the debt payment scheduleleads to problems in three areas (Hoff and Stiglitz, 1990): screening, incen-tives, and enforcement.

Financial organisations attempt to overcome these problems by demand-ing collateral. Where traditional collateral is lacking, they may look forsubstitutes which they can seize in the case of loan default such as (WorldBank, 1996):• tied contracts (specific credit cum labour, cum land, or cum marketing

arrangements) or leasing arrangements;• third-party guarantees (as practised by the Foundation for Enterprise

Finance and Development in Albania):• stocks and equipment as security similar to leasing arrangements

(Croatia, Poland); and• threat of loss of access to future borrowing opportunities.

Throughout the CEECs, banks tend to regard the traditional loan securi-ties in the farming sector as inadequate, for the above stated reasons.Collateral substitutes are only beginning to gain wider acceptance, both bybanks and clients. Private commercial banks are generally wary of involve-ment in subsidised lending schemes or guarantee funds as they generallyhave to assume some of the risk. Thus, farms and processing enterprises aremainly confined to dealing with state-owned banks (in the case of Romania,BA). While BA provides subsidised loans to agriculture, it can only sustainthis as long as the government uses it as a conduit for subsidies and carriesthe risk of non-repayment.

A major impediment to increased access to credit and savings services areTCs, incurred by the financial intermediary delivering the service or by theenterprise (household) demanding the service, or both. High TCs, due to

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information asymmetry, appear to be less of a hindrance in networks ofclose social interaction, e.g. in self-help group-based systems, such as theCAR or Roata in Romania. However, these institutional arrangements arenot suited to large-scale farming and agricultural processing enterprises.

In many CEECs, the financial system's legal and policy frameworkdiscriminates indirectly against small-scale rural entrepreneurs. Often, thepolicy of subsidised lending to priority sectors led to an adverse selectionphenomenon, namely the selection of large-scale public enterprises with ahigh incidence of moral hazard. This adverse selection incidence arises notonly due to information asymmetries between lender and borrower, but alsodue to institutional inefficiencies that neglect financial discipline in the creditmarket. This is particularly true for Romania, where in agriculture, the state-owned BA allocated credit mainly to large state enterprises that were ineffi-cient, already heavily indebted and incapable of repayment. Tesliuc (1997)estimates a 30 per cent loan default rate in agriculture vis-a-vis 10 per centin other economic sectors in Romania. In general, all state-owned bankshave accumulated large burdens of doubtful debts from state-owned enter-prises. A serious challenge will be to restructure these banks within theprivatisation process. Currently, they are under pressure from above andbelow. From above, the government pressurises banks into not foreclosingcredit lines to state-owned enterprises; from below, the state-owned enter-prises themselves remind their creditors of the serious consequences for thebanks' stability should they indeed drive the enterprises into bankruptcy.

The management structure of financial intermediaries is often ill-suited tobusiness requirements in rural areas. In Romania, as in other CEECs,transactions, particularly larger credit activities, are still centralised in thehead office, leading to long delays between a credit application and approval.Frequently, the processing of financial services in banking enterprises is non-transparent, complicated, expensive, and rent-seeking is reportedly common.This tends to drive potential investors away from the formal financial market;if accessible, investors prefer to turn to foreign sources of finance.

The services offered by financial intermediaries often do not reflect clients'demand. Deposit schemes lack flexibility, and depositing and withdrawalare expensive and subject to limitations or minimum requirements. Thesame frequently applies to credit schemes. Also, the managerial capabilityof loan department officials may be unsatisfactory. More flexibility, betterdemand orientation of financial services and an improved service mentalitycould enhance the participation of private rural enterprises in the formalfinancial market.

Complementary institutions. Financial markets in transition economies,particularly in rural areas, lack many features that are taken for granted indeveloped market economies. A poorly developed communication and trans-port infrastructure makes the use of formal financial services costly forpotential clients. The virtual absence of insurance markets such as those for

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crop and weather insurance, which mitigate income uncertainty, hindersfinancial intermediation. At the sectoral level, insufficient land and leasemarkets, distorted relative prices in input and output markets and the lackof extension for private farmers reduce the ability and willingness of potentialinvestors and creditors alike to engage in financial transactions (Heidhues,1995a). Small-scale farming dominates the scene because land lease onlybecame possible in 1994. An effective land market is lacking. These policiesare crucial to improving the size structure of Romanian agriculture. Thelink between the latter and the development of rural financial marketsis clear: a transformed and more efficient agricultural sector is essentialfor a dynamic development of the rural financial sector and, vice versa,effective rural finance is a vital element of any successful transformationprocess.

5. Implications for designing rural financial policies

Assuming a relatively favourable banking density, as found in Romania,there are sufficient rural financial intermediaries to serve the potential farmand non-farm rural enterprises. However, market distortions and the lackof a conducive institutional environment prevent financial intermediariesfrom servicing the demand of private rural enterprises. Too often, they havenot developed the variety, quality and efficiency of instruments to deal withthis type of clientele. While the Romanian rural financial market is relatively'deep' with regard to the number of intermediaries, it is by no means sowith regard to its monetarisation, service array and outreach.

Therefore, financial intermediaries engaging in rural finance need to adoptfinancial innovations to become capable of supplying their services efficientlywithout external support (Schrieder, 1996; Schrieder and Heidhues, 1995).The task lying ahead is considerable and varies by country. For Romania,Otiman (1997) estimates in his outlook 2015 that, in the mid-term, about1.4 million Romanians will remain in agriculture, cultivating about seven toeight million ha. of arable land. To restructure the agricultural sector effi-ciently, given this labour force, and to increase the average size of familyfarms from the current two hectares to about 20 ha., the following annualcredit demand until 2015 at current prices was estimated (Otiman, 1997):(1) 1-1.5 thousand billion Lei for land market transactions (500-750

thousand per ha. per year);(2) 3-3.5 thousand billion Lei for investments in tractors and farm

machinery (25-30 thousand tractors per year); and(3) 5-6 thousand billion Lei for agricultural production measures (around

1 million Lei per ha. cultivated land).The present structure of the financial system in most CEECs cannot cope

with such a financing task in an efficient way. In Romania, the finance sectorwould need to allocate credit of between 9 and 11 thousand billion Lei per

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annum to the agricultural sector for the next 15 years. In comparison, for1996, all commercial banks in Romania allocated 20 thousand billion Lei(US$ 7.56 billion) in domestic credit to the entire economy. Of this amount,about US$ 1.1 billion were short-term loans to agents with primarily privatecapital. Only around US$ 272 million were medium- and long-term loansfor economic agents with mainly private capital (NBR, 1996).

Faced with this enormous financing task, the agricultural transformationprocess desperately requires a financial market that is reliable, trustworthy,efficient and geared to serve the new demands of the agricultural and ruralclientele. Changes and innovations at four levels are required: at the macro-finance system level, at the level of financial organisations, in the administra-tion and processing of financial services (savings, credit, insurance andleasing), and in the product design (Schrieder and Heidhues, 1995; von Stein,1991). Improvements in each of these categories are needed to facilitate therural sector's access to the financial market. They will enhance marketintegration and expand customer coverage (see Schrieder and Heidhues,1997; Schrieder, 1996).

Financial system innovations. Financial system innovations at the macrolevel are aimed at creating a reliable, fair and enforceable legal and regulatoryframework, including standardised accounting procedures, together withpolitically and institutionally independent supervisory bodies whose deci-sions are strictly enforced. Banking regulations should not just be 'on thebooks', but forcefully applied. In Romania, the recently amended law onbank privatisation contains legislation to liquidate banks by court order(Romaniabusiness, 1997). Tight on- and off-site supervision must be imple-mented, sending a strong signal to bankers about the penalties for inappro-priate banking behaviour (Fleming et al., 1996). This is crucial in anenvironment where there is still a close and often cosy relationship betweenenterprises and banks. Collusion between them (and between banks) canlimit market entry and competition. Similarly, corrupt practices must notbe tolerated. No other sector in a market economy is so dependent on trustand ethical business practice as the banking sector. At the system level (asat the organisation level) a major institution building and training task liesahead. This is a process that will require time. A shock approach would beunrealistic and doomed to failure. In revising and strengthening the legal,regulatory and supervisory framework, established and generally acceptedprinciples should be the guide.

At the same time, macro-economic stability is essential for an efficientlyfunctioning financial system. Experience in East Asia, Europe and LatinAmerica has shown that financial crises are invariably associated withmacro-economic instability, particularly an appreciation of the real exchangerate and rapid increases in monetary growth (Kaminsky and Reinhart,1995). Macro-economic stability is also an important pre-condition forachieving positive real interest rates.

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Financial organisation innovations. This refers to changes in the structure,management, and legal form of an institution. Giassemi (1977) discussesthe restructuring of banking organisations, with regard to developingtheir capability in dealing with new market segments. This is particularlyimportant for the loan departments of banks in most CEECs, whereofficers are not trained to address different market segments competently.In Romania, the upgrading of the CCs into more commercially orientedbanking intermediaries geared towards the small and medium privateenterprise would be an important innovation. Also, the privatisation ofstate-owned commercial banks would offer the opportunity for organisa-tional change, including the introduction of strict profitability and credit-worthiness criteria in lending, incentives for efficiency and clientorientation. Probably, the RDB and BA in Romania will be among thefirst to be privatised (EBRD, 1997). It appears, nevertheless, that commer-cial banks are unlikely to restructure their operations sufficiently toprovide appropriate rural finance. The more promising options are eitherto establish new micro-finance organisations (institution building) or tostrengthen already existing rural financial intermediaries such as the CECand/or the CC system (institution strengthening) (Romaniabusiness, 1997;Embassy of Romania, 1997).

Administration and processing innovations. Processing innovations focuson improving organisational and service distribution aspects of financialinstitutions, such as the simplification of financial transactions. A process-ing innovation in the area of improved marketing would be a participa-tory client approach (Heidhues, 1995b). To ensure that processinnovations are beneficial to all rural clients, the target group ought tobe included in the design process of rural institution building (Schriederand Heidhues, 1995).

Product innovation. Financial product innovations are defined as new ormodified financial services that have not existed in the market before ordiffer substantially from existing ones (von Stein, 1991). Product innovationsplay a critical role in rural financial engineering that aims at acceleratingeconomic growth (Schrieder, 1996; Zeller et al., 1997). An often emphasisedproduct innovation is the introduction of flexible savings facilities in ruralfinancial intermediation. At the rural enterprise/household level, depositschemes reduce the risk of seasonal income shortfalls since stress periodscan be bridged through dis-saving. Rural finance schemes that offer savingscontracts are important in improving the capital and income situation ofthe rural population (World Bank, 1989 and 1996). The transition of theRomanian Savings House (CEC) into a fully fledged commercial bank mayalso bring about more flexible and profitable savings contracts for its ruralclientele.

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6. Conclusions

The building of an efficient and effective rural financial market requires amultifaceted approach. An essential requirement is financial discipline andmonetary stability. This cannot be achieved if the government pushes theCentral Bank into financing loss-making state enterprises. The governmentshould not interfere with the Central Bank. In Romania, NBR's key mandateshould be securing monetary stability, as this is a precondition for effectivefinancial market development. Even if institutional density is well developed,as is the case in Romania, financial innovations are required at four levelsto improve the access of private agricultural and non-agricultural enterprisesto the financial market:(i) at the financial system level in creating a reliable, fair and enforceable

regulatory framework with an effective supervisory structure;(ii) at the organisational level either by restructuring banking institutions

to better serve the rural client market or by strengthening existingrural finance institutions, such as the credit co-operatives in Romania,or instituting new ones if a reform of existing structures turns out tobe unfeasible;

(iii) within the finance intermediaries, streamlining application, approvaland supervision processes and integrating participatory client involve-ment, and

(iv) offering new services geared to the needs of the rural clientele.These are innovations that require a major long-term effort in education,training, gathering experience, in changing laws, in restructuring other insti-tutions and organisations. This is a longer-term process requiring time,patience and persistence; a shock approach will not succeed.

Notes

1. Until the end of 1996, and to some extent also in 1997, government fought inflation bycontrolling food prices because households' budget shares for food remain very high, averag-ing 58 per cent for urban and 76 per cent for rural families. About 80 per cent of theagricultural production of small private farms goes into subsistence (EC, 1995).

2. In transition economies, the term 'privatisation' includes both the legal transfer and actualissue of ownership rights to individuals and/or private firms (Davis, 1997).

3. Romcereal has since been divided into three main entities: (i) Comcereal which is a self-financing authority, organising State intervention stocks and purchasing large amounts ofcereal; (ii) SemRom is a SOE in charge of procuring and distributing maize, wheat andbarley seeds; and (iii) Unisem is involved in a similar operation for vegetables, grapes andhorticultural products (Davis and Hare, 1997).

4. The following paragraphs draw on Tesliuc (1996).5. Romania's privatisation programme involved two main components: the 'free distribution'

of 30 per cent of the shares in all the enterprises scheduled to be privatised, and the'subsequent sale of shares' of the remaining 70 per cent held by the state. The 30 per cent ineach company are distributed to one of the five POFs, state-created intermediaries techni-cally owned by all adult Romanian citizens through the 'Certificates of Ownership' (vouch-

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ers) issued to them by the state. The 70 per cent retained by the state is held in the POF,which the Privatisation Law (1991) was charged with selling within seven years.QFTs to agriculture are defined as direct and implicit subsidies transferred to the agricul-tural sector via the credit process; they include the subsidy component of preferential interestrates, payments of interest rates out of NBR funds, and exemption from principal andinterest.Davis (1997: 5) states that the agricultural privatisation process depends partly on theenabling environment. In this context, the chief role of government is to ensure that potentialinvestors meet as few barriers as possible, and that problems in marketing, distribution andproduction are overcome through private enterprise and investment, rather than directgovernment intervention. Emphasis should be placed on non-interventionist policies that donot significantly affect incentive structures, such as direct income support. While aiming atcreating an enabling environment, government should be policy neutral in its treatment ofeconomic sectors.M2 comprises currency in circulation plus demand, time, and savings deposits in banks.

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Franz HeidhuesDepartment of Agricultural Economics and Social SciencesUniversity of HohenheimD-70593 StuttgartGermany

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Agricultural transformation and implications for designing rural financial policies in Romania