Imperfect Substitutes: The Local Political Economy …Imperfect Substitutes: The Local Political Economy of Informal Finance and Microﬁnance in Rural China and India KELLEE S. TSAI

World Development Vol. 32, No. 9, pp. 1487–1507, 2004� 2004 Elsevier Ltd. All rights reserved

Printed in Great Britain0305-750X/$ - see front matter

lddev.2004.06.001
doi:10.1016/j.worwww.elsevier.com/locate/worlddev
Imperfect Substitutes: The Local Political Economy

of Informal Finance and Microfinance

in Rural China and India

KELLEE S. TSAI *Johns Hopkins University, Baltimore, MD, USA

Available online

Summary. — Banking authorities in both China and India have attempted to limit most forms ofinformal finance by regulating them, banning them, and allowing certain types of microfinanceinstitutions. The latter policy aims to increase the availability of credit to low-income entrepreneursand eliminate their reliance on usurious financing. Nonetheless, the intended clients of microfinancecontinue to draw on informal finance in both rural China and India. This article argues that thepersistence of informal finance may be traced to four complementary reasons––the limited supplyof formal credit, limits in state capacity to implement its policies, the political and economicsegmentation of local markets, and the institutional weaknesses of many microfinance programs.� 2004 Elsevier Ltd. All rights reserved.

Key words — Asia, China, India, informal finance, microfinance, rural finance

‘‘[O]fficial reports of the moneylender’s impending de-mise are much exaggerated.’’–– Clive Bell on India(1990).

‘‘The fact that these private or underground creditmoney houses exist and sometimes thrive in the coun-tryside even today has revealed that farmers needthem.’’––People’s Daily on China (November 29,2002).

*Earlier versions of this paper were presented at the

Workshop on Local Governance in India and China:

Rural Development and Social Change, Kolkata, Jan-

uary 6–8, 2003, and the Duke University Comparative

Politics Workshop, February 24, 2003. The paper bene-

fited greatly from the constructive input of the workshop

participants. I am also grateful for the insights of

Richard Baum, Anirudh Krishna, Laura Locker, Eddie

Malesky, Mark Selden, Suman Sureshbabu, Sarah

Tsien, Fei-ling Wang, Steven Wilkinson, David Zweig,

and four anonymous reviewers. They are, of course,

absolved from the article’s inadequacies. Financial sup-

port from the Ford Foundation Public Policy Grant

Competition is gratefully acknowledged. Final revision

accepted: 10 May 2004.

1. INTRODUCTION

Developmental economists have long notedthe complexity of providing effective ruralcredit delivery in large, agrarian countries suchas India and China. 1 Establishing and main-taining a network of rural financial institutionsis expensive, and managing their operationsis difficult in the absence of proper training,monitoring, and incentive structures. Theoperational challenges of rural financial inter-mediation are compounded by state develop-ment strategies that promote industrializationand urbanization at the expense of agriculturalproduction. At the macrolevel, the notoriousscissors gap between agriculture and industryredistributes savings from rural to urban areas,thereby limiting the relative supply of ruralcredit. At the microlevel, this means that even

148

well-located rural households that have theoption of keeping their savings in officialfinancial institutions may lack access to formalsector credit and rely instead on a wide range ofinformal, curb market mechanisms.It is in this context that governments

throughout the developing world have regardedinformal finance as a negative reflection ofdeficiencies in the formal financial system. Inboth China and India, the traditional image ofthe usurious moneylender adds an additionalpejorative dimension to the official depiction of

7

WORLD DEVELOPMENT1488

informal finance: when the poor lack access toconventional sources of credit, they areexploited by loan sharks and other illegal curbmarket operators. Following this logic, theprescription thus requires increasing stateefforts to eliminate informal finance, whileenhancing the availability of state-sanctionedfinancial intermediaries, especially microfinanceprograms devoted to poverty alleviation. Evenwith these policy measures, however, smallbusiness owners and farmers continue to relyprimarily on curb market finance in both Chinaand India. Moreover, in some cases, the scale ofinformal finance actually increases in commu-nities that have been targeted for a greatersupply of official credit. This raises the questionof why official attempts at limiting informalfinance and expanding the accessibility of for-mal finance may have such unintended conse-quences. One basic reason for the persistence ofinformal finance is that the supply of formalfinance is limited and insufficient to meet thedemand for credit. A second explanation is thatofficial state policies are not being implementedproperly. In addition to these economic andstate-centric explanations, this article arguesthat informal finance and formal finance areimperfect substitutes for two additional, com-plementary reasons: First, because credit mar-kets are segmented by local political and socialdynamics; and second, because government-sanctioned microfinance programs are oftenstructured in a manner that fails to serve itsintended clientele. This suggests that informalfinance is not simply a manifestation of weak-nesses in the formal financial system, but also, aproduct of local political, institutional, andmarket interactions. The analytical value inrecognizing these local interactions lies in theirability to explain why developmental outcomesdeviate from state intentions.The article proceeds as follows: Section 2

reviews the key expressions of formal and semi-formal finance in China and India, and showshow the countries’ strategies in rural financialintermediation compare with one another.Both have relied on directed credit andencouraged the growth of microfinance pro-grams, albeit to differing degrees. Section 3outlines the main expressions of informalfinance in China and India and discusses theextent to which they have been subject to stateregulation. Section 4 delineates four comple-mentary explanations for why state efforts tosubstitute informal finance with microfinancehave not been successful, and presents two local

case studies from India and China, respectively,to illustrate how the combination of creditsupply, local political economic conditions, andinstitutional characteristics of financial inter-mediaries mediates the dynamics of ruralfinance.

2. FINANCING RURAL DEVELOPMENTIN CHINA AND INDIA

To understand the formal institutional con-text against which curb market activities haveflourished, this section highlights major chan-ges in the basic structure of rural finance. Bothcountries have established credit cooperatives,commercial banks, and poverty alleviation mi-crofinance programs in rural areas, but theseformal sector institutions have not displacedinformal and semi-formal sources of credit. 2

(a) Formal financial sector

After India’s independence in 1947 and theestablishment of the People’s Republic ofChina in 1949, the 1950s represented a rela-tively optimistic and ambitious phase for bothcountries in establishing a national system foragricultural finance. Both newly inauguratedregimes shared the developmental goals ofpromoting growth without exploitation, andcreating grassroots-level savings and creditinstitutions to serve farmers.Although India inherited a basic network of

credit cooperatives from the colonial era, theReserve Bank of India’s (RBI) first decennialAll-India Debt and Investment Survey in 1951found that 93% of rural households relied oninformal finance (Bouman et al., 1989, pp. 12–14). This finding inspired a strong politicalcommitment to establishing formal sectoralternatives to the curb, which was popularlyviewed as being exploitative and even ‘‘evil’’(RBI, 1954). Hence, throughout the 1950s and1960s, the government actively promoted theexpansion of cooperatives ‘‘to provide a posi-tive institutional alternative to the moneylenderhimself, something which will compete withhim, remove him from the forefront, and puthim in his place (RBI, 1954, pp. 481–482)––ormore generally, to enhance the availability ofagricultural credit and alleviate rural poverty.In the mid-1970s, India’s rural financial systemwent through another expansionary stage withthe establishment of regional rural banks(RRBs) at the district level, farmers’ service

INFORMAL FINANCE AND MICROFINANCE 1489

societies at the village level, and further growthof nonbanking finance companies. 3 Eventhough the number of bank branches tripledduring 1969–79, the government consideredrural access to be too low at 37,000 people perrural bank branch; therefore, in 1980 anotherseven commercial banks were nationalized toextend their outreach in rural areas (AFC,1988, in Nagarajan & Meyer, 2000, p. 172). Inquantitative terms, progress has been made onthis latter objective: according to the RBI, by1998 India had a total of 64,547 RRB branches,which was equivalent to 17,000–21,000 ruralcitizens per bank branch. 4 But, the RRBs haveproven to be financially unsustainable andinefficient in loan delivery (Bhatt & Thorat,2001).Shortly after the founding of the People’s

Republic of China, the Chinese communistsordered the closure of all forms of privatefinance and banned popular forms of curbmarket financing, including pawnbrokeringand ‘‘loan sharking’’ (Hsiao, 1971). During the1950s, China also set up a network of ruralcredit cooperatives (RCCs), but unlike thecooperatives in India, China’s original RCCsacted mainly as fiscal institutions that funneledcredit between the state and the people’s com-munes rather than serving as commercialcredit-granting institutions. It was not until thecommencement of market-oriented reforms inthe late 1970s that RCCs started to functionmore as grassroots banking institutions thatserved rural households and collective enter-prises, and the Agricultural Bank of China(ABC) was re-established to handle larger scalecommercial banking activities. 5 Meanwhile, inthe early 1980s, the Ministry of Agricultureestablished a network of Rural CooperativeFoundations (RCFs) to serve farmers, but thePeople’s Bank of China never considered themformal ‘‘financial institutions’’ and succeeded inshutting them down at the end of the 1990s.Indeed, throughout the reform era centralauthorities have repeatedly waged nationalpolitical campaigns to crackdown on the curb.In July 1998, China’s State Council even issuedformal ‘‘Provisions on the Cancellation ofIllegal Financial Institutions and Activities,’’which reiterated that illicit financial institutionsshould be banned (Xinhua, July 22, 1998, citedin Tsai, 2002a, p. 1).The elimination of RCFs left about 44,000

RCCs at the township level (with about 280,000village branches) as the only formally approvednonbanking financial institution devoted to

serving rural enterprises and households. Sincethen, central banking authorities have deliber-ated over how to improve their performance(Watson, 2003), and injected approximatelyUS$4 billion in recapitalization funds into theRCC system because RCCs are technicallyinsolvent. As of mid-2003, RCCs accounted for11.5% of total savings and 10.8% of loansextended by formal financial institutions, and apilot reform scheme for decentralizing theirmanagement was underway in eight provinces(PD, November 30, 2003).

(b) The rise of microfinance

Given the inability of most formal sectorbanking institutions to reach rural populationsand the popularity of informal sector alterna-tives, microfinance programs have emerged as apotential solution for bridging the gap betweenthe supply and demand for rural finance. Inboth India and China, microfinance has takenthe form of subsidized loans in government-supported poverty alleviation (PA) programs,and various donor and nongovernmentalorganization (NGO)-lead endeavors. While theactual expressions and overall scale of micro-finance differs in the two countries, the relativeeffectiveness of these two main forms of mi-crofinance is similar. Specifically, subsidizedmicroloans in government-supported PA pro-grams tend to have low repayment rates andtend not to reach the intended clientele; andmicrofinance programs run by NGOs are moreeffective in reaching poor clients when loans arestructured in a financially sustainable mannerand use lending methodologies that are adaptedto the particular economic needs of the inten-ded clients.

(i) Directed subsidized credit in public povertyalleviation programsExtending subsidized loans to low-income

areas and households has traditionally been thefirst, and perhaps least effective strategy thatgovernments use in their rural developmentstrategies, and India and China are no excep-tions (Adams, Graham, & von Pischke, 1984;cf. Morduch, 2000). The Indian IntegratedRural Development Programme (IRDP) wasestablished in 1978 with the mandate ofextending microloans through the bankingsystem to impoverished households and nowregards itself as the ‘‘world’s largest programfor providing microloans to the poor (Sinha,2000, p. 66).’’ In its first two decades, the IRDP


extended Rs. 250 billion (US$12.3 billion)worth of subsidized loans to approximately 55million families who have an annual income ofless than Rs. 11,000 (US$305). 6 Given that 70million families live below the poverty line inIndia, it is apparent that the IRDP has hadsignificant outreach. In addition to the loans,IRDP borrowers also receive a cash subsidy atthe time of loan disbursal equivalent to 25–50%of the project cost (Nagarajan & Meyer, 2000,p. 170). The program has certainly disbursed ahigh volume of loans, but funds have beenmisused via the subsidy component such thatcash is diverted to local elites rather than theintended borrowers; as a result, the programhas had a repayment rate of only 25–33%(Sinha, 2000, p. 66). Meanwhile, the RRBs andprimary agricultural credit societies have notperformed any better. The RRBs have beensaddled with soft loans to priority sectors, whileprimary cooperatives have served mainly astools of political patronage. 7 Due to the non-commercial orientation of these programs,basically all of the formal sector institutionsinvolved in microfinance have depended onrefinancing and recapitalization by apex insti-tutions on a regular basis (Nagarajan & Meyer,2000, pp. 177–179).State-subsidized microfinance in China has

had a shorter history than in India, mainlybecause China started poverty lending aboutone decade later than India. To be sure, bothcentral and local governments in China havedirected subsidized credit to particular sectorsor industries, but that type of ‘‘policy lending’’has not occurred in the name of microfinanceor poverty alleviation. 8 In 1986, a subsidizedlending scheme for poverty relief was intro-duced, which targeted collective enterprises atthe township and village level rather thanindividual households (Rozelle, Park, Ren, &Bezinger, 1998). While official interest rates onloans ranged between 8% and 10%, the povertyalleviation loans charged only 2.88% annualinterest. As is the case with most subsidizedcredit schemes, the loans were distributed topolitically important enterprises and higher-income households, and the repayment rateswere about 50% (Park, 1999).Providing subsidized loans directly to

households did not start until a few years intoChina’s National 8–7 Poverty Alleviation Plan,introduced in 1993. As part of the strategy toraise 80 million people out of poverty in sevenyears (i.e., during 1994–2000), the central gov-ernment identified 592 poor counties where

households would be directly targeted for sub-sidized poverty loans. In quite a change fromthe previous mode of distributing subsidizedcredit to local enterprises, in 1996 many of thecounties adopted the Grameen Bank model ofgroup lending whereby groups of five borrow-ers would mutually guarantee the repayment oftheir respective microloans in multiple instal-ments (Bornstein, 1997; Holcombe, 1995;Khandker, Khalily, & Khan, 1995). Theseloans ranged from 1,000 to 2,000 RMB(US$120–240) and they continued to be subsi-dized at the official PA lending rate of 2.88%.Once the decision was made to disburse PAloans directly to households in officially desig-nated impoverished counties, they were dis-bursed rapidly, almost quota style:

By August 1998, official microcredit schemes wereoperating in more than 600 counties in 22 provinces,with the largest programs (in Shaanxi and Yunnan)reaching over 500,000 households. . . In 1999, with be-tween 30 and 40 million people still classified as poor,the central government’s budget for the 8–7 Plancalled for expenditures of Y24.8 billion ($3 billion),of which Y15.3 billion ($1.84 billion, or 62%) wasfor loans funds (Conroy, 2000, p. 36).

By 2000, the government had disbursedUS$775 million worth of subsidized microloans(Tsien, 2001), and by 2002 nearly US$3.7billion (or half) of the central governmentspoverty-relief funds were going toward pov-erty-relief loans (Xinhua, March 2, 2002). As inthe earlier model of poverty lending, however,repayment rates in these government programshave been low, i.e., less than 60%. Even thoughthe Agricultural Bank of China (a state com-mercial bank) took over the poverty lendingprogram from the Agricultural DevelopmentBank (a policy bank) in 1998, the People’sBank of China (PBC) has not been involved inmonitoring the microcredit component of theAgricultural Bank of China’s operations, andthe loans are treated more as social grantsrather than as commercial loans. In otherwords, the microcredit component of PAlending has been treated as one-time fixesrather than exhibiting a commitment to sus-tainable models of microfinance (Cheng, 2003).Meanwhile, the PBC has been encouraging

RCCs to extend microloans to rural house-holds. As of 2002, the PBC reported that RCCshad extended a total of 78.9 billion RMB(US$9.54 billion) worth of microloans and that25% of all rural households in the country hadreceived such loans (CIIC, November 5, 2002).


Although RCCs report higher repayment ratesthan the PA programs, as of year-end 2003,their ratio of nonperforming loans was stillquite high at nearly 30% (SIC, January 14,2004).

(ii) NGO and donor-managed microfinanceinstitutionsThe involvement of NGOs in running mi-

crofinance institutions (MFIs) varies signifi-cantly in India versus China. This is due in partto differences in the policy environment forboth NGOs and nonbanking financial institu-tions. While the government of India has pro-moted the growth of self-governing NGOs andencouraged domestic development financeinstitutions to collaborate with them, China’sNGOs are sponsored by a particular govern-ment unit (making them government-organizedNGOs rather than pure NGOs) or establishedby international donors. To date, India’sNGOs have had more extensive reach in mi-crofinance than their counterparts in China,but in both countries, few MFIs are financiallysustainable while the market for MFIs remainsvast.In India, microfinance NGOs have generally

taken one of the following three forms: self-help group (SHG) programs that have linkageswith banks; cooperatives; or Grameen replica-tors (EDA Rural Systems, 1996). Organized byNGOs, SHGs consist of 10–12 people withsimilar socioeconomic and demographic char-acteristics (e.g., low-income women in ruralareas). As of 2002, there were one millionSHGs with 17 million members (Ashe, 2002,cited in Wilson, 2002, p. 221). The purpose ofthe SHGs is to help the members save smallamounts of money on a regular basis, to createan internal insurance fund for members to drawon in times of emergencies, to empower themembers through collective decision-making,and to extend uncollateralized loans to groupmembers (Hannig & Katimbo-Mugwanya,1999, p. 7). Since 1992, the National Bank forAgriculture and Rural Development (NA-BARD) has experimented with creating link-ages between SHGs and banks, such that bankslend through NGOs or directly to SHGs. As ofMarch 2003, over 444 banks were participatingin microfinance linkages with 717,360 SHGs; intotal, the SHG–bank linkage program hadserved an estimated 7.8 million low-incomehouseholds (NABARD, 2002, 2003). 9 Ulti-mately, NABARD hopes to reach one-third ofIndia’s rural population through the establish-

ment of one million bank-linked SHGs by2008. (Bansal, 2003, p. 24).Aside from participating in the SHG–bank

linkage model, over 500 NGOs serve as finan-cial intermediaries themselves by brokeringfunds between banks and low-income borrow-ers. There are also a handful of cooperativessuch as SEWA Bank, the Indian CooperativeNetwork for Women, Tamil Nadu, and coop-erative credit societies associated with theCooperative Development Foundation that areinvolved in microfinance. Finally, about 10organizations may be considered Grameen re-plicators. The largest ones are SHARE, Activ-ists for Social Alternatives Trust, and RuralDevelopment Organization, Manipur (Sinha,2000, p. 70).Overall, MFIs in India have not been subject

to stringent regulations, especially those thatare not registered as cooperatives or nonbank-ing finance companies. Given the developmen-tal contribution of MFIs, the RBI has notenforced Section 45S of the RBI Act, whichprohibits savings mobilization from the publicwithout RBI permission. Furthermore, finan-cial liberalization since the 1990–91 economiccrisis has loosened interest rate controls onmicrocredit, which offers MFIs in India thespace to structure their loans in a financiallyself-sustainable manner. Whether this occurs,however, depends in large part on changingpopular perceptions that low-income borrowerscannot afford commercially viable interestrates.In contrast to the relative ease with which

NGOs may register themselves and act as MFIsin India, China’s policy environment is muchmore restrictive. All NGOs in China must havean official government unit sponsor theirapplication to register as ‘‘social organizations’’with the Civil Affairs Bureau (Saich, 2000). Assuch, China does not have purely nongovern-mental organizations engaged in microfinanceeven though they may be functionally equiva-lent to NGOs. The introduction of the Gram-een model of microfinance provides a goodexample of the close relationship betweengovernment entities and NGOs in China.The replication of the Grameen model in

China first came about through the individualinitiative of researchers at the Rural Develop-ment Institute of the Chinese Academy ofSocial Sciences (CASS) and internationaldonors; but to date, the most successfulGrameen replications are managed from anoffice housed at CASS. With funding from


Grameen Trust, the Ford Foundation, and theCanada Fund, in 1994 a small group of CASSresearchers led by Professor Du Xiaoshanestablished the Funding the Poor Cooperative(FPC) in Yixian, Hebei (Tsai, 2002a, pp. 200–202). To implement the project they collabo-rated with the Yixian county-level PovertyAssistance Bureau and the Civil Affairs Office.As of March 2003, there were three FPCs inYixian, Yucheng (Henan), and Nanzhao (He-nan) counties, respectively, and together, thethree FPCs had served a total of 15,244 bor-rowers (Du, 2003). With repayment ratesranging from 95% to 99%, the FPCs are con-sidered the best examples of Grameen-stylemicrofinance in China. A central part of theirsuccess has been structuring the loans in amanner that covers their operational costs, i.e.,at 16% effective interest per annum. 10 Scalingup to extend their reach and experimentingwith nonGrameen lending methodologies istheir next challenge. 11

Besides the FPC Grameen replications,international donors have initiated over 200microfinance programs throughout central andwestern China (Cheng, 2003, p. 123). Thedonors have all implemented their projects withdifferent local governmental partners. Forexample, the AusAid project in Haidong,Qinghai that started in 1996 collaborates withthe Agricultural Bank of China and the Qing-hai Commission of Foreign Trade and Eco-nomic Cooperation; the Heifer ProjectInternational has been collaborating with theSichuan Animal Husbandry Bureau since 1985;and since 1995, the International Crane Foun-dation has implemented a Trickle-Up Programin Guizhou with the cooperation of the Guiz-hou provincial Environmental ProtectionBureau. 12 With few exceptions, the donor-ini-tiated programs have been structured as pro-jects with a limited lifespan rather than as MFIsaiming for sustainability (Cheng, 2003; IFAD,2001, pp. 20–21; Park & Ren, 2001). Althoughthis may be attributed in part to the officialinterest rate ceilings on poverty loans, the FPCshave shown that it is possible to build in ahigher, sustainable rate of interest in theGrameen model; and that rural borrowers arewilling and able to pay those rates. Indeed, astudy of NGO MFI clients found that thehighest monthly interest rate that they would bewilling to pay is 32.6%. 13 This is consistentwith the popularity of informal financingmechanisms (discussed below) that charge evenhigher interest rates.

3. THE INFORMAL AND SEMI-FORMALFINANCIAL SECTOR

As suggested already, despite the substantialexpansion of rural financial institutions in bothcountries over the last several decades, informalfinance still represents a major source of creditfor farmers and petty traders. In China, a studyby IFAD estimates that farmers obtain fourtimes more credit from the curb market thanfrom formal financial institutions (IFAD, 2001,p. C11), and another study of small businessowners found that the curb accounted for up tothree-quarters of private sector financing dur-ing the first two decades of reform (Tsai, 2002a,pp. 36–37). In India, the 1992 AIDIS surveyrevealed that nearly 40% of rural householdscontinue to rely on informal finance––or moretechnically, ‘‘noninstitutional credit agencies,’’which include agricultural moneylenders, pro-fessional moneylenders, traders, relatives andfriends, and others. 14 Table 1 outlines theprimary forms of informal and semi-formalfinance in both countries and notes the extentto which they are sanctioned or prohibited. Inboth countries, private transactions involvinghigh interest rates are in violation of bankingregulations, as are organizations that mobilizesavings without registering with the appropri-ate authorities. 15 Beyond those two restric-tions, however, the legal marginalization ofcurb market activity has not been consistentlydefined or enforced. In practice, curb marketactors in both China and India have proven tobe adaptable despite multiple rounds of disci-plinary action by financial regulators.

(a) Grey areas in China’s curb market financing

In China, the extremes of legal versus illegalforms of financing are distinguished by whetheror not they are sanctioned by the PBC, whichhinges on whether they mobilize savings fromthe general public and offer/charge interestrates above the repressed interest rate ceilings.Interpersonal lending and trade credit, forexample, are among the most basic strategiesthat entrepreneurs use to deal with short-termliquidity requirements. Small business ownersfrequently borrow money from friends, rela-tives, and neighboring shopkeepers. Wholesal-ers may deliver goods to retailers on 10-day oreven 30-day credit if they have an establishedrelationship. Such practices are not illegal tothe extent that they do not entail interest abovethe rates of state banks, 16 in contrast to those

Table 1. Legal condition of informal finance in China and India

Type China India

Interpersonal lending––

loans extended among

friends, relatives, neigh-

bors, or colleagues

minjian jiedai––financial authorities do not

interfere with casual, interest-free lending

Interpersonal lending––financial

authorities do not interfere with

casual, interest-free lending

Trade credit––merchandise

credit between wholesalers

and retailers

hangye xinyong––neither sanctioned nor

prohibited

Trade credit, forward sales

Moneylenders, loan

sharks––loans from profes-

sional and nonprofessional

money brokers, typically at

high interest rates

gaolidai––all high interest lending is illegal Mahajan and Chettiar bankers––

Some are registered as finance com-

panies, trusts, banks, and partner-

ship firms

Rotating savings and credit

organizations (ROSCAs)––

indigenously organized

savings and credit groups

huzhuhui, hehui, biaohui, chenghui, juhui––

permitted in localities where they have not

collapsed

Chit funds––registered as companies,

partnerships, and sole proprietor-

ships

Pawnshops––extend collat-

eralized loans with interest

diandang, dangpu––permitted when oper-

ated according to regulations

Pawnshops––legal if licensed

Indigenous banks, money

houses, finance companies––

mobilize savings and extend

collateralized loans

siren qianzhuang, private money houses––

regarded as private banks, which are illegal;

most operate underground now

Deal with short-term credit (hundis)

combined with trade for financing

trade––committees have made efforts

to formalize them

Rural cooperative founda-

tions

nongcun hezuo jijinhui––approved by MOA

until closure by PBC in 1999

n.a.

Social organizations, mutual

benefit funds––registered

entities that are supposed

to serve lower-income

populations

huzhuhui, hezuo chu jijinhui (mutual

assistance societies, cooperative savings

foundations)––registered with MCA, but

not supposed to engage in for-profit

financial intermediation

Nidhi companies, mutual benefit

societies, permanent funds (mainly in

Tamil Nadu)––committees have rec-

ommended that they be regulated

more stringently


charged by loan sharks or private moneyhouses. The latter are clearly illegal by PBCstandards because they reflect the higher mar-ket cost of capital in a financially repressedenvironment. Indeed, with the sole exception ofMinsheng Bank, 17 private commercial banksare prohibited in China and the PBC haslaunched multiple ‘‘financial rectification cam-paigns’’ to shut down private money houses.Nonetheless, they have continued to operateunderground, not only in the coastal southwhere private commerce is better developed,but also in northern central provinces such asHenan (Tsai, 2002a, Chap. 5).Pawnshops straddle a finer line between

being legal and not quite legal and provide agood example of Beijing’s regulatory ambiva-lence in dealing with unconventional financingmechanisms. Their re-emergence during thereform era has been uneven and ambiguouslyregulated due to their usurious connotation. 18

By 1956 private pawnshops were effectively

eliminated, but after the first one opened upduring the reform era in Chengdu in 1987, theydeveloped rapidly and by 1993, there were3,013 documented pawnshops throughout thecountry. Most were operated by various bran-ches of government agencies, including statebanks, policy departments, tax bureaus, cus-toms bureaus, and finance and insurance com-panies (Li, 2000), though some simplyregistered as ordinary private businesses withthe Industrial and Commercial ManagementBureau (ICMB). The official interpretation ofthe ‘‘new’’ pawnshops was that they differedfundamentally from the traditional exploitativeones. As explained in a Ministry of Financereport,

It should be noted that today’s pawnshops in thecountry are not entirely what they used to be. Pawn-shops in old China took in personal effects at verylow prices when the owners were poverty-stricken.However, such businesses today represent a medium


for normal commodity circulation. . .The new-bornpawn brokering aims to serve the people and socialproduction (Zhongguo yinhang, 1993, pp. 240–243).

Despite this more favorable, revisionistevaluation of pawnshops, it became increas-ingly apparent that many were (illegally)mobilizing savings deposits from the public andoffering high rates of interest. 19 As a result, in1994 the PBC was granted administrativeauthority over pawnshops and two years later,a PBC-lead crackdown on illicit financialinstitutions closed over half of the registeredpawnshops, leaving only 1,304 shops with PBC

licenses. 20 In a further attempt to circumscribethe financial malfeasance of pawnshops, theywere reclassified in 2000 from being ‘‘financialinstitutions’’ under the PBC’s authority, to ‘‘aspecial kind of industrial and commercialenterprise’’ regulated by the State Economicand Trade Commission (JJRB, 2000). In short,over the course of the reform era, pawnshopshave been legally registered in some cases,registered with the incorrect local agency inothers, and engaged in practices that are clearlyillegal.While pawnshops are now technically sub-

ject to central-level regulations, rotating sav-ings and credit associations (hui) remainunregulated in most localities. When huiinvolve relatively small groups of people (5–10members on average) who pool set monthlycontributions and rotate the disbursal of thecollective pot of money to each member, localgovernments usually consider them a produc-tive form of mutual assistance among ordin-ary people, typically women. But if a memberruns off with the collective pot early in the lifeof an association, the members who have nothad their turn in collecting money are cheatedout of their contributions. In the coastalsouth, a handful of high-profile cases haveaccumulated where various types of hui wereexposed as fraudulent schemes organized bycon artists (Tsai, 2000). The large-scale caseswere not traditional ROSCAs, however, butrather, ponzi schemes that are never sustain-able because they generate extremely highreturns by exponentially expanding the net-work of investors. Hui collapses make head-lines, but they are actually relatively rare. Assuch, it is only in a small handful of localitiesthat hui have been banned by local govern-ments.The ambiguous and shifting legal status of

other curb market practices listed in Table 1

share the attribute of being legal according tocertain governmental agencies, but not sanc-tioned by the PBC. The establishment ofrural cooperative foundations (RCFs) by theMinistry of Agriculture in the mid-1980sexemplifies this phenomenon (Cheng, Findlay,& Watson, 1998; Du, 1998). As noted earlier,the PBC never recognized them as legitimate‘‘financial institutions’’ because another min-isterial bureaucracy created them. Nonethe-less, by the early 1990s RCFs had beenestablished in approximately one-third of alltownships, and by 1998 there were over18,000 RCFs with over five million depositors(Holz, 2001). Since RCFs were not permittedto mobilize deposits or extend loans likeformal financial institutions, they usedeuphemistic terms for comparable transac-tions; instead of paying interest on deposits,for example, they sold ‘‘shares’’ (rugu) andextended ‘‘capital use fees’’ (zijin zhan fei-yong). Like pawnshops and other forms ofinformal finance, RCFs had a variety ofgovernance structures and were more centralto rural finance in some provinces than oth-ers (Park, Brandt, & Giles, 2003). Theirquasi-legal status proved to be short-lived,however. As part of broader national effortsto rectify the financial system, in March1999, the State Council announced the clo-sure of poorly performing RCFs, and thetakeover of better performing RCFs by RuralCredit Cooperatives. These actions triggeredfarmers’ protests in at least six provinces,including Sichuan, Hubei, Hunan, Henan,Guangxi, and Chongqing (AP, March 22,1999; AFP, March 23, 1999). Apart fromRCFs, some de facto nongovernmentalfinancial institutions have managed to operateabove ground and serve private businesses byregistering as social organizations, which areadministered by the Ministry of Civil Affairs.These go by a variety of names, includingmutual assistance societies and cooperativesavings foundations. The credit societies aresupposed to be nonprofit organizations thatserve impoverished populations. In practice,however, they operate like RCFs or privatemoney houses in the sense that they mobilizesavings, extend credit to private entrepreneurswho may be well off, and use interest ratesthat are higher than that set by the PBC.These types of social organizations should bedistinguished from those that are genuinelyoriented toward poverty alleviation via mi-crofinance.


(b) Attempts at mainstreaming India’sinformal sector

Relative to China, India has a longer historyof state-directed credit for poverty alleviation,yet its formal financial sector is more liberalizedand its informal financial sector, better docu-mented and more likely to take corporate formsthan those of China. These apparent inconsis-tencies may be attributed to the fact thatIndia’s financial policy environment has alsofluctuated considerably over the years. Post-independence governments in India have beenconcerned about the negative effects of infor-mal finance on rural welfare and made repeatedefforts to regulate and create institutionalalternatives to the curb. Indeed, what mostobservers would regard as informal financialintermediaries are registered under the Com-panies Act, 1956 or regulated by the RBI. For

Table 2. Breakdown of informal

Type of noninstitutional sources 1951

Landlords 3.5%

Agricultural moneylenders 25.2

Professional moneylenders 46.4

Traders and commission agents 5.1

Relatives and friends 11.5

Others 1.1

Unspecified n.a.

Informal credit as share of total

household debt

92.8%

Source: Reserve Bank of India, All-India Debt and Investma 1991 figures do not add up to 39.6% even though Tableinstitutional agencies account for 39.6% of total rural hous

0%

10%

20%

30%

40%

50%

60%

1951 1961 1971 1

Figure 1. Distribution of informal fin

example, moneylenders acts at the state levelregulate nonborrowing lenders, while borrow-ing lenders (or intermediaries) are also subjectto various types of regulation. 21 Furthermore,the RBI has tracked informal financial activi-ties in official statistics as a means to measureprogress in expanding credit access into ruralareas. (Table 2 lists the official categories ofinformal finance as defined by RBI and Figure1 shows their relative share of the curb marketover time.) The extent of curb market regula-tion and tracking in India stands in contrast tothe situation in China where many types ofinformal financing activities are simply banned.After taking into account sampling and

nonsampling errors in the decennial surveys,the main trend is that informal credit has cer-tainly declined as a percentage of total debt,and both professional and agricultural money-lenders have reduced their share of the curb

finance in rural India over time

1961 1971 1981 1991

1.1% 8.6% 4.0% n.a.

47.0 23.1 8.6 6.3

13.8 13.8 8.3 9.4

7.5 8.7 3.4 7.1

5.8 13.8 9.0 6.7

7.5 2.8 5.5 4.9

n.a. n.a. n.a. 3.8

82.7% 70.8% 38.8% 39.6%a

ent Survey, various years.

5 of the 1991–92 AIDIS report clearly states that non-ehold debt.

981 1991

Landlords

Agriculturalmoneylenders

Professionalmoneylenders

Traders andcommissionagents

Relatives andfriends

Others

ancing mechanisms, India 1951–91.


market over time. The decline of the money-lender in official statistics reflects in part stateefforts to register and regulate professionalmoneylenders during the 1950s. Some wentunderground to avoid regulation and otherswere probably re-classified as agriculturalmoneylenders or traders (Bell, 1990). Inthis regard, note that the first three officialcategories of informal lenders––landlords,agricultural moneylenders, and professionalmoneylenders––are not necessarily distinctfrom one another depending on the locality.But generally speaking, landlord lenders extendcredit to tenants; agricultural moneylendersprimarily deal with agricultural laborers andsmall farmers; and professional moneylendersservice a wider range of customers and mayregister themselves as companies, partnerships,and trusts (Ghate et al., 1992, p. 45).Those in the fourth official category of

‘‘traders and commission agents’’ are alsoknown as indigenous bankers. In contrast toprofessional moneylenders who lend their ownmoney, indigenous bankers broker fundsbetween banks and their clients, who tend to betraders rather than farmers (Schrader, 1994).The Shroffs of Western India, for example,provide a short-term credit instrument calleddarshani hundi to traders who need to travelgreat distances to purchase inventory andtransfer funds (Ghate et al., 1992, pp. 198–200).In addition to serving as financial intermedi-aries, indigenous bankers are also business-people themselves. 22 Besides trading, they mayoperate commission agencies or hire-purchasefinance (HPF) companies, which are basicallyleasing companies that finance automobiles andother goods over a fixed term for clients wholack sufficient cash to purchase capital goodsup front (Nayar, 1992, pp. 199–200). Eventhough formal sector HPFs exist, one studyfound that informal HPFs finance a muchhigher volume of vehicles than official autofinance corporations––probably because lower-income populations find the informal HPFsmore accessible (Das-Gupta & Nayar Associ-ates, 1989).Forms of informal finance in the other cate-

gory also include indigenous bankers who arenot registered as traders or commission agents;unregistered finance corporations; nonprofes-sional moneylenders (other than those identi-fied as friends and relatives); various types ofleasing, investment, and housing finance com-panies; ROSCAs (chit funds) and Nihdi socie-ties. Unlike the ROSCAs in China, which are

completely informal, a number of chit funds inIndia are registered as companies, partnerships,and sole proprietorships under the All-IndiaChit Funds Act 1982 or the state acts (Ruth-erford & Arora, 1997). The state’s rationale forregulating them is to increase the security of themembers’ contributions and to reduce theincidence of defaults. As such, organizers arerequired to have licenses and make securitydeposits with the Register of Chit Funds; thecost of collecting the pot (i.e., the de factointerest rate) is capped at 30% of the size of thepot; and chit funds are limited to a maximumof 60 months (Ghate et al., 1992, p. 197). Theseregulations have not had their intended effect,however. Rather than increasing the stability ofchit funds in general, many organizers havegone underground and taken their members(who seek higher returns) with them.In addition to chit funds, Nidhi companies or

mutual benefit societies are also an importantpart of the nonbanking world of financialintermediation, especially in south India.Incorporated under the Companies Act 1956,Nidhis mobilize savings from their membersand extend loans that are collateralized withjewelry and real estate (Nayar, 1992, pp. 197–199). When nonmembers wish to make adeposit or borrow from a Nidhi, they take ashare of the Nihdi. Over the years, the state hasmade repeated efforts to regulate these mutualbenefit societies; and an Expert Group onNihdis constituted by the Department ofCompany Affairs has recommended a host ofadditional regulations to professionalize theiroperations (PIB, 2002).

4. THE PERSISTENCE OF INFORMALFINANCE

State authorities in both China and Indiahave clearly recognized the importance of for-mal financial institutions in rural areas,including the expansion of microfinance pro-grams for poverty alleviation purposes. Finan-cial regulators have also made repeated effortsto eliminate and/or regulate of curb marketactivity. Why, then, has informal finance per-sisted and even expanded in both countries?Four complementary explanations may bederived from the perspective of supply-leadingeconomics, state–society relations, the localpolitical economy of markets, and the institu-tional characteristics of lending programs. Aswill be shown, the first two hypotheses capture


macrolevel dynamics, while the second twohave explanatory leverage at lower levels ofanalysis. Specifically, the economic hypothesisconcerns the gap between the overall supplyand demand for formal credit, and the state–society hypothesis concerns limits in statecapacity to reach the intended recipients ofsubsidized loans and microcredit. Both thelocal political economy and institutional designperspectives then explain why certain groups ofpeople do or do not receive credit at the groundlevel. The rationale for each explanation isdiscussed in more detail below.

(a) Neoclassical economics: a matter of supplyand demand

Based on the logic of supply and demand inneo-classical economics, one reason that infor-mal finance continues to play such an impor-tant role in rural China and India may simplybe because the amount of credit demanded byrural households exceeds that supplied by theformal financial sector in rural areas. There-fore, to reduce the rural population’s relianceon the curb, official sources of credit should beincreased. This is known as the supply-leadingapproach to finance and development (cf.Chandavarkar, 1992; Patrick, 1966). Table 2shows that according to official statistics, therelative dominance of the curb market in ruralIndia has declined over time with the expansionof formal credit institutions. Bell (1990) drawson two independent World Bank surveys todemonstrate, however, that the decennial RBIsurveys underestimate the true scale of informalfinance. This leads him to conclude:

[A]lthough the moneylender did lose ground relativeto [formal financial] institutions over the period from1951 to 1981, he remained a very important source offinance to rural households, and the expansion ofaggregate debt was almost surely so great as to implythat his volume of business grew.

In other words, despite significant increasesin the supply of bank loans and microcredit(over US$15 billion), rural households continueto draw on informal sources of credit. A morerecent study of credit rationing in rural Indiaconfirms that this is due to the combination oflimited access to formal credit and continuinghigh demand for such credit (Swain, 2002).In rural China, the closure of RCFs elimi-

nated an important source of semi-formalfinancial intermediation, but we can still heu-

ristically test the supply-leading hypothesis byconsidering the impact of the government’slarge-scale poverty lending programs. Specifi-cally, if people were turning to informal financeonly because more institutionalized sourceswere unavailable to them, then ceteris paribuswe would expect clients of microfinance pro-grams to rely on subsidized poverty loansrather than high-interest loans from thecurb. 23 Yet this turns out not to be the case. Intheir surveys of MFI clients, Park and Ren(2001) discovered,

[O]ver 50% of households in program areas had out-standing loans from other sources, and that this per-centage was similar for both members andnonmembers. The most common source by amountwas Rural Credit Cooperatives (55% for members,46% for nonmembers), followed by informal sources.Thus it does not appear that microfinance participantslack access to other credit sources, whether formal orinformal (p. 46).

Their study also found that the overall level ofindebtedness is higher among microfinance cli-ents, and that only one-quarter of them wouldhave engaged in income-generating activities ofthe same scale in the absence of these loans.This suggests that although government-spon-sored microloans are not going only to ruralhouseholds that lack access to formal credit,‘‘microfinance lending relieves credit con-straints at the margin’’ (Park & Ren, 2001, p.46).Applying the supply-leading hypothesis to

India and China explains in part the on-goingpopularity of informal finance among ruralhouseholds, but it also raises a number ofquestions. Why is business getting better forIndia’s moneylenders amid the expansion informal sector institutions and MFIs? If MFIclients already have access to RCC loans, thenwhy are they receiving MFI loans in the firstplace? Examining the issue from the perspectiveof state–society relations helps to explain thisdisjuncture between the intended and actualrecipients of targeted and microcredit.

(b) State–society relations: a matter of statecapacity

A second reason why increasing the officialsupply of credit has not translated into amatching decline in informal financial activityis because official state policies are not beingimplemented properly. This may occur in threemain ways: First, state actors may not be


distributing targeted credit properly due toinsufficient knowledge of how to identify theintended clients of subsidized credit and MFIprograms. Second, state actors may intention-ally divert credit from the intended recipients.Third, nonstate actors may interfere with theproper disbursement of formal and MFI credit.Taken together, all three types of implementa-tion failure could be interpreted as reflectingweaknesses in state capacity (Evans, Reusche-meyer, & Skocpol, 1985).The first type of implementation failure is

rooted in the conditions under which formalcredit is disbursed. In both India and China,conventional commercial banks do not haveinstitutional experience in lending to rural cli-ents who lack an established credit history andcollateral or guarantor. Therefore, the typicalstate response has been to require thatnational banks allocate a certain portion oftheir lending portfolios to lower-income ruralhouseholds. Quota-style lending often does notachieve its substantive objectives, however,because the emphasis is placed on ensuringthat a certain number of loans is disbursed,rather than on the identity and needs of theborrower.When quota-style lending is accompanied by

subsidized interest rates––which has been thecase in both India and China’s PA loans––theprospects of reaching the intended clientele arefurther diminished. Instead of reaching lower-income households, subsidized loans usuallyend up in the hands of local elites who do notfeel obligated to repay the loans (Adams et al.,1984). This common phenomenon relates to thesecond implementation failure, whereby stateagents knowingly distribute credit to sectors ofthe population that are not necessarily excludedfrom the formal financial system. In India anumber of government interventions in ruralfinance have been motivated by short-termpolitical objectives that coincide with the elec-toral cycle. While China’s political contextdiffers significantly from India’s, targeted creditand PA loans are similarly subject to politicalpatronage at the local level. Compared withparticipants in the FPCs and mixed NGO-government programs, borrowers in the mi-crocredit projects run by local governmentstend to be much wealthier and engaged innoncropping activities (Park & Ren, 2001). Thenext section shows that the underlying reasonfor this second type of implementation failure isdue to local market segmentation along politi-cal and social lines.

Aside from the top-down weaknesses in statecapacity discussed above, nonstate actors mayalso be responsible for distortions in policyimplementation (Migdal, Kohli, & Shue, 1994).In this case, nonstate actors would includeprivate economic actors such as financialentrepreneurs and politically important con-stituents of society. First, the argument couldbe made that the curb market thrives becauseinformal financiers are determined to evadebanking regulations. In other words, no matterhow much formal credit is available in ruralareas and no matter how stringent the penaltiesare for violating state laws, a certain strata offinancial entrepreneurs will always endeavor tosubvert state policies. After all, informalfinance persists even in advanced industrializedcountries with sophisticated financial systems.The second main expression of noncomplianceby societal actors may come from borrowersthemselves. One could argue that lower-incomefarmers and rural traders boycott formal andsemi-formal financial institutions to underminetheir legitimacy (Selden & Perry, 2000). Thusfar, however, there is no evidence for this inIndia and China. Instead, it is more typicallythe privileged slice of the population that hasinterfered with the implementation of PAlending policies. In India, local politicians mayextend subsidized credit to the upper tier ofsociety, but after elections, loan recovery hasalso proven to be difficult because ‘‘the creditagencies’ bureaucracy is reluctant to touch theinfluential rural elite who wield much formaland informal influence and considerable power’’(Yaron, Benjamin, & Piprek, 1997, p. 102).The low repayment rates in China’s subsidizedPA programs suggest that similar dynamics arein operation. 24

Analyzing the persistence of informal financethrough the state–society lens takes us one stepcloser to explaining why state financial policieshave had unintended outcomes, i.e., why state-subsidized credit and microfinance have notgone to their intended recipients. But concep-tualizing the curb market as an inverse functionof state weakness and societal strength sufferssimilar problems as the supply-leadinghypothesis. Just as increasing the supply ofgovernment-sanctioned credit does not auto-matically crowd out informal credit, strength-ening state capacities in rural financialintermediation does not necessarily come at theexpense of nonstate actors such as money-lenders and wealthier households if local agentsand institutions face competing political


incentives. In both China and India, intrastateactors (such as local officials and bureaucratscharged with loan disbursal) are just as likely asnonstate actors to distort policy implementa-tion.

(c) Segmented markets: a matter of institutionaldesign and local political economy

Ultimately, rural credit markets are morefinely differentiated than a dichotomous trade-off between state and society. Rather thanassuming the perfect fungibility of credit(whether it be formal, semi-formal, or infor-mal), this explanation starts from the premisethat credit markets are segmented even at thegrassroots level. This means that no single typeof credit can meet the needs of various potentialborrowers, and no single type of credit isaccessible to everyone (Hoff & Stiglitz, 1990).The concept of segmented markets typicallyrefers to the variation in preferences amongconsumers in different economic strata, e.g., interms of loans for consumption versus pro-ductive purposes, and the conditions of creditaccess such as collateral, third party guaran-tees, and savings requirements. In other words,various forms of credit are not functionallyequivalent to the borrower. Both the institu-tional design and lending methodology of differ-ent forms of credit influence the relativeattractiveness of, for example, government-subsidized loans versus unsubsidized microfi-nance loans from NGOs versus high-interestloans from the curb. All of them have differentrestrictions in terms of loan size, amount,repayment terms, preferred clientele, etc.Hence, a borrower might take out a high-interest loan from a moneylender rather than alow-interest one from a government programbecause the former entails lower transactioncosts or because the latter requires that the loanbe used for productive purposes.In addition to supply-side differences in the

institutional types of rural credit, market seg-mentation also occurs along political and sociallines, which further distorts the way local creditmarkets function in practice. Far from being apure market where prices (interest rates) reflectthe relative supply and demand of differenttypes of financing, formal and semi-formalsector credit for PA purposes often faces state-mandated interest rate ceilings and is subsi-dized. That is to say, even during periods ofcredit scarcity, the cost of directed bank creditmay be extremely low. By definition directed

credit cannot go to the highest economic bid-der; instead, it is disbursed by credit officers.Moreover, as with any government-allocatedgood or resource, the distribution of subsidizedcredit and PA loans is political. Therefore,when PA loans do not reach the target popu-lation, more often than not, examining localpolitical and social hierarchies may revealwhere the soft loans were distributed.Similarly, the cost of accessing informal

credit also varies depending on the structure oflocal political and social networks. Interest-freelending only occurs among tight knit groups ofpeople, typically close friends or relatives.Members of ROSCAs usually know oneanother, or at a minimum, know the organizeror one other member. The higher rates ofinterest charged by professional moneylendersreflect in part the higher level of risk associatedwith lending to clients with unconventionalforms of collateral (if any). Even then, however,accessing most forms of informal financerequires some form of introduction. Local curbmarkets are also segmented, though not alwaysin expected ways. The following two cases fromIndia and China illustrate more concretely howlocal social, political, and economic dynamicsmediate the use of both formal and informalfinance. 25

(i) Tribal, caste, and occupational segmentationin a North Indian villageIn a diachronic study of a South Rajasthan

village that Jones (1994, Chap. 18) calls Chan-drapur, we can compare the nature of the localcredit market before and after a village bankwas introduced. As of 1989, Chandrapur Vil-lage had a population of over 1,000 people in200 households, within which were four mainsocial groups engaged in different economicactivities: Hindu households engaged in caste-based nonagricultural activities, Jain house-holds prevailed in commercial and financialservices, Jogis relied on income from workingas migrants in Gujarat and Bombay, and theBhil population lived in the hinterland. Beforea village bank was introduced at the end of1983, Chandrapur residents relied solely oninformal sources of credit. The records of a Jainshopkeeper (called B. Jain) who providedpawnbrokering services revealed that even sixyears after the village bank was established, B.Jain’s lending volume had increased by over100% in nominal terms––from Rs. 53,351(US$5,455) in 1982–83 to Rs. 110,818(US$6,756) in 1988–89––and the annual


number of loans had increased from 290 to 335,but the interest rate had remained at 3% permonth throughout the same period. 26 Mean-while, the total number of pawnshops in thevillage increased from 15 in 1983 to 24 in 1989.Most remarkably, however, Jones found thatthe volume of loans extended by pawnbrokersvastly outstripped that of the village bank:

For Chandrapur, as a whole, a tentative estimate ofpawnbroking loan volume is made by multiplyingRs. 110,818 (B. Jain’s loan volume) by the proportionsof loan volume indicated by this shopkeeper for theother 23 lenders in the village. Adding the figure tohis own loan volume produces a total of Rs.2,292,850 for all 24 pawnbrokers in the village: fivetimes the loan volume advanced by the bank during1988–89.

A similar extrapolation from the 335 loans advancedby B. Jain, results in a total of 6,799 loans for all 24pawnbroking businesses: 75 times the number of loansadvanced by the bank in 1988–89, six years after it wasestablished (Jones, 1994, pp. 18–24).

In addition to the expansion in pawnbro-kering, mutual finance groups emerged duringthe same phase. By 1991, 50 out of the 200households in the village were participating inthese savings and credit groups, and by 1992,the loan volume of mutual finance groups wascomparable to that of pawnshops and exceededthat of the village bank (Jones, 1994, pp. 18–8,18–9). Why did a substantial expansion in curbmarket activities follow the introduction of thevillage bank?Each of the explanations outlined above

offers insight into the question. First, from aneconomic perspective, one could infer that theoverall demand for credit in Chandrapur sim-ply increased dramatically over those yearssuch that a single village bank could never havefulfiled the demand. Indeed, during 1988–89 thevillage bank accounted for only 90 out of thetotal of 425 loans extended in the village (Jones,1994, pp. 18–23). 27

Second, irrespective of credit supply, the vil-lage bank itself was poorly managed and failedto carry out its intended mandate. Specifically,the Chandrapur village bank was supposed toservice a total of 17 different villages, yetChandrapur village residents alone receivedover half (54%) of its loans. Furthermore, eventhough the Bhil are Scheduled Tribe membersand represent a specific target group of thebank, over half (52%) of these bank loans wereextended to Jain borrowers who are relativelywell off. It is also worth noting that in 1989,

52% of the bank’s loan portfolio was in arrears,and 30% was past due for over three years, i.e.,in default. By way of contrast, during the sameperiod 70% of the loans extended by B. Jain’spawnshop were repaid in full.Third, the local credit market was highly

segmented on both the supply and demandsides. On the supply side, the lending method-ology varied considerably among differentsources of credit. The village bank did not offerthe types of services demanded by certaingroups in the community. In contrast, thepopularity of pawnbrokering and mutualfinance groups may be attributed to their flex-ibility relative to restrictions associated withloans from the village bank. Villagers turned tothe pawnshops to meet seasonal needs such asproductive household consumption (e.g.,housing construction, education, migration),agricultural cultivation, and ceremonial expen-ditures. At the other end of the income spec-trum, members of mutual finance groups usedthem to engage in money lending rather thanconsumption or productive investment pur-poses.At the same time, Chandrapur’s local credit

market was also highly segmented along tribaland occupational lines. For example, the Jogiswho are on the Scheduled Caste lists weresupposed to receive targeted credit from thevillage bank, but due to their life cycle andconsumption needs (e.g., weddings and funer-als), they ended up relying on pawnbrokeringloans from Jain shops. Meanwhile, only 23% ofthe number of pawnbrokering loans extendedby B. Jain went to local villagers, while 75% ofthe loans went to Bhil customers who focusedon agricultural cultivation in tribal settlements.By 1989, Jain households themselves did notuse the services of pawnshops because ‘‘to takesuch a loan would involve loss of prestige withfellow Jains (Jones, 1994, pp. 18–27).’’ Instead,Jains not only enjoyed privileged access toloans from the village bank, but also dominatedthe ownership of pawnbrokering businessesand accounted for one-third of the participantsin mutual finance groups, which were gearedtoward enhancing the volume of their informallending activities.In addition to intertribal and caste differen-

tiation, informal credit markets are also seg-mented along occupational and gender lines.This is reflected in the participation of savingsand credit groups: of the 126 people partici-pating in mutual finance, 125 are men; and thegroups are organized by professional occupa-


tion such that the Jains form the GovernmentEmployees’ group, the Blacksmith Caste formthe School Staff group, and relatively few (8%)Bhil cultivators participate in mutual finance.These multiple dimensions of segmentationhelp to explain why the scale of informalfinance actually increased after the introductionof the village bank: not only did the villagebank deviate from its mission, but ironically,the fact that most of the bank’s loans went tolocal curb market financiers (Jains) enabledthem to expand the provision of informalfinancial services to other groups in the village.

(ii) Segmentation within a single surname villagein South ChinaWhile it may seem intuitive that a multitribal

village would have a segmented economicstructure and therefore credit markets, the caseof a single-surname village in the southerncoastal province of Zhejiang shows that stronginternal forms of differentiation are notuncommon even in a village where everyonecould be considered a relative of some sort. LinVillage is comparable in size to ChandrapurVillage, but unlike the latter it appearshomogenous: 95% of the households share thesurname Lin and the village temple, whichtraces the Lin lineage back to the late Qingdynasty. 28 Despite this shared ancestry, accessto various forms of credit is segmented alongpolitical, sectoral, and gender lines in Lin Vil-lage.The political fault lines in the village are

based on the three branches of Lins that orig-inally settled in the village. The first branch wasvery active during the Communist Revolutionand ended up with the most Communist Partymembers. The third branch was the mostprosperous one before the Revolution and wasthus subjected to considerable political perse-cution throughout the Mao era. For example,during the Great Leap Forward, adult mem-bers of the wealthiest household were sent to re-education through labor (prison) camps andtheir spacious traditional courtyard home wasturned into the communal mess hall. 29 Theprivileged position of the first branch has car-ried over into the reform era. Even thoughmajor decisions are supposed to be made by thedemocratically elected Village Committee,households from the first branch dominatevillage governance and the allocation of keyresources, including access to land and credit.As such, members in the third branch have adifficult time contracting land for their busi-

nesses and accessing official sources of credit.Although members of the second branch areneither politically privileged nor persecuted,they also have disadvantaged access to variousproduction inputs relative to the first branch.It is important to point out, however, that

the political hierarchies in Lin Village have nottranslated neatly into economic stratification.During the Mao era, the third branch certainlysuffered more than most, but in the reform era,the second and third branches have found waysto operate private businesses without goingthrough official channels. Given the paucity ofarable land, 30 virtually every household in LinVillage operates a small factory. Interestingly, amember of the third Lin branch owns thelargest of these factories with over 30 employ-ees––yet he has never borrowed from formalsources of credit. Owner Lin explained,

It’s not worth it to me to apply for a loan from a statebank or rural credit cooperative because the creditofficers are dirty and rip me off given my family back-ground. If I applied for a 100,000 RMB (US$12,000)loan, I would only receive 60,000 RMB (US$7,200)because the credit officer would pocket the other40,000 RMB (US$4,800). Meanwhile, I would stillbe expected to pay interest on 100,000 RMB.

Owner Lin explained that households fromthe first Lin branch were more likely to borrowfrom state banks or RCCs because their rela-tives work there. Lacking such official connec-tions, Owner Lin nonetheless managed toinvest 700,000 RMB (US$84,000) in hismotorcycle parts factory by using 100,000RMB (US$12,000) of his own savings, bor-rowing 200,000 RMB (US$24,000) interest freefrom his four older siblings, and borrowing400,000 RMB ($48,000) at 24% annual interestthrough moneylenders (yinbei). The latter loanswere guaranteed by his sisters who have goodcredit among moneylenders in the textile sector.As of 2001, Owner Lin still had the largestfactory in town even though his family’s localpolitical status remained low.Before Owner Lin’s motorcycle parts factory

was established in 1998, there were larger col-lectively-owned factories in the village and eachof them raised their funds in different ways. Forexample, at the outset of reform, there was aniron factory, which relied mainly on RCC loansbecause it was run by managers from the firstbranch of Lins. Later on, in the early 1980s,about 25 households in the second branch setup a plastics factory by pooling their savingsfor four years and registered it as a collective


enterprise. This is called the ‘‘wearing a redhat’’ strategy because the plastics factory wasreally privately owned––registering it as a col-lective gave it preferential land use and taxtreatment. Meanwhile, clusters of smallerhousehold factories producing sugar, lime,paint, autoparts, and textiles tend to raise theirstart-up and working capital in sectorally dis-tinctive ways, except in cases where extendedfamilies are involved in more than one sector.Given the rapid industrial transformation ofLin Village in the first two decades of reform, itis unlikely that the local RCC and county-levelAgricultural Bank could have kept up with thegrassroots demand for investment and workingcapital. As such, the expansion in informalfinancing during the reform era is not surpris-ing. It is noteworthy, however, that the busi-nesses that have received formal sector loans,i.e., those run by the first branch, have notperformed as well as those financed by the curb.This may be attributed at least in part to thetendency of local political elites to view theloans as grants rather than serious businessobligations.Gender represents the third major dimension

along which credit markets are segmented inLin Village. In contrast to the male-dominatedsavings and credit groups in Chandrapur, theROSCAs in Lin Village (called chenghui or hui)are only managed by women. In China’ssouthern coastal provinces, women dominatehui participation because they have betterdeveloped social networks with one another,because they are more likely to remain in townyear round (as opposed to men who mayengage in seasonal migration), and becausemen are more likely to have other financingoptions (Tsai, 2000). In Lin Village, a handfulof middle-aged women run ROSCAs full time,but most hui organizers have other income-generating activities as well. The organizer withthe largest volume of hui in Lin Village, forexample, is a doctor who operates the villageclinic from the courtyard home of the third Linbranch. At any given point in time, she runs upto five hui in the range of 200,000 RMB(US$24,000) each (i.e., 20 members contribut-ing 10,000 RMB/US$1,200 each meeting), andthe interest rates run up to 36% annually. Vil-lagers find Doctor Lin to be a trustworthyorganizer because as the village doctor, sheknows everyone and is unlikely to flee townwith their money.The manner in which credit markets in Lin

Village are segmented is only one example of

how single-surname villages may be internallydifferentiated (Tsai, 2002b). Indeed, regardlessof the particular distribution of surnames at thevillage-level, many other patterns of local seg-mentation may be identified in rural Chinadepending on the structure of the economy, thenature of geographical constraints or resources,the extent of external versus internal migration,and the often path dependent developmentalorientation of the local government (Unger,2002; Walder & Oi, 1999; Whiting, 2001; Wu,1998).Finally, despite the shared popularity of

informal finance, the financial landscape in LinVillage differs significantly from that of Chan-drapur. While the introduction of formalfinance to the latter had the unintended effect ofexpanding the volume of the curb, in Lin Vil-lage the formal financial institutions havealways been captured by local political eliteswho are not especially adept at business (cf.Adams et al., 1984; Otero & Rhyne, 1994). Thevast majority of commercially successful oper-ations in Lin Village have relied on informalfinancing mechanisms that do not involve thefirst branch of Lins. This is typical of China’sprivate sector as a whole. As of year-end 2003,less than 1% of all loans extended by statebanks were going to private entrepreneurs(PBC, 2004). Hence, even though there ispolitical and economic segmentation at thelocal level, the expansion of informal finance inChina is largely attributable to the limitedsupply of formal credit to the nonstate sector.

5. CONCLUSION

The enduring popularity of informal financein rural China and India may be traced to anumber of complementary factors: First, for-mal financial institutions and microfinanceprograms are often unable to meet the demandfor grassroots credit. But, merely increasing theavailability of official credit may not reach thetargeted population because it still needs to bedisbursed in some manner. Even if the supplyof official credit were sufficient, credit officersand poverty alleviation cadres charged with thetask of extending loans to rural householdsoften face local pressures and incentives forcredit distribution that deviate from the origi-nal intentions of state authorities. This isespecially the case when it comes to subsidizedmicrofinance programs because microloans arereadily treated as political patronage. Mean-


while, curb market operators at the grassrootslevel generally have a comparative advantage inserving rural households because they possessbetter knowledge about local market actors andconditions.This is not to say, however, that informal

finance trumps formal finance in either eco-nomic or normative terms, but rather, that top-down efforts at rural financial intermediationare not likely to achieve their objectives if theyare not structured in a sustainable manner andimplemented properly. It is no wonder thatsubsidized PA programs have low repaymentrates when the loans are presented as develop-mental side-payments. MFIs that charge sus-tainable interest rates, on the other hand, tendto have higher repayment rates; and whilereliable estimates of repayment rates in the curbare not available, it is probably safe to say thatmost informal financiers face hard budgetconstraints. While the constant threat ofbankruptcy looms over the curb, the potentialpromise of additional subsidies fuels targetedmicrocredit. That is why informal finance andmicrofinance are imperfect substitutes. Ratherthan crowding out informal finance, the infu-sion of public and donor funds into microfi-nance adds another discrete source of credit inlocal markets. As seen in the Chandahar case,the establishment of a village bank enabledpawnbrokers to expand their role as financial

intermediaries to local populations in theScheduled Tribe and Scheduled Caste lists.Meanwhile, the Lin Village case demonstratedthat from the perspective of borrowers withlower political status, formal sector credit isactually more expensive to them than the curb.Informal and formal sources of finance are notnecessarily in competition with one anotherbecause they serve different segments of localsociety.Analytically, if we accept that local-level

political and economic dynamics fundamen-tally mediate developmental outcomes, then itmakes sense to transcend the conventionalstate–society dichotomy by disaggregating bothstate and society. Just as local state agents maysubvert central state objectives, different seg-ments of society may be at odds with oneanother. Recognizing the complexity of grass-roots segmentation ultimately has implicationsfor the local distribution of both governmentaland nongovernmental sources of finance.Commercial bank credit, subsidized loans, mi-crofinance facilities, and curb market financingall entail a mix of social, political, and eco-nomic incentives that are contingent on localcontext. Only when microfinance programs arestructured according to local needs and aimedat cost recovery will microfinance hold greaterpotential for displacing usurious forms ofinformal finance.

NOTES

1. Useful compilation of the debates include Bouman

and Hospes (1994) and Hoff, Braverman, and Stiglitz

(1993).

2. By definition, informal finance refers to financial

flows that occur beyond the scope of a particular

country’s formal financial system of banks, nonbanking

financial institutions, and officially sanctioned capital

markets. Most countries, however, also have a range of

financial intermediaries that are best described as semi-

formal because central banking authorities do not regard

them as part of the formal financial system, but they may

be approved by some government agency or entity. In

India and China, the definitional boundaries among

informal, semi-formal, and formal finance have shifted

due to changes in their political, macroeconomic, and

regulatory environments. Furthermore, each of the

categories encompasses a wide range of different financ-

ing mechanisms. In this article, formal finance comprises

not only conventional banking and financial institutions,

but also officially sanctioned microfinance programs,

which include both subsidized and unsubsidized pro-

grams, as well as state-sponsored and NGO-led pro-

grams. Informal and semi-formal finance will generally

be discussed together because both fall beyond the scope

of standard commercial and developmental/policy-ori-

ented financial institutions. As the article discusses,

many forms of informal finance are subject to regulation

in India, while most forms of informal finance are simply

banned in China.

3. RRBs represent a hybrid between cooperatives and

commercial banks; they were established specifically to

serve impoverished farmers, laborers, and microentre-

preneurs in rural areas.

4. By 1999 India had a total of 140,000 branches of

various rural credit facilities, which is equivalent to one

formal financial institution per 5,600 rural citizens

(Sinha, 2000, p. 66).


5. In 1984 the responsibility for RCCs shifted from the

PBC to the ABC. Also, the Agricultural Development

Bank was established in December 1993 to handle the

policy lending functions of the ABC so that the latter

could devote itself to commercial banking activities.

6. During 1978–98, one US dollar ranged from Rs. 8.2

to 41.3. The conversion for Rs. 250 billion is based on an

annual average rate of 20.3 over that period. The figure

includes repeat assistance to the same families.

7. Especially during the 1980s, nationalized banks had

periodic loan melas, which entailed extending massive

quantities of subsidized loans to targeted sectors of

society without regard for their creditworthiness.

8. When it comes to subsidized loans for state-owned

enterprises or collectives that employ large numbers of

people, the argument could be made that propping them

up has local employment and therefore, welfare impli-

cations; but in the development field, microfinance refers

specifically to loans that are extended to individual,

small business owners rather than larger scale corpora-

tions that have larger capital requirements.

9. Note that the participating ‘‘banks’’ include com-

mercial banks, RRBs, and cooperatives. For additional

information about SHGs and what is known as the ‘‘new

microfinance,’’ see Bansal (2003), Satish (2001), and

Wilson (2002).

10. For a comparison of the performance of NGO,

joint NGO-government, and purely government-run

microfinance programs in China, see Park and Ren

(2001).

11. Citibank has committed US$1.3 million to FPC via

Grameen Trust for expansion. Xinhua (November 19,

2002).

12. For a list of microfinance projects supported by

international donors, see China Development Brief

(1999).

13. NGO participants said they were willing to pay up

to 32.6% in annual interest, while participants in

government-run PA programs were willing to pay up

to 21.4% annually and those in mixed NGO-government

programs were willing to pay up to 20.2% (Park & Ren,

2001, p. 45).

14. The survey found 39.6% of rural households relied

on ‘‘noninstitutional credit agencies.’’ RBI (2000), Table

5.

15. Note that ‘‘high’’ interest rates are defined as

rates that exceed the interest rate ceilings in China

and the anti-usury laws in India. These limits are in

the range of 10–12%/year for China and 24%/year for

India.

16. They are ‘‘legal’’ to the extent that they have not

been banned explicitly.

17. China Minsheng Banking Corporation was estab-

lished by the All-China Federation of Industry and

Commerce in February 1996. In November 2000, it went

public by issuing 350 million A shares on the Shanghai

Stock Exchange.

18. Communist-era references to pawnshops in impe-

rial China condemned them as an expression of class-

based exploitation. For example, Xin (1993).

19. For example, pawnshops in Xingtai, Hebei offered

annual interest of 40% to its depositors in 1991 (Xin,

1993). A more recent study found that some pawnshops

charge monthly interest rates between 5% and 8% (i.e.,

up to 72% interest annually), which is how they are able

to offer depositors such high rates of return. China

Online (September 9, 1999).

20. The rectification effort was not entirely effective,

however. The PBC issued additional regulations

throughout the late 1990s to standardize their operations

and reiterate prohibitions against charging/offering

high interest rates––again, to limited avail in implemen-

tation.

21. Many nonborrowing and borrowing lenders prob-

ably do not comply with the various acts. Moreover,

informal moneylenders fall beyond the scope of regula-

tion. I thank one of the anonymous reviewers for

pointing this out.

22. In pre-colonial and colonial India, Multanis,

Gujarati Shroffs, Marwaris, Nattukottai Chettiars, and

Kallindaikurichy Brahmins represented the most prom-

inent indigenous bankers. During the late colonial

period, many invested in industry and commerce (cf.

Bagchi, 1972).

23. Of course, formal and informal sector loans do not

have similar lending methodologies (in terms of size,

length, repayment schedule, collateral requirements,

etc.). But this section of the article only focuses on the

actual financial cost of formal versus informal credit to

examine the issues of access to and demand for credit,

ceteris paribus.


24. This phenomenon is not specific to India or China

(Adams et al., 1984; Otero & Rhyne, 1994).

25. The local case study from India––‘‘Chandrapur

Village’’ in South Rajasthan––was included in a larger

project on microfinance in general. The local case study

from China––‘‘Lin Village’’ in Wenzhou, Zhejiang––was

part of a project on informal finance and rural indus-

trialization in Wenzhou.

26. The US$ equivalent of the Indian Rupee went from

Rs. 9.8 per 1 US$ in 1982–83 to Rs. 15.1 in 1988–89.

27. Note, however, that the village bank accounted for

80% of the total loan volume.

28. ‘‘Lin Village’’ is a pseudonym. This case is based

on fieldwork in Wenzhou, Zhejiang province, 2000–

01.

29. During my visit in 2001, faded slogans from that

period could still be seen from the wooden beams. The

thought-reformed family was permitted to return to

their home in 1963, but as might be expected, during the

Cultural Revolution much of the intricate artwork along

the entryway, roof, windows, and walls was destroyed or

damaged.

30. Lin Village is ‘‘all mountains and water,’’ as the

locals put it.

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Documents

Imperfect Substitutes: The Local Political Economy …Imperfect Substitutes: The Local Political Economy of Informal Finance and Microﬁnance in Rural China and India KELLEE S. TSAI