An analysis of access to formal credit of the households in rural areas

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

VIETNAM-NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

AN ANALYSIS OF ACCESS TO FORMAL CREDIT OF
THE HOUSEHOLDS IN RURAL AREAS
The case of the Mekong River Delta

BY

TRAN THI THU HONG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, December 2012


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

'

INSTITUTE OF SOCIAL STUDIES

THE HAGUE
THE NETHERLANDS

VIETNAM-NETHERLANDS

•

PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

AN ANALYSIS OF ACCESS TO FORMAL CREDIT OF
THE HOUSEHOLDS IN RURAL AREAS
The case of the Mekong River Delta
A thesis submitted in partial fulfillment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRAN THI THU HONG
)

'

Academmic Supervisor

DR. TRAN TIEN KHAI

't
HO CHI MINH CITY, December 2012

CERTIFICATION

"I certify that the substance of this thesis has not already been submitted for
any degree or examination.
I certify that to the best of my knowledge, help received in preparing this thesis,
and all sources used, have been acknowledged in this thesis."

Signature

TRAN THI THU HONG
Date: 31112/2012

'

Pagei


ACKNOWLEDGEMENTS

First of all, I would like to thank for my teacher, Dr. Tran Tien Khai who has
taught me methodically conduct research, for his encouragement, and guidance during
the completion of this thesis.
I would like to express my appreciation towards the teachers and staffs of
V~etnam-Netherlands Program, for the knowledge that I received throughout the

years. This knowledge helped me to complete thesis.
Finally I would like to thank my family, my husband who have encouraged and
hctlped me very much in my study.

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ABSTRACT:

This study attempts to find out what are the main determinants that affect the access to
the formal credit sector of the households live in the Mekong River Delta with the
data extracted from VHLSS 2006 and 2008. To fulfill the research objective, this
study relies on the function of credit given to a household of M.H. Quach, A. W.
Mullineux, V. Murinde (2004). With the helpings of Stata- 9 and Stata -11 software,
the logistic model and Ordinary Least Squared method are employed to explore the
main factors that can be used to measure households' access to formal credit sector by
the possibility of getting credit or not and the loan amount that households got from
the formal credit sector. The results of regression indicates that some variables such as
poor household, real per capita expenditure, purpose of loan, house own, household
head's education, farm size and interest rate have significant effects on households
access to formal credit. Therefore, in order to broaden the access to formal credit of
the households in the Mekong River Delta as well as Vietnam, the banking system and
'

the government should concentrate on solving problems that related to variables

m~ntioned above.
I
I
I
I

KEYWORDS: access to formal credit, households, Mekong Delta River

Page iii
I ..
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TABLE OF CONTENTS
Acknowledgements ................ :........................ .................................................................. 11. .
Abstract.. ........... .
.. ············································································································ iii
Tables of contents ............................................................................................................ .iv
List of abbreviations .•..•.••.•...•.•....•.....•.•.•..•.•...•......•......•........•.......•....••...............•.•.......... Vl·
List oftables and figures........................................................................ ························· v 1·1·
CHAPTER 1: INTRODUCTION

1.

Problem statement ................................................................................................... 1

2.

Research objectives ................................................................................................. 3

3.

Research questions ................................................................................................... 3

4.

Research hypothesis ................................................................................................. 3

5.

Data sources and methodology ................................................................................. 4

6.

Scope and limitation of the research ........................................................................ 4

7.

I

Structure of the thesis ............................................................................................... 5

CHAPTER 2: LITERATURE REVIEW
I

2.1. Definitions .....................,. ......................................................................................... 6
2.1.1
I

2.l2

Households and households in rural areas ............................................................. 6
Formal credit versus Informal credit .................................................................... 6

I

2.1.3

Micro finance and Access to credit ........................................................................ 7

2.2 Theoretical framework related to determinants that affecting to the formal credit
by rural households ............... :.......................................................................................... 8
2.2.1 Traditional approach - the dominant paradigm in the 1950s- 1970s .................... 9
2.2.2 Financial repression approach ............................................................................. 10
2i.2.3 New institutional economics approach ................................................................ 12
2.2.4 Conclusions ofthree approaches ........................................................................ 13
2.3 Credit market model ..... :........................................................................................ 13
2.3.1 Households' borrowing behavior and the Demand for Credit ........................... 15

.

2.3 .2 Credit supply and behavior of formal lenders ..................................................... 17
2.4 Empirical studies related to the determinants that affecting to the formal credit by
rural households ................................................................................................. ·........ · .. · 19
2.4 .1 The household

charact~ristics .............................................................................. 20

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2.4.2 The lender characteristics .................................................................................... 23
2.4.3 The location characteristics or the availability of the formal funds .................... 24
2.4.4 The local market characteristics .......................................................................... 24
I

2.5 Chapter remark ....................................................................................................... 24

CHAPTER 3: RESEARCH METHODOLOGY26
3 .1 Methodology ........................................................................................................... 26
~.2

Model specification ................................................................................................. 26

CHAPTER 4: FINANCIAL SYSTEM AND ACCESS TO FORMAL CREDIT
BY HOUSEHOLDS IN ME~ONG RIVER DELTA
4.1 Rural financial system in Vietnam ......................................................................... 30
4.1.1 Overview of rural financial supplier .................................................................... 30
a. The formal sector ........................................................................................................ 30
b. The semi-formal sector ............................................................................................... 32
c. The informal sector ............ :........................................................................................ 33
d. Summary .................................................................................................................... 34

4.1.2 Some weakness and challenges ofthe rural financial system ............................. 34
a. Weakness of the financial system ............................................................................... 34
b. Rural finance challenges ............................................................................................. 37
4.2 Households in the Mekorig River Delta ................................................................. 39

4.2.1 General picture of the Mekong River Delta ....................................................... 39
4.2.2 Rural financial system in the Mekong River Delta ............................................. 41
a. Households characteristics .......................................................................................... 41
b. Production characteristics ........................................................................................... 43

4.2.3 Credit characteristics ........................................................................................... 44
a. Credit sources .............................................................................................................. 44
b. Interest rates ................................................................................................................ 4 7
c. Loan size ..................................................................................................................... 49
d. Aim ofborrowing and uses of loan ............................................................................ 50

e. Lending procedures and collateral requirement .......................................................... 52
f. Information problem of banks with respect to households ......................................... 54

4.3 Summary ................................................................................................................... 54

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4.4 Determinants of credit accessibility of households in Mekong River Delta ............ 55
4.5 Chapter conclusions .................................................................................................. 61

CHAPTER 5: CONCLUSION AND POLICY IMPLICATION
5.1 Conclusion ................................................................................................................. 63
5.2 Policy implication ...................................................................................................... 64
5.3 Research limitation .................................................................................................... 66
References ........................................................................................................................ 67
Appendices ....................................................................................................................... 74

LIST OF TABLES
Table 3.1: Table of independent variables ..................................................................... 29
Table 4.1a: Household's size, householder's age and real expenditure per capital (with
VHLSS 2006) ........................•........................................................................................ 41
Table 4.lb: Household's size, householder's age and real expenditure per capital (with
VHLSS 2008) ................................................................................................................. 42
Table 4.2a: Education level of household head (with VHLSS 2006) ............................ 42
Table 4.2b: Education level of household head (with VHLSS 2008) ............................ 42
1

Table 4.3a - Typology of credit sectors and lending characteristics in MD (wi th
VHLSS 2006) ................................................................................................................. 45

Table 4.3b - Typology of Credit sectors and lending characteristics in MD (with
VHLSS 2008) ................................................................................................................. 45
Table 4.4 a- Source of the rural credit in classifying poor or not poor (with VHLSS
2006) ...................................... :........................................................................................ 46
Table 4.4 b- Source of the rural credit in classifying poor or not poor (with VHLSS
2008) ······························································································································· 46
Table 4.5a- Sources of the rural credit in interest rates (with VHLSS 2006) ................ 48
Table 4.5b- Source of the rural credit in interest rates (with VHLSS 2008) ................. 48
Table 4.6a- The average loan amount of the poor households (with VHLSS 2006) .... 49
Table 4.6b- The average loan amount of the poor households (with VHLSS 2008) .... 49
,Table 4.7a- Loan uses by wealth categories (with VHLSS 2006) ................................ 50
Table 4.7b- Loan uses by wealth categories (with VHLSS 2008) ................................ 51
Table 4.8a: Collaterals require)llent in two sectors (with VHLSS 2006) ....................... 54

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Table 4.8b: Collaterals requirement in two sectors (with VHLSS 2008) ....................... 54
Table 4.10a: S~multaneous equat~on models w~th VHLSS 2006 ................................... 56
table 4.10b: Simultaneous equatiOn models w1th VHLSS 2008 ................................... 60

LIST OF FIGURES
Figure 1: The vicious circle of capital formation ........................................................... 10
Figure 2: The commercial banks' lending procedure ..................................................... 52

ABBREVIATIONS
MFis: micro-finance institutions
NGOs: non-governmental organizations
LUCs: Land Use Certificates
VBARD: Vietnam Bank of Agriculture and Rural Development.

VBP: Social policy Bank
GDP: Gross Domestic Product
MD: Mekong River Delta
RD: Red River Delta

Page vii


CHAPTER 1: INTRODUCTION
1. Problem statement

Vietnam is regarded as the rapid growing economy in the world. The average
growth rate of GDP in the period 2000-2008 is about 7.4%/year, in 2009 is 5.32%
and in 2010 is 6.78%. With 75% of the population live in the rural area, agricultural
production accounts for 22% of GDP, 30% of exports and 60% of employment.
The Mekong River Delta (MD) is one of the two main agricultural production
regions in Vietnam. In the early 8 months of the year 2011, MD has export 4.1
million tons of rice, account for 90% of rice export of all the country, value export
of rice is above 2 billion USD. However, the rate of the poor ofthis region in 2010
is very high, accounts 18.85% the poor households of the country, the income is
about 975

USD/person/year,

very

low

in

compared to

income

1,160

USD/person/year of the country.
It is found that "limited access to available resource. including financial capital, is

among the main underlining causes of poverty in Vietnam. Microfinance is a key
part of such resources from which the poor can choose and develop better
livelihood" (UNDP, 1996). Morduch and Haley (2002) also found that when the
poor get access to credit, they can "improve their productivity and management
skills; create jobs, smooth income flows and consumption costs; enlarge and
diversify their businesses; and hence, their income can be increased and they have
a better conditions on taking health care and education ".
Since in 1997, the Vietnamese government has launched the Hunger eradication and
Poverty Reduction concentrated on improving the poor's access to credit, especially
in the rural areas. The major institutions do that mission are Vietnam Bank for
Agriculture and Rural Development (VBARD), Vietnam Bank for the Poor (VBP)
and People's Credit Funds (PCFs). Through credit programs, they provide loans to
poor households at subsidized interest rates. However, they have failed to provide
sustainable and large extent access to credit to the poor and be sustainable credit
institutions. According to Stijn Claessens (2005, page 2), the main reason of this

1


.

problem is that "the financial system does not cater to the demand of all customers .

Banking systems and capital markets are often skewed towards those already better
off, catering mainly to large enterprises and wealthier individuals while many
segments of the enterprise and household sector suffer from lack of access to
finance, hindering their growth and welfare".
Quach Manh Hao, A.W. Mullineux and V. Murinde (2004) found that "providing

credit in particular and financial services in general to the poor has a consistent
impact on household poverty reduction", and "in order to help rural households
gaining more access to credit, the credit network must be extended to the village
lever.
Despite the growth and mcrease of formal credit sector, there are still a large
number of the poor being excluded from access to formal credit. They have to
depend on informal credit sector consists of relatives, friends and professional
moneylenders with very high lending rates. In 2001, 40% of households in Vietnam
could not get credit from the formal credit sector. In 2011, the interest rates in black
credit market is from 18%- 20% per month, it means that if you want to borrow one
million Vietnam dong in black market, you have to pay from five to six thousands
interest per day.
Access to formal credit sector has become an important matter of the overall
development in most of countries, especially in developing countries. There are so
many researches examining the factors that affect the rural poor's accessibility to
credit market. According toLe Nhat Hanh (2002), there are four main determinants
affect to the rural households' access to formal credit:
The first determinant that constrains the access of the households to the formal
credit is lack of collateral while collateral is the prerequisite for borrowing money
from the bank.
The second determinant is the land area and the land certification status, when the
households have the large farms and its titles, the access to formal credit will be

extensive and smooth to them.

2


.

The third determinant is .the educational level of the household, when the
households have the high certificates, they have ability to make profit investments
and dealing with complex borrowing procedures easier.
The forth determinant is the production scale and cycle, with larger production, the
households have the higher probability and scale to get formal credit and the
households will choose the short-term credits or long-term credits that suitable for
their production cycle to borrow.
With the boom of the financial market in 2008 last to now, the banking system of
Vietnam has showed its weakness. The most of credit is supplied to the stock
market, gold market and land market, while the material production area is lacked
of capital. That is because of this area does not have the high rate of returns in the
short investment time. Therefore, the thesis will based on these findings to answer
the question that why a large number of the households do not get access to the
formal credit concentrating on the households living in the big rural area: the
Mekong River Delta. The thesis will also find out some specific policies could be
apply to improve the access to the formal credit to this region.

2. Research objectives
Firstly, the research will analyze the main determinants that affect to the access of
the households to the formal credit in the MD.
Finally, the research will withdraw some implications and give some key policies to
improve the access to the formal credit of the above region.

3. Research questions
The research question is What are the main determinants that affect to the

household access to formal credit institutions in the Mekong River Delta?
4. Research hypothesis
The households have to manage with many factors on the way to get the formal
credit, such as value of the household assets, the land certification status, production
scale and cycle, the expenditure and income of households, the educational level of

3


the household, the age and gender of the household head, the complicated
procedures of the formal credit institutions, etc.
5. Data sources and methodology
Data sources

The analyses will be conducted based secondary data and tertiary data. Secondary
data collected from the latest data set - VHLSS 2006 and VHLSS 2008 (The
Vietnam's Households Living Standards Surveys), so the data set does not reflect
the variation or fluctuation of the economic - financial environment in the recent
years. This survey was implemented by General Statistics Office (GSO) with
funding from Swedish International Development Cooperation Agency (SIDA) and
UNDP, and technical assistance from World Bank (WB).
Tertiary data collected from various sources, including theses of VNP (Vietnam Netherlands Program) students, working papers and papers on the Internet and in
the VNP library.
Methodology

This research will start with cleaning data process. In this process, some missing
observations, which are represented to households having no demand for credit, are

eliminated, only household want to borrow money from the bank are kept.
Descriptive statistic and econometric methods will be used to analyze in order to
draw a general picture of the Vietnam rural credit markets, household
characteristics and others fundamental issues related to the access to the formal
credit. Stata-9 software and Stata-11 software are used for VHLSS 2006 and
VHLSS 2008 analyses to find the main determinants that have strong effects to
access to the formal credit of the households live in the MD. Logit model is used in
this thesis. As a result, the matter can be solved in quantitative and qualitative
methods.
6. Scope and limitations of the research

The research will concentrate into the households live in the Mekong river delta.
There are 885 observations were analyzed in VHLSS 2006 and 856 observations

4


were analyzed m VHLSS 2008. Therefore, the results will be qualified
appropriately.
7. Structure of the thesis

The research starts with the introduction part. After reviewing the literature in
Section 2, Section 3 is devoted to methodology. Section 4 provides an overall
picture about the rural credit market in Vietnam, and the characteristics of the rural
credit market of the MD in specific. It is also used for interpreting the regression
results and Section 5 summaries of findings and discusses some key policies that
suitable for the region.

5

CHAPTER 2: LITERATURE REVIEW
2.1 Definitions
2.1.1 Households and households in rural area

Household: is a group of at least two people contributing their incomes for using

Ringen (1991). According to McCarty (2001), households live in the rural area are
more likely to borrow from formal credit sector than households live in the urban
area.
Behavior of households in credit market: the households lacking in materials need

to borrow while the households abundant in materials want to lend out for earning
interest. Therefore, credit market is born to facilitate the need and the want of these
households. Credit market has function to transfer materials from abundant
households to lacking ones.
Rural finance: refers to the supply of financial services for people live in the rural

area and they are working in agricultural production and/or doing small business.
Rural finance includes formal, informal and semiformal credit sectors with different
kinds of products and services such as loans, deposits, payment services, money
transfers and insurance. (Geetha Na Garajan & Richard L. Meyer, 2005).
2.1.2 Formal credit versus Informal credit

Formal credit: Ghate ( 1992) defines formal financial market is a place where

financial activities that are controlled and monitored by government. This marker is
much more developed in the urban area than in the rural area with many bank
branches and animated activities.
Informal credit: In developing countries, the main reason for the existence of the

informal credit sector is the underdevelopment of the formal credit sector.
In contrast to the formal credit sector, the informal credit sector supplies credit for
people who need loans with much easier requirements. The reason is that borrowers
and lenders often live in the near places, and know each other before. Therefore, in
order to maintain the trust and the relationship with lenders, borrowers make every
effort to repay. Moreover, instead of requiring collateral or documents (such as red

6


certificates, stocks, bonds, etc), lenders usually use informal laws to obligate or
threaten borrowers to repay. Although moneylenders usually exploit the borrowers
by giving them short-term loans with high interest rates that may lead to their
unable repaying situations, moneylenders still play a significant role in the informal
credit sector (Aleem, 1990).
2.1.3 Microfinance and access to credit

McCarty (200 1) defines micro finance is lending and saving activities in small-scale
of households in the rural area.
According to ADB, microfinance plays an important role in reducing poverty.
Facilitating access to microfinance can help the poor to cover their expenditures,
performed their businesses, hence, increase their income, and improve their lives.
Some main activities of micro finance are: loans, deposits, payment services, money
transfers and insurance.
Three sources ofMicrofinance
•

formal institutions (rural banks and cooperatives)

•

semiformal institutions (non- government organizations NGO)

•

informal sources (money lenders and storekeepers)

Microfinance is most often provided by non-bank institutions such as NGO.
Microfinance institutions are often based on the group-lending approach.
Financial exclusion: is a process that the formal credit sector performs to prevent
borrowers from getting credit (John D Conroy, 2004).
A repressed financial system: is system where the government sets the interest rate
at a level below the equilibrium interest rate of the market. This rate is negative
because it is smaller than the inflation rate (McCarty, 2001).
Access to credit or access to finance: "refers to the availability of supply of quality
financial services at reasonable costs" (Stijn Claessens & Konstantinos Tzioumis,
World Bank, 2006). Jan Van Heeswijk presented in the Access to finance
International conference in 2004 that "Despite a proliferation of financial
institutions in many countries, limited access to quality financial services remains a

7


challenge across the region". Quality here means financial services that are
supplied reliably, conveniently, continuously and flexibly. In some countries, the
quality of financial services is not good, it means that the need of credit is limited in
scope and carries high interest rates.
Developing countries realized the importance of bringing some basic financial
services such as deposits, savings, payments, loans, and insurance to the poor

households.
Diagne ( 1999) said that a household gets access to credit from a certain source
credit if it can borrow from that source, even if it do not need to borrow. A
household has access to credit if the amount of credit it received is larger than zero,
and it is constrained if this amount is zero or less than the amount it wants to
borrow. The maximum amount of credit it can borrow is called its credit limit.
According to Nimal A.Fernando (2007), a person who has full access to the formal
financial services when he wants to use it and he is able to use it.
Access to finance is a problem that only can be solved effectively by both financial
and non-financial sector measures. Some non-financial sector measures are
improvements in education, infrastructure, basic health care and other essential
services.
2.2 Theoretical framework related to determinants that affecting to the formal
credit by rural households
Credit rationing: refers to the circumstance where the lenders lend their money at

the amount lower than the amount they can supply regardless of the high interest
rate the borrower can pay for them. This is an inefficient situation of credit market
(Stiglitz & Weiss, 1981).
The lender's credit rationing behavior is based on the characteristics of borrowers,
the expected returns of the project, the terms of the loans, and the imperfections of
credit market. If the principal plus interest of the loan higher than the expected
return, the probability of default will be high, the lender will provide a smaller

8


credit amount than the amount that the borrower want to borrow, or even the lender
reject to provide credit.
Interest rate acts as price of credit and tool for controlling risks. When there is an

excess demand for credit. interest rates will increase, so the lender's income
increases which offsets greater risk. When interest rate is low and funds are
rationed, it is called that credit rationing without the possibility of rising interest
rates (Nathan Okurut, Andrie Schoombee & Servaas van der Berg, 2004).
Now, we review three theoretical paradigms to show a picture about the operations
of the formal and informal credit sector as well as the process of making decisions
of households.
2.2.1 Traditional approach- the dominant paradigm in the 1950s-1970s

This approach develops the Keynesian views on the role of the government. It
supposed that in developing countries, the lack of capital fund is the main problem
restraining the household access to formal credit sector.
From the supply side, governments supplies credit for agricultural production at
subsidized interest rates (this rates are often less than the inflation rate). This
approach concentrated on the effects of the constraints in the rural financial
environment instead of reducing them. This approach supposed that in the rural
area, the potential savings was too low for formal credit sector mobilizing or
offering savings facilities. In order to break down the vicious circle of capital
information in the rural area, the government should pump external funds to
develop investment, should not established agricultural credit organizations to
provide credit for consumption needs. (Doug Pearce, 2004).
From the demand side, this approach supposed that the borrowers are very sensitive
any changes of interest rates, if the interest rate reduced, households can apply new
technologies to their production and make their investment more productive. The
government should intervene into the credit market by using credit policies such as
interest rate ceiling and interest rate subsidies in order to provide cheap credit to the
households.

9

However, the traditional approach has some weakness: Subsidized credit programs
did not contribute much to the agricultural growth. There were only the large-scale
farmers and wealthy households had access to formal credit, the rest had to go to the
informal sector. Therefore, the government policies have been distorted and the
growth of credit market has been repressed (Doug Pearce, 2004).
~

The traditional approach suggested that the governments in developing countries

should apply low interest rate policies, and concluded that land size and
consumption characteristics might be important determinants of households' access
to formal credit.
Figure 1: The vicious circle of capital formation

a
Low
productivity

Low per
capital
income

Low
investment
rate
Source: model of vicious circle of poverty (vcp).htm

2.2.2 Financial repression approach

The financial systems approach assumed that the institutions adhering to
commercial principles could achieve extensive outreach and sustainability. The
government should ensure the favorable environment to the growth of such
institutions; financial institutions and credit programs should satisfy the household
demands for credit solidly and flexibly.
This approach appreciates the role of the formal sector, and informal sector cannot
replace the formal sector. This approach also supposed that liberalization in
financial system would deepen and improve the financial efficiency, hence, shorten
the gap between the rates of bank deposits and the interest rates, increase the flow
of capital between segments, restrain the development of informal credit sector and

10


broaden the access to formal credit sector in developing countries (McKinnon, 1973
& Shaw, 1973).
It is hard to provide credit for agricultural production because it needs arrangements

that are more flexible. So, lenders favor in lending to larger borrowers than to a
larger number of small borrowers in order to minimize the lending costs (Donald,
1976). Besides that, formal financial institutions were abused to provide credit at
subsidized interest rate to borrowers who have political or social position (Von
Pischke, 1983). In many developing countries, MFis introduced flexible and more
accessible savings facilities (product innovations) for borrowers in order to reduce
the risk of seasonal income shortfalls; used technology such as cash machines,
mobile phones (mechanism innovations) to reduce costs and expand the rural
financial services; used model of village bank-type (institutional innovations).
Implementing these changes and innovations can improve the formal credit sector
(Doug Pearce, 2004 ).
Some weakness ofthis approach:

The problems about the underdeveloped market and asymmetric information in the
rural credit market such as moral hazard and adverse selection were not addressed
in this approach. The formal credit sector was willing to charge the high interest
rates instead of solving the information problems. These high interest rates do not
reflect the scarce funds but the high information costs.
This approach supposed that the governments should keep the extension of the
financial and banking sectors under their control in order to increase revenues from
other channels.
In conclusion, the financial repression approach suggested that the governments in
developing countries should apply high interest rate policies to encourage savings,
and hence, creating opportunities to invest in agricultural production. This approach
concluded that loan size, the social position and political position maybe affect
household access to formal credit. The credit allocation may result from
government intervention and rational behavior of lenders and borrowers.

11


2.2.3 New institutional economics approach

Similar to the financial repression approach, this approach also supports the credit
market is imperfect. The difference is that, credit allocation through non-interest
rate mechanism is from rational behavior of lenders and borrowers in asymmetric
information environment of credit market not resulted from government regulations.
In credit market, asymmetric information arises when the lenders do not have
enough reliable information about the borrowers' potential risk of default (Aleem,
1990). Because the collection of reliable information takes a lot of time, money
human resource, so the lenders compensate for these costs by increasing the interest
rates, resulting in adverse selection and moral hazard. Finally, the lenders cannot
reach higher expected return because the average riskiness of projects is high and

the chance to make repayment is low (Nathan Okurut et al., 2004).
Adverse selection arises where borrowers with low profitability projects but safe

might hesitate to borrow because their profit might not cover the high cost of
borrowing while riskier projects with higher potential profits and probability of
default are attracted into the market, which in turn reduces the profitability of
lending operations (Nathan Okurut et al., 2004 ).
Instead of increasing the interest rate, lenders can use other screening devices such
as character assessment, collateral requirement to lighten the adverse selection
problem, if not, they can reject loan applicants (Thorsten Beck & Augusto de la
Torre, 2006).
Moral hazard occurs where projects with low risk change to higher risk and returns

projects. To solve this problem, lenders usually design credit contracts with
provisions that tie the borrowers to do their bets efforts that enhance the ability of
repayment as well as attract low risk projects (Nathan Okurut et al., 2004).
Lenders may also choose non-price devices or reduce the loan amount in order to
lighten moral hazard problems (Thorsten Beck & Augusto de la Torre, 2006).
Because of adverse selection and moral hazard, lenders use non-interest rate
mechanism to allocate credit. They assess borrowers' riskiness basing on household

12


observable characteristics: land area, housing conditions, main occupations of
household head, education and reputation of household before deciding whether to
accept or reject the loan application. Borrowers who have reliable information to
ensure that they will use the loan wisely and make repayment in time will have
larger access to formal credit of household.
The institutional approach also supposed that other approaches neglected the

transaction cost that is paid by the borrowers for completing the borrowing
requirements such as transportation costs - beyond the interest rate. Although
interest rate is low, transaction costs maybe restrain the poor access to the formal
credit institutions. In the rural area, agricultural activities accompanied with high
risks and low average returns, informal sector depends on personal and localized
information. Although informal sector has a monopoly power, it is hardly for this
sector to expand its activities (Stiglitz, 1992).
This approach suggested that household observable characteristics: land stze,
household assets, main occupations, education and reputation of household head
might affects access to credit of farm households.
2.2.4 Conclusions of three approaches
There are many determinants that affect the households' access to formal credit
such as land size and consumption characteristics (traditional approach), loan size,
the social or political position (financial repression approach), household assets,
main occupations, education and reputation of household head (new institutional
economics approach). Hence, in order to analyze the households' access to formal
credit in the rural area, it is necessary to consider the above determinants
thoroughly.
2.3 Credit market model

There is a significant difference between access and usage of financial services.

Access is the possibility to use while use is the actual use offinancial services. A
person may have access to a financial service, but he can decide not to use it.

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Inversely, a person may want or need a financial service, but he does not have

access to it (Genesis Analytics, 2004 ).
Access has many dimensions: services need to be available when desired and
tailored to specific needs; the prices for these services need to be affordable; credit
resources should not be limited to borrowers; provision of these services should
bring forth profits for the lenders, and therefore be available on a continuous and
sustainable basis. Therefore, it is difficult to measure access (Asli Demirguc-Kunt,
Thorsten Beck & Patrick Honohan, 2006).
Credit can be considered as a commodity, the price of credit (interest rate) will
determine both demand and supply side. It means that both of the borrower's choice
and the lender's decision have effects on household access to credit simultaneously.
A credit market is characterized by limited supply but excess demand (Nathan
Okurut et al., 2004).
Patrick Honohan (2004) proposed that considering the access to finance on both
sides:
The demand side: includes the contribution ofgetting credit to household welfare.
The supply side: includes cost conditions and other barriers to access. There are
three barriers to access:

* Price

barriers: includes the price charged by the formal credit institutions (this

part related to technical efficiency, regulatory, tax factors and competition), and the
additional costs the households have to pay in accessing this service (such as costs
for transportation and communication infrastructure).
Price barriers are used to measure the level of using the financial services.
*Information barriers: increase the cost of credit and restrain a certain number of

households in getting access to formal credit. Information barriers raise credit
rationing too.

Reforming and finishing procedures and laws relating to activities in the credit
market can help reducing the need for information.
*Product and service design barriers:

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Products and services that are offered by the formal credit sector are unadapted with
the household demands. The main reasons are the terms of payment of the loan
contracts may not suitable for the borrowers' cash flow patterns, or the small
savings of the households in the vast rural areas are hardly to collect because of
lacking of branch locations, the cumbersome administrative procedures that raising
borrowers' transaction.
Now we examine the demand for credit and the supply of credit, as well as the
behaviors of both borrowers and suppliers in the rural credit market.
2.3.1 Households' borrowing behavior and the demand for credit

Households have access to credit may or may not be credit restrained. Households
are credit constrained when they cannot get the amount of credit they need at the
current interest rate, nor they can get credit at a higher interest rate. With limited
access to credit, households have to regard carefully how to invest, what inputs to
buy for production. (Nguyen Thi Thu Phuong, 2006).
Quach Manh Hao et al., (2004) assume that household i in location j at time k.
During the period from k-1 to k, this household would have a demand for credit
rdijk function:

where:
•

IIijk

is household characteristics vector such as: gender of householder,

initial endowment, number of years of education of household head, etc
•

Q

d
ijk

is location characteristics vector such as index of location goods

prices, the prices of selected goods and services, etc
d

•

is market conditions vector such as the price of credit and the

<I>

mechanism by which credit is distributed, competition among borrowers. etc
d

•

8:J is unobservable characteristics of household and location vector such

as the human effort and dedication

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According to Nathan Okurut et al., (2004), there are a large number of variables that
have statistical significance on the credit demanded:
•

Age, education and household expenditure have positive and significant
effects the credit demanded.

•

Higher dependency ratio and higher for males than for females, higher
demand of credit for a household.

•

Households have been ill for more days in the past 30 days, and households
have more land assets have lesser in credit demand. However, other assets do
not have a significant effect.

Credit demand for long-term investment requires long-term and large loans while
short-term and small credits are suitable for short-term investment. In rural areas,
households mainly invest in expanding production such as buying or renting
additional land, new machineries and applying new technologies. Credit demand is
also for consumption in urgent cases such as ill, funeral, diseases, natural calamity,
etc (Ray, 1998).

Households has stronger political and social position (have closed relationship with
bank staffs) will have much more knowledge and information about credit
programs, so they can apply for formal credit easily and early (Donald, 1976).
Households with high level of education will have more access to formal credit.
Because they have better investment plans and can solve the complex loan
procedures easier. Moreover, richer households have lesser demand for credit
because they have stronger financial capacity. Young households with more
children might borrow more to satisfy their larger consumption demand (Kooreman
et al., 1997).
The determinants that affect to the households' demands for credit are: household
incomes, household assets, investment and consumption expenditures, production
characteristics and other important characteristics such as age, education, political
and social position of household heads.

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