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The Determination of Interest Rate by Informal Lenders in Cabuyao and Los Banos, Laguna, 2018

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Thesis outline submitted in partial fulfillment of the requirements for graduation with the degree of Bachelor of Science in Agricultural and Applied Economics, major in Agricultural Finance and Cooperatives from the Department of Agricultural and Applied Economics, University of the Philippines Los Bańos, under the supervision of Dr. Marilyn M. Elauria.




Background of the Study

        Informal credit is an important source of capital for farmers especially those who cannot borrow from a formal financial institution such as a bank or a cooperative. The distribution of credit to farmers is just as important like other factors (e.g. climate) to the productivity of the farmers. The reliance of farmers on informal credit providers as opposed to formal financial institutions is something that researchers have been pondering upon for decades. A good explanation for this is “due to information asymmetry between formal credit providers and farmers” (Bell, Srinivasan & Udny 1997; Conning 1996; Hof & Stiglitz 1990 as cited by Yuan, Ho & Gao, 2011). It is common knowledge that banks require collateral in giving out loans and this is probably one of the reasons why farmers shy away from banks when borrowing money.

        The informal sector of the rural financial system is composed of credit cooperatives and private moneylenders. Credit cooperatives are groups who focus on mobilizing the savings of its members and providing small loans to its member-borrowers such as small farmers and marginal fishermen. On the other hand, private moneylenders are individuals such as landlords, traders and input suppliers who provide small loans to market vendors, employees, and farmers (Llanto, 1993). The informal sector can be characterized by the smallness of loans, ease of entry and exit and the informality of transactions (Bautista 1991 as cited by Garcia, 2011). The formal sector and informal sector are not necessarily in competition since some banks such as the Land Bank of the Philippines (LBP) have programs that transfer loans from the bank to some cooperatives (Llanto, 1993).

        This study focuses on the determination of interest rates in a town (Los Baños) and a city(Cabuyao) because according to Bhattacharjee and Rajeev (2010), the “level of development of a place or town is a significant factor in the level of interest rate” (Garcia, 2011). The common misconception among people is that these private moneylenders charge high interest rates because of greed but this may not be the case. Cabuyao and Los Baños were selected for the study because the level of development in each place differs and this may affect the interest rate charged to market vendors and other borrowers.

        Formal financial institutions in Los Baños and Cabuyao are widespread but some borrowers still prefer the informal sector because of its accessibility and the lack of legal requirements in getting a loan. These formal financial institutions include banks, lending investors and cooperatives while the informal sector consists of private moneylender or “5/6”.

Statement of the Problem[a]

Despite the 6.3% growth of the Philippine economy in the last quarter of 2015 (Philippine Statistics Authority [PSA], 2015), the growth for the agricultural sector remained at 0.2%. This is low considering that the sector employs one-third of the country’s labor force. This is not a good scenario since the demand for agricultural credit may slow down.

        The failure of formal financial institutions to extend credit to farmers[b] aggravate the problems in the agricultural sector. According to ACPC, banks are required to allocate 25 percent of their loan portfolio for agriculture and agrarian reform under the Agri-Agra Law but what happened is that most banks did not comply with this law. Only 19 percent (as of 2010) of the 25 percent target loan were actually lent out to agriculture. Banks can also choose not to lend the money out to the agricultural sector by just investing it in virtually “risk-free” government securities. This provision in section 4 of the Agri-Agra Law provided incentives for the banks not to lend to the agricultural sector since government securities are less risky relative to farmers. The situation is that banks do not want to lend money to farmers because of the perceived riskiness and the farmers do not want to borrow because of voluminous requirements imposed by banks on borrowers.

        This is where the informal credit providers (ICP’s[c]) come in. However, the sector suffers from a bad misconception that they charge very high interest rates to farmers who really need the capital for their businesses. Despite the bad reputation, ICPs still remain as the main source of credit for farmers. Some of them charge very high interest rates but farmers are indifferent to this factor because what they focus on is accessibility and the timeliness of the loan which the informal sector can provide (Llanto, 2005). The informal sector can also provide loans that cater specifically to the needs of the farmers. However, informal credit providers are constrained by their limited funds so they cannot provide credit to a lot of borrowers unlike a bank (Llanto, 2005).

        The stereotype of the private moneylender as a “loan shark” is misplaced since some charge low rates, others at the same level as what formal financial institutions charge while the rest charge an interest rate of 200% p.a. (Agabin et al, 1989). The interest rate by the informal sector is affected by a host of factors such as the maturity of the loan, type of loan, deposit rates (for cooperatives) and repayment scheme.

        This stereotype may be based on the microeconomic theory that the informal sector operates as a monopoly, thus the interest that they get represent the monopoly rent (Garcia, 2011). There is no strong evidence for this thus a study of the factors affecting interest rate determination of the informal sector is needed.


Significance of the Study

        This study can help the government formulate policies regarding rural finance. It has been shown that the informal sector is the main provider of agricultural credit but the government clearly has a bias against this sector. The government thinks that the informal sector is taking advantage of the farmers but what the sector really do is fill a gap between the supply and demand for agricultural credit which the formals sector failed to do.

        Despite the liberalization and deregulation of the financial sector in the 1980’s, the formal sector still failed to give credit to the small farmers who needs it (Llanto, 2005). The formal sector favors big landowners who have collateral and have the ability to pay (Gualberto, 2007). This is the reason why informal lenders have flourished in the rural areas.



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