Published on All About Finance

The economic effects of India’s farm loan bailout: business as usual?

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In 2008, one year ahead of national elections and against the backdrop of the 2008–2009 global financial crisis, the government of India enacted one of the largest borrower bailout programs in history. The program known as the Agricultural Debt Waiver and Debt Relief Scheme (ADWDRS) unconditionally cancelled fully or partially, the debts of up to 60 million rural households across the country, amounting to a total volume of US$ 16–17 billion.

While high levels of household debt have long been recognized as a problem in India’s large rural sector, the merit of unconditional debt relief programs as a tool to improve household welfare and productivity is controversial. Proponents of debt relief, including India’s government at the time, argued that that debt relief would alleviate endemic problems of low investment due to “debt overhang” — indebted farmers being unwilling to invest because much of what they earn from any productive investment would immediately go towards interest payments to their bank. This lack of incentives, the story goes, is responsible for stagnant agricultural productivity, so that a reduction on debt burdens across India’s vast agricultural economy could spur economic activity by providing defaulters with a fresh start. Critics of the program argued that the loan waiver would instead undermine the culture of prudent borrowing and timely repayment and exacerbate defaults as borrowers in good standing perceived that defaulting on their loan obligations would carry no serious consequences. Which of these views is closest to what actually happened?

In a recent paper, we shed light on this debate by collecting a large panel dataset of debt relief amounts and economic outcomes for all of India’s districts, spanning the period 2001–2012. The dataset allows us to track the impact of debt relief on credit market and real economic outcomes at the sub-national level and provide rigorous evidence on some of the most important questions that have surrounded the debate on debt relief in India and elsewhere: What is the magnitude of moral hazard generated by the bailout? Do banks make riskier loans, and are borrowers in regions that received larger bailout transfers more likely to default after the program? Was debt relief effective at stimulating investment, productivity or consumption?

We find that the program had significant and economically large effects on how both bank and borrower behavior. While household debt was reduced and banks increased their overall lending, contrary to what bailout proponents claimed, there was no evidence of greater investment, consumption or increased wages as a result of the bailout. Instead, we find evidence that banks reallocated credit away from districts with greater exposure to the bailout. Lending in districts with high rates of default slowed down significantly, with bailed out farmers getting no new loans, and lending increased in districts with lower default rates. Districts which received above-median bailout funds, saw only 36 cents of new lending for every $1 dollar written off. Districts with below-median bailout funds on the other hand, received $4 dollars of new lending for every dollar written off.

Although India’s banks were recapitalized by the government for the full amount of loans written off under the program and therefore took no losses as a result of the bailout, this did not induce greater risk taking by banks (bank moral hazard). On the contrary, our results suggest that banks shifted credit to observably less risky regions as a result of the program. At the same time, we document that borrowers in high-bailout districts start defaulting in large numbers after the program (borrower moral hazard). Because this occurs after all non-performing loans in these districts had been written off as a result of the bailout, this is strongly indicative of strategic default and moral hazard generated by the bailout. As critics of the program had anticipated, our findings suggest that the program indeed had a large negative externality in the sense that it led good borrowers to default — perhaps in anticipation of more lenient credit enforcement or similar politically motivated credit market interventions in the future.

On a positive note, banks used the bailout as an opportunity to “clean” the books. Historically, banks in India have been required to lend 40 percent of their total credit to “priority sectors”, which include agriculture and small scale industry. Many of the agricultural loans on the books of Indian banks had been made as a result of these directed lending policies and had gone bad over the years. But since local bank managers face penalties for showing a high share of non-performing loans on their books, a large number of these ‘bad’ loans were rolled over or “evergreened” — local bank branches kept channeling credit to borrowers close to default to avoid having to mark these loans as non-performing.  Once the ADWDRS debt relief program was announced, banks were able to reclassify such marginal loans as non-performing and were able to take them off their books. Once this had happened, banks were no longer “evergreen” the loans of borrowers that were close to default and reduced their lending in regions with a high level of defaults altogether. Thus, anticipating the strategic default by even those who could afford to pay, banks actually became more conservative as a result of the bailout.

While bailout programs may work in other contexts, our results underscore the difficulty of designing debt relief programs in a way that they reach their intended goals. The impact of such programs on future bank and borrower behavior and the moral hazard implications should all be taken into account. In particular, our results suggest that the moral hazard costs of debt relief are fueled by the expectation of future government interference in the credit market, and are therefore likely to be especially severe in environments with weak legal institutions and a history of politically motivated credit market interventions.


Martin Kanz

Senior Economist, Development Research Group

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