India’s annual economic growth exceeds 7% and the country just passed sweeping tax reforms. Despite this progress, it faces a growing crisis over farm lending. Farmers are demanding loan waivers that may cost up to 2.6% of GDP. They’ve captured headlines with their protests, destroying milk and agricultural produce and taking even more extreme measures. Although India’s agricultural sector is in distress, loan waivers are a costly, temporary solution to complex problems and will likely further strain the country’s public sector banks, already stressed by asset quality problems.
Seeds of Crisis
Following a good monsoon in 2016, farmers expected a prosperous year, particularly after droughts in both 2014 and 2015 caused significant suffering in the countryside. However, a combination of the sector’s long-standing structural weaknesses, export restrictions, a worldwide glut in farm commodities, and demonetization, meant that a bumper crop led instead to a collapse in prices. Amid this backdrop, Prime Minister Modi promised to waive farmer loans in the run-up to state elections in Uttar Pradesh. When the state minister announced the fulfillment of this promise in April, farmers in other states began agitating for loan waivers, leading to the current crisis.
India’s agricultural sector’s problems are long-standing: the country suffers from small, inefficient land plots. Less than half of the country’s farmland is irrigated. While the harvest was plentiful this year, inadequate infrastructure for transportation and storage meant farmers could not get their goods to market or store their crops to wait for better prices. An estimated one-third of India’s farm harvest spoils every year because there is not enough storage and supply chain infrastructure. Farmers are often at the mercy of middlemen and have little pricing power.
The government’s decision to demonetize high-value notes further exacerbated falling prices. According to IndiaSpend, after demonetization, prices for staples such as tomatoes and onions fell by over 80% in parts of India. The Reserve Bank of India (RBI) acknowledged the role of demonetization, along with excess supply, in lingering food price depression. Payments from government procurement centers, which offer a better price than competing markets, were delayed due to the lack of available cash, forcing farmers to sell for less at market or face delayed payment. Many farmers who sold produce in March 2017 had yet to receive payments by June. Without access to cash, farmers couldn’t pay for storage or seed and fertilizer for the next season. Adding insult to injury, even as food prices fell, the costs for seed and fertilizer increased, squeezing farmers’ ability to repay debt.
Agricultural Loan Waivers Have a Long History in India
Farm loan waivers, whereby outstanding loans are forgiven if the debt meets criteria set out by the government, are not new to India. Farmers make up over half of the labor market and are crucial in elections. The first national loan waivers date back to 1990, when the central government waived Rs100 billion ($5.6 billion) in farm loans.1 In 2008, the government announced a major round of loan waivers totaling Rs650 billion, equivalent to 1.3% of India’s GDP. Over the nine years until March 2017, the central and state governments waived nearly Rs890 billion (approximately US$14 billion) in loans to 48 million farmers.
Since April, four states have announced farmer loan waivers, prompting farmers in other states to demand similar measures. The estimated cost of loan waivers announced by Uttar Pradesh, Maharashtra, Punjab and Karnataka total US$13.6 billion. Analysts predict that the loan waivers, if implemented nationally, will ultimately cost between 2–2.6% of GDP (approximately US$40-50 billion). Their long-term impact will go beyond the immediate cost: waivers will damage the country’s credit culture and lead to a tightening of lending, dampening growth. The RBI staunchly opposes loan waivers. RBI Governor Urjit Patel stated this policy “undermines an honest credit culture, it impacts credit discipline, it blunts incentives for future borrowers to repay, in other words, waivers engender moral hazard.” The RBI also warned that loan waivers will crowd out private borrowers in favor of government lenders and will worsen inflationary risks, limiting the RBI’s ability to lower interest rates.
The exact process of executing waivers, especially terms for compensating lenders, is unclear, as is who will ultimately bear the cost. The central government said that it will not pay for waivers, but state governments have weak finances and high debt levels. For example, Maharashtra’s farm loan waiver would raise its 2017 fiscal deficit to 2.71%, from a budgeted 1.53%. States will likely issue bonds to pay for the waivers. They are considering issuing special bonds directly to banks rather than issuing state development loan (SDL) securities, which are disseminated through the central bank and implicitly guaranteed by the government. This would allow the states to fund the waivers without pushing up the cost of borrowing. Because the banks most affected by the waivers are state-owned, they will have little choice but to accept these bonds.
Waivers Would Hurt Public Sector Banks Already Under Stress
Public sector banks (PSBs) will be the most negatively affected by the loan waivers. Nomura estimates that state-owned banks hold two-thirds of loans to be waived. The loan waivers would further exacerbate the PSBs asset quality problems and their already weakened capital levels. A recent McKinsey report estimates that the level of distressed assets in PSBs exceeds their equity base and that the gap between provisions and expected losses is nearly US$88 billion. This is on top of the capital shortfall that PSBs face ahead of full Basel III implementation which the government forecasts to be US$30-40 billion. PSB stock prices dropped after the loan waiver announcements with analysts warning investors to be wary of the sector until the full extent of costs are known.
Frequent farm waivers create moral hazard, as expectations of future waivers encourage farmers to stop loan repayments. Indeed, some farmers in other states have already stopped paying loans and are withdrawing deposits from banks in anticipation of waivers. The Times of India reported that in some states, the default rate has increased by up to 50% in recent months. HFDC Bank recently reported a 60% rise in agricultural loan delinquencies in the most recent quarter ending June 30, 2017. Some fear that the breakdown in credit discipline will spill over to other borrowing. Microfinance institutions (MFIs), which have been challenged by the aftermath of demonetization, are also expected to see higher delinquencies. MFIs have already been facing collection delays in some states. Higher delinquencies and lower profitability for farm loans can lead to tighter underwriting standards for advances to farmers and less credit availability as banks pull back on these loans, pushing farmers to rely more heavily on moneylenders for funds.
The demand for loan waivers will likely spread across the country as farmers in other states mobilize. Farmers’ unions have called for a national march in support of loan waivers. This augurs poorly for PSBs and central and state government finances. Loan waivers in the past were popular but ineffective because they did not address the structural problems in the agricultural sector. Moreover, loan waivers from banks will likely not help those most destitute, who typically borrow from moneylenders, not the formal banking sector. Going forward, the government will have to continue to balance the needs of a vulnerable and politically important constituency with the economic costs.
1. Average 1990-91 US dollar to rupee exchange rate of 17.94
The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.