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A growing number of Indian farmers are receiving and paying back loans intended to help them buy seeds and fertilizer. But fertilizer use is declining, and so are the incomes of farmers. SCID India Program Director Anjini Kochar came closer to understanding that paradox during a recent trip to India when she observed that repayment of official loans was accompanied by significant loans from relatives, friends and professional moneylenders.

“High repayment rates, normally considered to be an indicator of the household’s strong financial position, actually hide very high levels of indebtedness to the informal sector,” says Kochar, who was in the central Indian state of Madhya Pradesh to understand whether credit access can boost agricultural incomes. The research is part of a broader project on the links between credit access and child nutrition. The work is supported by the Financial Inclusion in India initiative at SCID, a center at the ��ɫApp Institute for Economic Policy Research.

Credit for agricultural purposes has become widespread in India through the Kisan Credit Card (KCC) program, which gives farmers short-term loans for seeds and fertilizer. Farmers make most of their money during the harvest, leaving them with a lump sum that needs to stretch across an entire season of expenses. Buying seeds and fertilizer at the start of the season can mean less food on the table in the immediate future for cash-strapped farmers.

KCC loans are designed to remove this tradeoff and help farmers buy what they need to increase their yields. As more crops mean more money, the loans are intended to fight widespread rural poverty. The loans are interest-free if repaid within a year, and this has helped to make them popular. But despite repeated borrowing from the KCC program, agricultural productivity and incomes remain low.

Part of the problem is weather: droughts or poorly timed rains can wipe out an entire crop yield, and weather patterns are becoming increasingly unpredictable due to climate change. But even after a bad season, the incentive to repay KCC loans on time is high since farmers must avoid defaulting to remain eligible for future low-cost loans. Without the money to repay the full loan, farmers generally turn to other village residents to borrow the balance of what they owe.

This money from the informal market usually has very high interest rates. So right after the new KCC loan becomes available, it is used to repay farmers’ informal debt. Because the informal loans exist only for a very short period – sometimes just a week – they rarely show up in household surveys. The data therefore suggest an unexpected combination: popular KCC loans with successful repayments and declining agricultural productivity.

“Ensuring access to financial services can only be considered a first step,” Kochar explains. “What is more important is how effectively these services are delivered.”

Crop insurance programs exacerbate the problem. Though farmers are required to purchase crop insurance when they take out a KCC loan, insurance payouts are only available if the village is officially classified as having experienced drought. This means that if weather patterns wipe out soybean crops but not wheat, insurance payments will not be made and soybean growers will bear the entire burden of their crop loss. The fact that different crops are vulnerable to different monsoon patterns makes insurance payments unlikely. More significantly, payments that do manage to get approved are rarely available on time and may reach the farmer only after a few years. While credit access can temporarily mitigate the effect of lost crop income, without effective insurance, years of drought imply rising rural poverty.