India's Agricultural Loan Interest Subsidy Perversity- How Rich Farmers Make Risk Free 3-5% Carry using Zero Capital

India’s policymaker keep making dumb policies to promote agriculture in the country which leads to huge losses for taxpayers and leads to no gains for poor farmers.One such policy is to give a interest rate subsidy of 3% to farmers who have repaid their loans.This means that if you are getting a loan from the banks at  7.5% normally,you will now get it at 4% if you are a farmer who has repaid his loans.Note the condition “repaid his loan” is meant to sound as if it is a  great thing like saving someone from a burning building.Last time I though all loans were meant to be repaid.But evidently different rules apply to farmers, who  in the election year in 2009 were given a loan waiver.The government effectively allowed the farmers to convert their loans to a grant.It was an indirect gifting of billions of dollars to farmers to get votes and it worked splendidly for the ruling Congress party.A winning idea is seldom abandoned even it leads to perverse economic outcomes.

Now the government has made repaying your loans a great virtue,it has led to another bonanza for rich farmers.Note farmers are now taking loans at 4% and depositing these loans as deposits in the same bank at higher interest rates of 8-9%.This means a carry of 4-5% on zero capital and without any risk whatsoever.No hedge fund would be able to come up with such a high return zero risk strategy.Note only the rich farmers are making hay as small farmers have little access to loans or jewellery which they can keep as collateral to get farmer loans easily.The Banks in India on the other hand have no option as they have to meet specified loan targets set by the government.

Money plant: Clever farmers borrow at 4%, invest at 8.5%

When finance minister Pranab Mukherjee brought down the effective interest rate on crop loans to 4% in this year’s budget, it was to encourage farmers to grow more food and address the supply side issue of food inflation. But canny farmers in some states have discovered an arbitrage opportunity in this – they avail of the loans from banks at 4% and then invest them in fixed deposits at 8.5%.

A senior executive with an old-generation private bank told TOI that the bank was seeing an increase in short-term deposits from farmers. “We understand that several of these borrowers are availing of the special farm loan schemes from public sector banks,” he said. Asked about this, Indian Banks Association chairman M D Mallya said that all banks exercised due diligence to make sure that farm loans were used for agricultural purposes. “We ensure that the farmer owns agricultural land and that the land is being used for growing crops,” he said.

However, it is impossible to prevent anyone from taking undue advantage of the scheme, as the funds are handed over to the borrower.

The story of the 4% interest goes thus. A couple of years ago, the Reserve Bank of India introduced a scheme where short-term farm loans of up to Rs 3 lakh were made available to farmers at a rate of 7%. This year, Pranab Mukherjee announced that those farmers who repaid their dues in time would get an interest subsidy of 3%. This subsidy brought down the effective rate of crop loans to 4%. Combine this with the recent rise in interest rates on short-term deposits, and many finance-savvy farmers figured that they could make a neat packet on their loan without taking any risk. Some private banks offer as much as 8.5% on short-term 180-day deposits with half a percentage point more for senior citizens.

In southern states, where most families have at least some gold holdings, it is easy to avail of loans against gold jewellery. Farmers are discovering that banks are quite willing to extend a farm loan if the borrower is willing to offer security in the form of jewellery. A loan against gold is considered risk-free because banks maintain a significant margin between the loan amount and the value of gold.

Although these loans are not very profitable for banks, even with the interest subvention of 3%, they are keen on extending them since they form part of priority sector lending.