Moral Hazard in an Indonesian Farmer Credit

In 1998, Indonesian Government through the Ministry of Cooperative, Small and Medium Enterprise made an astonishing 2,117 % increase for a Small-Scale Farmer Credit scheme, Kredit Usaha Tani (hereon KUT). In the budgeting year of 1996/97, they distribute Rp. 231,333 billion. In 1997/1998, when the crisis depressed Indonesian currency, like other countries in the region, the scheme only rise up to Rp. 374,631 billion (85,05%). Next year, in 1998/1999, the number surprisingly shoots up to Rp. 8.336,329 billions. And finally fall to -79,98% for the year of 1999/2000, which is as much as, Rp. 1.108,226 billion. Judging from the mid term realization of the credit in July 2000, Rp. 5,904 billions, the number even potentially much lower.

Why such a dramatic increase occur in one single year? To explore the question, first I will explain what kind of micro credit is the KUT, and its potential importance for the farmers, then the political context within which the bizarre jump took place. I will also describe the difference between KUT and micro credit schemes distributed in southern countries before discussing the moral hazard created by this extreme rise. Finally, I will present an impact of the scheme on the distributing institutions and the farmers groups as beneficiaries.



KUT in crisis

The program was run by the Department of Cooperatives and Small and Medium Enterprise, designed to support several type of crops, namely rice, second crops (such as soybean, corn, sugarcane etc), and horticulture products. Before the credit distributed, the proposing farmers obliged to form a group of minimum 20 members, write a proposal showing the land size cultivated for the assigned crops, and proposed amount of money they need for one planting season. A committee formed for this year’s credit scheme will screen the proposal. It comprise of several local authorities and parliament members. After the approval, the money channeled through a bank specially assigned for this task, cooperatives, and different types of NGO, to the proposing farmers groups (Gatra, February 19, 2001; Syafa’at and Madjid 2003).

The Indonesian small-scale farmers were facing difficult time because of the international financial crisis, mis-management of state subsidy on price, and rice import. The depreciation of Indonesian currency, for instance, shoot prices up, and in many places cause complete unavailability of commodities because retailers hold their products. Most Indonesian farmers are smallholders, which hardly can survive solely on their land cultivation. In addition to these problems is the inherent risk of farmers from natural disaster or extreme seasons. La Nina hit Indonesia in 1999 caused a perpetual rain, created over supply of secondary crop on one hand and the fall of rice production on the other. Thus, the subsidy was of much needed, and small-scale credit is one of its most established schemes.

However, the dramatic increase of the KUT drive the mushrooming of newly established cooperatives and NGOs; to put it bluntly, they are formed to distribute the credit. Data from the Ministry of Cooperative, Small and Medium Enterprise, stated that in the year of 1996/1997, there was 2.541 unit of cooperative distributing the credit. In 1997/1998, rise to 3.938 units, and dramatically shoot up in 1998/1999 to reach 9.517 units. This number of involved cooperative is relatively modest if compare to the celestial jump of the credit fund itself. Thus, the inclusion of NGOs as part of the distributing institutions in 1998/1999 was arguably necessary. A dramatic fall of the KUT budget in the following year (1999/2000) consequently decreased the number of cooperatives involved to 3.586 units. And in mid term (July) 2000 there was only 34 cooperative involved (Chart 2).  Meanwhile, there was no aggregated data on the number of the NGOs involved. However, we can see an indicative picture by looking at data from one of the biggest recipient province, South Sulawesi, which involves 92 NGOs. They distribute credits together with 425 village cooperatives within the province (Kompas, April 24, 2000).


A Brief on Microcredit        

Micro credit in has been a successful tool to reach the poor in some areas of the global south. The flourished of Grameen Bank in Bangladesh, BancoSol in Bolivia, and Bank Rakyat Indonesia’s Unit Desa (village units) in Indonesia, capture wide attention to culminate in 1997 Microcredit Summit (Haynes 2003; Holvoet 2005).  Wedahuditama (2006) describe the ideal type of microcredit, apparently developed by Grameen Bank, that is a credit lend to a peer-based group upon a social collateral group, conducted by a specific microfinance institute to serve the poor of the un-bankable, usually women (p.13-14).

The KUT itself arguably falls into ‘Old Credit Policy’ category (Ellis 1992), that tend to see credit as a transfer of money to the farmer—usually from the state or overseas funding agencies. It lacks the mobilization of farmers saving, and micro-finance institutions (MFIs) innovations for their sustainability. Therefore, it tend to cause ‘fungibility’ (diversion and substitution of the loan to other allocation), low interest rate (that ready to kill the MFIs), high transaction cost (if distributed to individual farmers), failure in loan recovery (out of inability to pay and unwillingness to repay), and less saving mobilization among farmers (the schemes are supply driven, heavily depend on external fund, unrealistic level of interest, deliberate discouragement of formal credit institution) (ibid.: 160-163).

Even against this frame, which describes more or less failed credit schemes, the KUT may represent the worst scenario, so much so that it avoid us to even call it a credit scheme. Several points are relevant to be mentioned here in relation to this. First, the micro-credit’s ideal-type of social collateral that holds a pivotal position to ensure the repayment entirely absent in KUT: many farmer groups are pseudo (i.e. formed only to receive different types of government support). There is weak economic relationship among members that can motivate them to repay the loan.

Second, the distributing institutions are often newcomers and actually non micro-credit specific, and see little importance or lack of skills to pressure the farmer to compel the contract. The MFIs normally should have sufficient skillful staff to carry out this very specific and delicate task in dealing with money among the poor. However, in the KUT case, we often encounter with the newly built fund-oriented loan suppliers. The cooperatives and NGOs from various camps (from children advocacy to environmental NGOs) are not a viable enough institution to run the business. These were not appropriate micro finance institution. Therefore, we cannot even talk about increasing interest rate, lessen the fungibility, mobilizing the farmers saving, or tackle the high loan default, when some of these organizations see the scheme as distribution of money from political parties to their constituencies (see below).

Third, the mechanism of forming and selecting the farmer groups in this scheme was problematic as well. In another microcredit program Wedahuditama (ibid.:31) explains that to form the executing MFIs (in this case called ‘Financial Unit Management’) the participatory method employed, especially to nominate people from the villagers; and those were chosen supposedly know their people and were more able to deal with their fellow villagers. This ‘Financial Unit Management’ is responsible to select the receiving groups, manage the grant and monitor the loan.  This program at least show a more sufficient check and balance than that of the KUT scheme as political interests follow the forming of KUT’s selecting committee down to the farmer group level. More on these will be address below.


A Banal Moral Hazard

The actors involved in the scheme seem to understand that there will be lack of enforcement for repayment. It is a typical moral hazard occurring in the most banal shape. Moral hazard has been a useful concept and analytical framework originally to tackle leaks in the insurance enterprise (Marshall 1976; Chambers 1989). It explains the excessive usage or misallocation of fund resulted from insufficient information on the beneficiaries hold by insurance company upon the signing contract or policy (Chambers ibid.: 604). The concept then apply to different financial or other commercial agencies, to mention but a few examples, the intra firm resource allocation (Cohen and Loeb 1982), the unemployment benefit (Dufwenberg and Lundholm 2001), and, relevant to our discussion, in the farm lending (Johnson 1990). In our case, the credit distributed with many premature or even fake MFIs, proposing fake needs (mainly written by village officials and NGO staff), and conducting fake check and balance. Consequently, the scheme failed miserably. The rate of the repayment was very low, many of which did not even intended to do so, and eventually create large number of scandal end up in the court. Likewise, a report from ‘Philanthropy and the Third Sector’ (see, on the scheme describes that

“This effort resulted in the booming of not only farmer cooperatives, but also other cooperatives from 50,000 to ±100,000.  However, almost half of those cooperatives then ‘died’ or became inactive, because the primary motive for the formation of cooperatives was to take advantage of the funds provided by the government – soon after the funds were used up, the cooperatives ‘died’.”

Most of the distributed fund consumed by the agencies supplying the credit, and least to the small farmers, the prescribed target of the scheme. Out of IDR 7,8 trillion of the credit distributed, IDR 5,8 trillion fall into non-performing loan (Kompas, Feb 12, 2000). Several practice of abusing the credit range from fictive farmer groups, and therefore fictive proposals (ibid.), excessive misallocation done by the supplying agencies and screening committee, i.e. purchasing office building and equipments, cars, and pay for their operational cost (Syafa’at and Madjid 2003). This practice deflected a considerable part of the fund towards the supplying agencies, the screening committee in district level (local elites and parliament members), the executing institution (NGOs and Cooperatives), and the elites of farmer groups. Thus, the scheme largely ended up with non-performing loan. As an example, again from South Sulawesi province, the amount of the credit in 1999 was Rp. 322, 740 billion. This loan was due to March 2000, but by April 2000, the loan repayment only reached IDR 40 billion, which means that 87,4% of the credit was non-performing. There was only 4 out of  92 NGO have completed the repayment and 8 out of 425 village cooperative (Kompas, April 28, 2000).

One possible explanation on this moral hazard, which underlines the apparent absent of sufficient monitoring of the fund, is political interests. The ad hoc nature of the ‘credit’, as its screening committee and many of its distributors are newly formed, creates the moral hazard among the entire actors involved. The story of money evaporates as its flow down the ladder in Indonesian government fund distribution is a norm, as discussed by Dove and Kammen (2001) on a study of the ‘vernacular model of development’. They make a distinction between formal purported development and vernacular model of development. While the former being put as formal written document, the latter is what actually taken place during the development project. They describe that as the fund goes down, in each level the government assign ‘incentives’ for the officers in charge from the budget itself, in order to avoid more leakage that if there is no ‘incentives’. They call this vernacular because it is they could not call this process a non-formal of informal due to its compulsory nature despite its inappropriateness.

Some intermediaries consider the fund as chance to gain potential voters for the soon-to-come general election, itself not an entirely new practice in Indonesian politics—where bureaucrats using state fund as hidden campaign (see for example Li 1999 in the case of Indigenous Resettlement Project). The supplier from time to time explicitly expresses their voting expectation rather than the repayment. Meanwhile, newspapers harvesting news on three ruling political parties competed to claim to be the one who arrange the distribution of the KUT (e.g., Kompas, April 7, 1999; Suara Merdeka, June 5, 1999; Suara Pembaruan July 8, 1999; SiaR, May 5, 1999).

As the parliamentary and presidential election was approaching, the discussion on the unpaid credit again capture the attention of stakeholders involves. The promise of a write off of IDR 7,89 trillion KUT loan was published by the government in April 2004 (Suara Merdeka, May 22, 2004). Apparently the moral hazard in this case has completes its circle by this promise. In November 2004, the newly elected government used this issue again, namely to write off the credit, among their other popular program, as one of their cabinet’s “first 100 days programs.” (Tempo Interaktif, November 4, 2004).


A politically Inspired Scheme with Its Unintended Trace

The scapegoat for the low rate of repayment initially directed towards the crop failure, more specifically pointed to the innocent El Nino. However, as the investigation pursue the real picture began to unfold. There were crop failure and price downfall because of La Nina, however, the farmers grievance more aimed at the 5,9 million tons of imported rice, a three-fold jump of fertilizers’ price, and the misallocation of the KUT—only reach wealthier villagers with better political connection (Kompas, March 15, 1999; Meyer and Nagarajan 2000:279).

In fact, suggestion to tackle farmer’s problem has come before and after the 1998, and the fantastic rise of the KUT as one answer did not provide necessary impact in relation to farmer’s yields. In 1997 the rice production was 51,2 million tons and slide down to 48,2 in the next year, and only slightly rose in 1999. Advice to stop rice import and more subsidy for chemical inputs—original aim of KUT—has also been perpetual. Voices against liberalization of agricultural products have been around as well (Wardhana n.d.; Widiatmono n.d.; Kompas, February 2, 2000).  Resulting from agreements with IMF in 1998 and with WTO in 2004, the rice price liberalization even raised farmer protests in several places in Indonesia (Ascholani 2006). However, as we have seen, the politically induced scheme become priority, and continued to produce moral hazard like many other Indonesian government schemes. But this program has an additional impact: it serve as character assassination for one of the celebrated hero of Indonesian political change, the NGOs.



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