Will More Credit Increase Interest Rates in Rural Nepal?

This study tests two alternative models of interest rate determination in informal rural credit markets, using data from a cross-sectional household survey from Nepal.

The authors:

• Model fragmented oligopolies, focusing on a complex model of price determination within the segments;
• Apply a model of collusive pricing that determines the effect of larger lending capacity on the equilibrium price;
• Compare their model with other models of cost pricing;
• Explain that the relatively high interest rates in segments of rural credit markets with low default rates is due to nearly perfect information and high degree of economic and social control.

The paper finds strong support for a full-information, capacity-constrained and repeated oligopoly model with third-degree price discrimination. It also finds that:

• Price discrimination depends on the observable characteristics, caste, instalment period and geographical region;
• The interest rates decrease as village lending capacity increases upto a certain level of capacity;
• Interest rates do not depend upon risk-related variables such as land value and loan size.

The paper concludes that:

• The informal rural markets of Nepal are characterized by an aggregate credit constraint at the village level, and oligopolistic collusion on price discrimination;
• A credit program that is able to target the higher priced segments will redistribute net income due to a reduction in interest payments.