Rural Household Finance in China : A Study on Peasant Household Cooperative Financial Institutions in China from the Perspective of the Household Contract System 9781844644407, 9781844644391

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Rural Household Finance in China : A Study on Peasant Household Cooperative Financial Institutions in China from the Perspective of the Household Contract System
 9781844644407, 9781844644391

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Rural Household Finance in China A Study on Peasant Household Cooperative Financial Institutions in China from the Perspective of the Household Contract System Fan Dijun Translated by Erebus Huang et al

Rural Household Finance in China – A Study on Peasant Household Cooperative Financial Institutions in China from the Perspective of the Household Contract System Author: Fan Dijun

Translated by: Erebus Huang et al*

* Chapters 1, 2, 6, 7 are translated by Erebus Huang.The preface, chapters 3, 8, 9 and appendix by K.Y. Lin, chapter 4 by Alex L.S. Hsu, chapter 5 by Chan Wai Fong. All chapters are revised by Erebus Huang. Kho Tung Yi proofreads chapters 1–3 and 6–7

Contents Abstract Preface Chapter 1  Introduction


1.1 The Question


1.1.1 The Background and the Significance of this Research


1.1.2 The Theoretical and Practical Significance of the Research


1.2 Review on Rural Finance Literature


1.2.1 Theory of Rural Financial Development Model


1.2.2 Theory of Financial Market Supply and Demand


1.2.3 Rural Household Credit Demand Theory


1.2.4 Theory of Rural Financial Institution


1.3 Framework and Main Contents


1.3.1 Research Framework


1.3.2 Main Contents


1.4 Methodology and Innovations


1.4.1 Research Methodology


1.4.2 Innovations


1.5 Prospects


1.5.1 Institutional Supply


1.5.2 Problem of institutional Model Pilot Experiment


Chapter 2 Theories of Peasant Household Cooperative Finance


2.1 Theoretical Survey on the Peasant Economy in China under the Household Contract System 2.2 Institutional Change and Rural Household Cooperative Finance

23 27

2.2.1 Theory of Institutional Change


2.2.2 The Causes of Institutional Change


2.2.3MiThe Historical Trajectory and the Causes of Rural Financial Institutional Change


2.3 Incentive Compatible Mechanism


2.3.1 Mechanism Design Theory

35 1

2.3.2 Incentive Compatibility


2.3.3MiThe Application of Mechanism Design Theory and Its Implication to Financial Theory


Chapter 3 Analysis of the Peasant Household Financial Needs Under the Household Contract System 41 3.1 Analysis of the Founding Causes and Nature of the Household Contract    System


3.1.1MiThe Founding of the Institution of Rural Household Operation and the Double-Decked Operation and its Reason


3.1.2MiAnalysis of the Nature of Land Institution under the Household Contract Operation System


3.1.3MiAnalysis of Economic Relationship among the Peasant Household, the Village Collective and the State


3.2MiAnalysis of the Peasant Household’s Economic Behavior under the Household Contract System


3.2.1 Analysis of Family Functions


3.2.2 Analysis of Income Behavior


3.2.3 Analysis of Consumption Behavior


3.2.4 Analysis of Investment Behavior


3.3MiAnalysis of the Peasant Household Saving Behavior under the Household Contract System


3.3.1 Saving Need


3.3.2 Saving Motive Analysis


3.3.3 Savings Institution Options


3.4MiAnalysis of Peasant Household Loan Behavior under the Household Contract System


3.4.1 Consumer Credit


3.4.2 Production Credit


3.4.3 Need for Agricultural Insurance


3.5MiAnalysis of Conditions Constraining Peasant Household’s Financial Need under


the Household Contract System


3.5.1 Credit Constraint


3.5.2 Institutional Constraint


3.5.3 Information Constraint


3.5.4 Cost Constraint


3.6 Brief Summary


Chapter 4 Paradox of the Reform: Exogenous Institutional Arrangement in Rural Finance 75 4.1MiAnalysis of the Causes for and Objectives of Creating an Exogenous Institution in Rural Finance


4.1.1MiObjective Reasons for the Creation of the Exogenous Financial Institution


4.1.2MiThe objective function of the financial institution under the national strategy


4.1.3 The Ideal Positioning of the Exogenous Financial Institution


4.2MiPerformance Analysis of the Institutional Arrangements in the Rural Commercial Finance


4.2.1MiRelative Deficiencies: Fundamental Judgments with Regard to China’s Institutional Arrangement of Rural Commercial Finance


4.2.2MiPerformance Analysis of the Agricultural Bank under Commercial Institutional Arrangements


4.3MiPerformance Analysis of the Institutional Arrangement of the Policy-based Rural Finance


4.3.1 History of the Policy-based Rural Finance Institutional Arrangements 93 4.3.2MiPerformance Evaluation of the Institutional Arrangements of the PolicyOriented Rural Finance


4.4MiPerformance Analysis of the Institutional Change of Formal Cooperative Finance in Rural Regions


4.4.1 History of the Reform of Rural Credit Unions


4.4.2MiThe Difference of Deposits and Loans as an Indicator of the Performance of the Institutional Change


4.4.3 The Performance of the Institutional Change of the Credit Unions as 100 4.4.4MiPerformance of the Institutional Change of Rural Credit Unions as Indicated by the Evolution of Their Assets and Liabilities


4.4.5MiThe Institutional Change of the Credit Union System from the Perspective of the Original Intention of the Reform

101 3

4.5 The Causes of the New Rural Financial Institution and Its Performance    Analysis


4.5.1MiThe Cause of New Institutional Supply of Rural Finance and the New Institutional Framework


4.5.2MiPerformance Analysis of New Institutional Supply in the New Rural Credit Unions


4.5.3MiPerformance Analysis of the Institutional Arrangement for VillageTownship Banks


4.5.4MiPerformance Analysis of the Institutional Arrangement for Loan Companies


4.5.5 Performance Analysis of the Institutional Arrangement for Postal    Savings Banks


4.6 Analysis of the Exogenous Institutional Change in regard of Transaction Cost   and the Game under the State’s Preference


4.6.1MiExogenous Institutional Arrangement in Rural Finance with Externalization of Transaction Costs


4.6.2MiExogenous Institutional Arrangement in Rural Finance with Internalization of Transaction Costs


4.6.3MiExogenous Institutional Arrangement in Rural Finance with Diversification of Transaction Costs


Chapter 5 Supply Repression: Endogenous Rural Financial Institutional Arrangement 129 5.1 The Formation and Evolution of the Endogenous Institution of Rural    Finance


5.1.1 Historical Factors Regarding the Formation of the Endogenous    Institution of Rural Finance and Its Necessity


5.1.2MiFormation and Development of Informal Credits by Individuals or Organizations


5.1.3MiFormation and Evolution of Cooperatives and Other Community-Based Financial Establishments


5.2MiPerformance Analysis of Institutional Changes of the Informal Cooperative Finance in the Informal sector 5.2.1MiOrganization Modes, Function and Performance of Traditional Folk 4


Cooperative Finance


5.2.2MiIncentive of Institutional Changes in Traditional Informal Cooperative Finance


5.2.3 Performance of Institutional Changes in Traditional Informal    Cooperative Finance 5.3 Performance Analysis of Institutional Changes of Rural Fund Unions 5.3.1 The Founding of Rural Fund Unions

138 140 140

5.3.2 Incentives for Institutional Changes of Rural Cooperative Fund    Unions


5.3.3 Efficacy of Changes in Rural Cooperative Fund Unions


5.4MiGame Analysis of Institutional Changes of Endogenous Finance with the Preferences of Rural Households and the State 5.5 Brief Summary

145 148

Chapter 6 Model Selection: Peasant Household Cooperative Finance Institutional Model 151 6.1 The Goal and Principle for the Peasant Household Cooperative Finance    System 6.1.1 Rural Cooperative Financial Institutional Arrangement

151 151

6.1.2 The Goal of Institutional Arrangement of Rural Cooperative Finance 153 6.1.3 The Principles of Rural Cooperative Finance’s Institutional    Arrangement 6. 2 Peasant Household Cooperative Finance Model 6.2.1 Basic Contents of the Model

156 158 158

6.2.2 The Theoretical Implications and Practical Significance of the Model 159 6.3 Analysis of the Compatibility between Peasant Household Cooperative    Financial Institution and Exogenous Financial Institution


6.4 Model of Conjoined Institution in Peasant Household Cooperative Finance 175 6.4.1 Basic Contents of the Model


6.4.2 Mechanism of the Model


6.4.3 The Model’s Theoretical and Practical Significance


6.5MiComparison of Peasant Household Credit Cooperative and Formal Cooperative Institution


6.5.1 Comparison of Objective Function of Institutional Supply

180 5

6.5.2 Comparison on the Credit Base of Institutional Supply


6.5.3 Comparison of Product Features of Different Institutional Supplies 186 6.5.4 Comparison of Costs of Risk of Institutional Supplies


6.5.5 Comparison on Managerial Model of Institutional Supplies


6.6 Brief Summary


Chapter 7 Analysis of the Efficacy of the Institutional Arrangement of Peasant Household Cooperative Finance 195 7.1MiAnalysis of Peasant Household’s Bounded Rationality and the Efficacy of Rural Cultural Credit


7.1.1 Hypothesis of Peasant Household’s Bounded Rationality


7.1.2 Hypothesis of Rural Cultural Credit Efficacy


7.2MiStrategic Game Analysis of Peasant Household and Endogenous and Exogenous Financial Institutional Arrangements


7.2.1MiIncentive Compatibility Analysis of Rural Household Credit and Exogenous Financial Institution


7.2.2MiIncentive Compatibility Analysis of Rural Household Credit and Endogenous Financial Institution


7.3MiIncentive Compatibility Analysis of Endogenous and Exogenous Rural Financial Institutions


7.4MiAnalysis of the Transaction Costs of the Endogenous and Exogenous Financial Institutional Arrangements


7.4.1MiComparative Analysis of the Cost of Financial Demand by Peasant Households


7.4.2MiComparative Analysis of the Operation Costs of Different Institutions of Financial Supply


7.5MiAnalysis of the Competitiveness of Coupling Endogenous and Exogenous Financial Institutions


7.5.1 The Comparative Advantage of Asymmetric Information


7.5.2 The Comparative Advantage of Adverse Selection


7.5.3 Comparative Advantage in Moral Hazard


7.5.4 The Advantage of Joint Endogenous and Exogenous Institutions


7.6 Brief Summary



Chapter 8 Case Studies in the Household Contract System’s Birthplace: Fengyang County 219 8.1 Basic Information


8.1.1 General Descriptions


8.1.2 Trajectory of Economic Development


8.1.3 Rural Financial Development


8.2 Conditions of the Development of Peasant Credit Cooperatives


8.2.1 The Course of Development for Peasant Credit Cooperatives


8.2.2 Characteristics of the Operation of Peasant Credit Cooperatives


8.2.3 Existing Problems of Peasant Credit Cooperatives


8.3 Conditions of Development of the Federation of Peasant Credit    Cooperatives


8.3.1 Founding Background for the Federation of Peasant Credit    Cooperatives


8.3.2 Founding Process for the Federation of Rural Credit Cooperatives


8.3.3MiOperation and Supervision of the Federation of Rural Credit Cooperatives


8.4MiComparison of the Performances of Peasant Credit Cooperative, Rural Credit Union and Village-Township Bank


8.5MiGame Analysis of Association of Credit Unions, Village Banks and Credit Cooperatives


8.6 Case Study of Rural Credit Cooperatives in Xiaogang Village


8.6.1 Basic Information of Xiaogang Village


8.6.2 Trajectory of Xiaogang Village


8.6.3 Fund Needs of Peasant Households in Xiaogang Village


8.6.4 Analysis of Loans by Formal Finance in Xiaogang Village


8.6.5 The Example of Peasant Credit Cooperatives in Xiaogang Village


8.7MiDifferent Receptions for the Experiments of Peasant Household Cooperative Financial Institution in Fengyang County

Chapter 9 Conclusion and Policy Orientation



9.1 Conclusion


9.1.1 The Solution for Rural Financial Problems Lies in Institutional 7



9.1.2MiRural Financial Institutional Arrangement Must Be Compatible with the Basic Rural Economic Institution


9.1.3MiRural Financial Institutional Supply Must Adapt to the Financial Preferences of Peasants


9.1.4MiThe Optimal Performance of the Peasant Cooperative Financial Institutional Arrangements Lies in the Coupling of the Endogenous and Exogenous Institutions 9.2 Policy Orientation

259 260

9.2.1MiPeasant Household Cooperative Financial Laws Must Be Formulated and Implemented


9.2.2MiCultivation and Construction of Cooperative Culture in Rural Communities


9.2.3 Social Insurance System for Peasants Must Be Constituted


9.2.4 Rural Financial System Must Be Optimized and Restructured


Appendix 1MiPreliminary Statistical Results of the Survey on Fengyang County Peasants’ Needs


Appendix 2 Fengyang County Peasant Credit Cooperative Pilot Experiment       Proposal and Management Measures


Appendix 3MiFengyang County Federation of Peasant Credit Cooperatives Set-up Proposal, Guidelines and Organization Structure Layout


Appendix 4MiThe First Federation of Peasant Credit Cooperatives Established in Fengyang County of Anhui Province (News Report) Bibliography


319 325

Abstract Since 2004, five consecutive annual No.1 Documents issued by the Central Committee of Communist Party of China have made specific requests concerning the rural financial issues. In the 17th Third Plenary Session of the Party in 2008, The CPC Central Committee’s Resolutions on the major issues in Pushing Forward Rural Reform was passed, clearly stating that rural finance was the core of the modern rural economy. The goals are to innovate in the rural financial system, relax entrance regulations, and accelerate the combination of commercial, cooperative and policy-oriented financial sectors so as to establish a well-funded, functional, effective and safe rural financial system providing good services. According to the Resolution, small-scale rural financial organizations are allowed to raise capital from other financial establishments and qualified specialized peasant cooperatives can set up credit cooperation. The Resolution also suggested normalizing and guiding the healthy development of informal private lending to speed up the establishment of the rural credit system and a rural credit surety mechanism with the government’s support and multilateral participation in the operation of the market. This is an important resolution made by the CPC Central Committee in a new situation to promote rural reform and development. It has set the orientation and direction in furthering rural financial reform, promoting a healthy development of rural economy and new rural reconstruction. There is no doubt that peasants are the main force in rural economic and social development and in new rural reconstruction. In order to develop the rural economy and increase the peasants’ revenue, the primary task is to meet their increasingly growing financial needs. Since the launch of China's rural economic reform in 1978, a series of reforms have been implemented in the old rural financial system and the current rural financial system has been formed so as to meet the development needs of the rural economy. In the new system, the Agricultural Bank of China, rural credit unions and the Agricultural Development Bank of China are taken as representative. The operation is facilitated by three forms of institutional supply: commercial finance, cooperative finance and policy-oriented finance. But with a careful study, we can easily see that the problems in current rural finance are still very prominent, including the difficulties rural households face in getting loans, a serious outflow of capital from rural areas and the contraction of financial 1

establishments in rural areas. At present, commercial banks have largely retreated from the rural areas and the Agricultural Development Bank is only responsible for the state's acquisition of cotton, grains and edible oil, leaving only the rural credit unions to provide loans to peasant households. Rural finance is essentially in a state of supply failures. A new round of pilot reform of rural credit unions began with eight provinces in 2003. Focusing on property rights reform and engaged in the establishment of a new governance structure and management model, the authorities tried to help rural credit unions to throw off the historical burden by “spending money to purchase a proper mechanism” for them. The reform was then introduced to the whole country in 2004. Since the pilot reform, certain achievements have been accomplished and substantial progress has been made particularly in the mechanism conversion. However, this new institutional change is not a result from the internal driving force, but from top-bottom external pressure, so it is an imposed institutional change and in the process, a number of problems have been inevitably exposed, such as the failure of the supposed advantages of the financial institution, the adverse selection of the mechanism as well as the marginalization of the goal of servicing the tripartite agrarian sector (san nong, i.e. the peasants, the agriculture and rural areas). It is just as Mr. Liu Mingkang said, "China's rural finance is the weakest link in the financial system as a whole and the financial services in rural areas lag far behind the needs of a new socialist countryside." Financial reform in rural areas still has a long way to go. Analyzing the evolution and performance of China's rural financial institution, we can draw a conclusion that, to solve the problems in rural finance, the key issue is the design of a rural financial institution to match the basic rural economic institutions of China at this stage. New institutional economics has proved that only an institution with incentive compatible mechanisms can be effective. At this stage, the basic rural economic institution in China is the Household Contract Responsibility System, whose effectiveness has been proven by over 30 years’ of reform. In view of most of the rural regions in China, the only financial institution compatible with the Household Contract Responsibility System will be the organizational form which is adaptable to the rural household mode of production with low productivity and in an under-developed rural market. Accordingly, rural household cooperative finance (peasant credit cooperative or peasant mutual funding organization) is the only effective institution, under which the households are the subject, having advantages in information and transaction costs. Such 2

cooperative financial organizations have the following features: 1. rural households are the subjects that develop financial cooperation and assistance among themselves; 2. they are bound by village borders and therefore the information and transaction costs among the households in villages are minimized; 3. industrial cooperation is the basis: the cooperation between rural households is based on their collaborative production; 4. village culture is the basis of credit for such a fund cooperative because the households living in the same village share the same cultural and moral constraints, which are forces shaping the particular credit form of rural finance. Obviously, it is essentially different from the existing cooperative institution represented by rural credit unions. In this research, we take as our basis the theories of incentive compatible mechanism and transaction cost in new institutional economics, combining the achievements in the theories of modern finance, cooperative economy and peasant economy. Our fundamental perspective is the household contract system. This book analyzes peasant households’ financial demands and the corresponding supplies. It sets up a framework for the evaluation and analysis of the performance and effectiveness of different forms of institutional supply, revealing the ineffectiveness of exogenous financial institution (the formal financial institution) and the necessity of endogenous institution (rural household cooperative financial institution) in rural areas, through performance analysis and games of strategy analysis. Based on these analyses, we design two models for rural household cooperative financial institution. In the light of the experiences of rural cooperative financial institution in other countries and the case study of Fengyang County, it proves the effectiveness of the rural household cooperative financial institution in the forms of peasant credit cooperative and association of peasant credit cooperatives. Finally, conclusions are drawn and policy recommendations are offered on the basis of theoretical analysis and case study. This book contains nine chapters. Chapter 1 is an introduction in which the central issue has been put forward and a survey has been made on the literature of rural finance in China and abroad. It has outlined the framework and contents and introduced the research methodology and possible innovations. And it has also proposed the direction and major issues for further research. Chapter 2 illustrates the main theories on which this research is based, including peasant economy theory and the incentive compatibility theory. Chapter 3 analyses rural households’ financial needs under the Household Contract Responsibility System and 3

investigates rural households’ economic behaviors, saving behaviors and lending behaviors, as well as their demand constraint. By analyzing the cause and goal of the exogenous financial institutional arrangements, and also the performance of its institutional supply, chapter 4 reveals the incentive incompatibility of rural exogenous financial institutions. Chapter 5 looks at the evolution of the rural endogenous financial institution and reveals the causes of its repression in the state’s preference of financial institution from a historical perspective. Based on the incentive compatible mechanism, chapter 6 puts forward two models of rural household cooperative financial institution, namely, peasant credit cooperative and federation of rural credit cooperatives. Based on analyzing the credit basis of rural household cooperative financial institution (village culture) and its compatibility with the family contract system, chapter 7 shows the effectiveness of the institutional arrangements of rural household cooperative finance with the game analysis of rural households in relation with the exogenous and endogenous financial institutions and also from a comparative analysis of transaction costs and competitiveness. Chapter 8 tries to apply the model of institutions into practice. Through pilot experiment, it investigates the setting up and operation of peasant credit cooperatives and the Federation of Peasant Credit Cooperative in Fengyang County of Anhui Province, the birthplace of China's rural economic reform. With a comparative analysis of the performance of rural credit unions and villagetownship banks, it proves the effectiveness of the institutional arrangements of rural household cooperative finance. Chapter 9 is based on theoretical research and case studies, and draws a conclusion, and proposes corresponding policy-orientations. Key words: financial institution; financial system; rural household cooperative finance; incentive compatible mechanism; Fengyang case study Translator’s note: in the translation, we follow a commonly accepted definition in new institutional economics by Douglass North: “Institutions are a set of rules, compliance procedures, and moral and ethical behavioral norms designed to constrain the behavior of individuals in the interests of maximizing the wealth or utility of principals” (North 1981:201-2). In other words, institutions refer to the "rules of the game", consisting of both the formal legal rules and the informal social norms that govern individual behavior and structure social interactions (institutional frameworks), whereas organizations, are those groups of people and the entities 4

they create to coordinate their team action against other teams performing also as organizations (see “new institutional economics” in Wikipedia). So 制 度 is rendered as “institution”. Its meaning is close to “system” as in “financial system”. However, in common usage, entities like banks and credit unions are usually known as financial “institutions” ( 机构 in Chinese), which causes confusion in the context of this research; and therefore we use “establishments” (and organizations) to refer to these entities. However, in conventional terms like 家庭承包制 , we follow the common phrases, such as “household contract system”.


Preface Fengyang County is the birthplace of China’s rural reform. After a development of over 30 years, some bold experiments in rural financial reform have been tried out in the county. Dr. Fan Dijun, who at that time served as the county magistrate of the Fengyang County, has pored over the issues of this reform and made it the topic of his post-doctoral research. Based on theoretical study and applying it on practice, he has come up with this book summarizing the fruits of his research. In recent years, great achievements have been made in the development of rural finance, whether in terms of organization set-up, product innovation, service improvement, or loan quantity growth. However, a fundamental solution is yet to be found when it comes to the problem of difficulty in getting loans for the peasants. Clearly there is not sufficient financial support for the tripartite agrarian sector (san nong, i.e., agriculture, countryside and the peasants), which has become a significant bottleneck constraining rural development and the peasants getting prosperous. We cannot help asking why, after the tremendous efforts, big progress and great achievements made in rural financial reform, as affirmed by the financial sector, the peasants continue to say “no good”? There are indeed several issues worthy of further reflections. The first concerns government support. Financial establishments are not the only ones to blame for the lack of growth in san nong related loans. Banks in China have been transformed to the share-holding system, and it is their main objective to pursue high profits. The government should offer appropriate policy support and concessions to create favorable conditions for banks, so they could work to the benefits of the san nong. The second issue concerns the banks themselves. To say the least, banks do not adapt themselves to the demands of villages, agriculture and the peasants in terms of organization, staff and institutional arrangements. In addition, if banks are not truly committed to servicing the san nong, it is impossible that they could do well in boosting rural finance. This has to be a thorough reform. 1

The third issue is about rural land as collateral. A hot debate around this time is the “dual right collateral” ( 两权抵押 ) of contracted farmland operation rights and residential land use rights. For the peasants, the obtainment of both rights is based upon their status as members of collective economic organizations. On the surface these look like rights in rem (sachenrecht), but in essence they are about the membership rights of the peasants in the collective economic organizations. Do the peasants still possess their membership rights of the organizations once they lose the collateralized “dual rights”? Would the peasants become homeless once they lose their land and house? If non-members of the organizations obtain the “dual rights” through auctions, do they also get the membership rights of the collective organizations? These issues would affect the stability of rural economy as well as societal organization. In Korea, Japan, and other countries characterized by peasant economy, it is not common that formal commercial banks would take a small plot of farmland or residence of the peasant as collateral. In countries like Japan and Korea, where cooperative financial organizations are well-developed, and policyoriented finance facilitated by the government in support of agriculture functions well, commercial finance generally finds it hard to enter rural areas. The Guaranty Law of China makes it clear that the contracted land operation rights and residential land use rights of the peasants shall not be collateralized. Why, we must ask, in some places people are still attempting to do what is not permitted by the law? It says much about the severe lagging behind of the institutional reform of rural finance. The financial reform must therefore be attempted in other ways, bolder and more innovative. The CPC Central Committee has always placed much emphasis on the reform of rural finance system. It should be noted that some substantial progress has been made in recent years. Nevertheless, from the perspective of the peasants and agriculture, or from the perspective of rural demands for financial services, there is still a large gap and considerable problems exist. The biggest problem is how much of the newly increased loans are actually given to villages or to be granted to the peasants. As a matter of fact, most loans are given to big projects, because the financial costs for these projects are relatively low, and many of them are state-owned and therefore government-guaranteed, and banks are reassured of the investment. On the contrary, most of the peasants work on small projects with limited credit line and high operational costs, which discourage active participation 2

from financial establishments. In order to resolve the issue, I would say that we must have grand conception about institution, including system reform and institutional innovation, etc. At present the overall setup of banking corporations is not suitable for rural areas. Big banks have the strength, but in reality it is hard to have them installed directly at townships and villages, and serve the peasants village by village, or household by household. To solve the rural financial problems, apart from enhancing the functioning of current commercial and policy-supported banks, it is essential to develop regional and local small and medium-sized financial establishments and organizations, for they could better adapt to the demands from the rural grassroots level. The village-level credit cooperative organizations initiated by the peasants in Fengyang County could be seen as an institutional innovation of rural finance. Not only has the government set up specialized management and service organizations, but also related surety companies to connect with the financial authorities. This is different from the former rural foundation, or credit unions regulated by the State’s financial supervisory authorities. In view of security and regulation, pilot programs were tested in villages with favorable conditions, and further promotion was launched based on the results of the pilot programs. Fan Dijun has studied this financial innovation and conducted theoretical research on the subject, and validated the feasibility and necessity of cooperative financial organizations working within village borders, with the peasants as their main subjects, production as their foundation and funding as contents. He remarks that the fundamental institutional arrangement for rural finance must be compatible with the household contract operation system to be vital. This type of grassroots financial organizations supported by the government should have the following characteristics. First, the peasant households are the subjects of the organizations, which initiate funding cooperation and mutual funding among households. Second, such organizations should function within village borders. The minimized border limits could reduce information costs and transactions costs. Third, industrial cooperation should serve as the basis for the organizations, and the cooperative relationship of peasant households is centered on production. The greatest advantage for these financial organizations is the cost advantage because of low transaction cost and information symmetry, depending on the cultural credit of villages composed of people who know each other well. This is definitively beyond the reach of state-owned banks. 3

Not only can this institution supply for the mutual credit demands between peasant households, but it also offers a new financial cooperative advantage by connecting itself with external organizations such as rural credit unions and village-township banks. Rural credit unions and village banks could see rural credit cooperatives as their branch organizations, to which they provide funding services. This will solve the problems of high transaction costs and information asymmetry when they provide one to one service to the peasant households. A new credit model comes into shape. As we know, the reforms practiced in villages of Fengyang County have gained some success, and they are therefore welcomed and supported by peasants. We hope these reformative experiments could provide helpful examples for rural financial innovation in China. For many years, Comrade Dijun has worked at the grassroots level, and knows the rural society and economy very well. He is good at exploring and studying key issues, and his post-doctoral research at the Renmin University of China bears fruit in this book. Because of my work, I have visited Fengyang many times to conduct research and investigation, and know the place well, particularly Xiaogang Village, for which I have special feelings. I have known Comrade Dijun for many years, and he always gives me the impression of being diligent and studious. Working at the first tier of the grassroots level with lots of chores to handle, he still perseveres with his studies in high spirits. And what is more, he puts his study into practice as much as he brings back issues discovered at work to the domain of academic research. The result is the proactive attempts he has made to push for rural economic development. I sincerely hope for his continued devotion to the sound development of rural economy in his new position, and look forward to more contributions from his part. I therefore dedicate this as the preface of his book.

Chen Xiwen Chinese Rural Reform Task Force Deputy Team Leader and Office Director November 8, 2011


Chapter 1 Introduction 1.1  The Question “Rural finance is not only a problem confronting China’s development, but also a complication confronting the world.” (Wen 2006) The academic attention on this issue can be indicated by a search on Google which produces over 1310000 results. Wan Fang Data has collected over 6900 studies on rural finance published since 1989. In terms of practice, rural finance has become an increasingly important issue along with the advancement of the New Rural Reconstruction (NRR) throughout China. The problems in the existing institution and system constitute a major bottleneck of NRR. Cheng Si Wei, the former Deputy-Director of the Standing Committee of National People’s Congress, summarized the problems as follows: “the ineffectiveness of rural finance policies, commercial finance’s neglect for for the poor but preference for the rich, and the fact that cooperative finance exists only in name and with the existence of a rampant black finance market.” [1]The director of The People’s Bank, Zhou Xiao Chuan pointed out that the structure and mechanisms of rural finance are still defective, and inadequate in meeting the demand for financial service in solving the tripartite agrarian problems [san nong wen ti, which comprises the agriculture, the rural areas and the peasants]. He also noted that they were deficient in the innovation of products and organizations to satisfy the needs of peasants’ livelihood and production. The difficulty peasants face trying to get a loan has not been fundamentally resolved.[2] Since 2004, five consecutive No. 1 Documents of the Communist Party of China have promulgated specific instructions on rural finance. In 2008, the 17th CPC Third Plenum has indicated in the document, The Central Committee of CPC’s Resolution on Several Important Issues about Promoting Rural Reform and Development, that rural finance “is pivotal to the modern rural economy. The goals are to innovate in rural financial system, relax the entrance regulation and accelerate the combination of commercial, cooperative and policy-oriented financial sectors so as to establish a well-funded, functional, effective and safe rural financial system providing good services.” “Small-scale rural financial organizations are to be permitted to

[1]  Shanghai Zheng Quan Bao (Shanghai Securities), 2006-12-06. [2]  Xinhua Net, 2007-01-02.


raise capital from other financial establishments. Qualified specialized peasant cooperatives will be allowed to set up credit cooperation. Informal private lending is to be normalized and guided toward a healthy development. The establishment of a rural credit system is to be accelerated. A rural credit surety system supported by the government and operating in the market with multilateral participation is to be founded.” Thus, it can be seen that rural finance is not merely a general academic problem but rather an imminent issue of institutional innovation and reconstruction. New institutional design will be essential to the healthy development of the rural economy and the smooth advancement of New Rural Reconstruction. A sound development of the rural economy in turn has a bearing on the realization of China’s modernization. The problem is therefore not just of realistic but also strategic significance. 1.1.1  The Background and the Significance of this Research (1) Resolving rural financial problem is needed in order to solve the complication in NRR. NRR is the Party’s and the state’s strategic solution to the tripartite agrarian problem of contemporary times. It is an effective policy undertaking to resolve the disparities between the urban and the rural sectors, between regions, as well as income inequality. Nevertheless, even though NRR provides a good vision of the development of rural economy and society, it has in practice been confronted with a series of predicaments since its beginning. The central government’s policies of “subsidizing the agrarian by industry and pushing the development of the rural by the urban” are difficult to implement in less-developed areas where the urban economies are under-developed with less of a solid industrial foundation. The implement of the policy is eventually underpinned by public expenditure and the state’s revenues become the policy’s single source of funding. This model is wanting in terms of solving the problem of rural development. Rural economic development, environmental improvement and infrastructure require a great amount of funding. Agricultural production and peasant enterprises demand a lot of capital investment. The development of the second and the tertiary industry, particularly of small and medium enterprises also needs a lot of funding. Where do these investments come from? It should depend on the market and financial capital rather than public finance. In the long run, the key effective mechanism of NRR is to let the peasants become the subjects and the investors who increase their incomes by developing production and raising productivity. After initiating the task of NRR in 2

2006, The Central Committee’s No. 1 Document of 2007 proposed the development of modern agriculture as the core issue. In 2008, the core issue was concerned with how to increase peasant incomes. Besides information asymmetry and technological deficiency, the most difficult problem the peasants faced developing modern agriculture was the shortage of financing. In general, traditional agriculture requires relatively less investment. The peasants can support themselves through simple reproduction. However, modern agriculture is a high-input and high-risk sector. Without financial capital support, the peasants would not choose to venture into the field. Modern agricultural development and peasant income improvement would fall through. Without income increases, there will be no NRR. The very real problem is that although a rural financial system has been constructed, it fails to solve either the problem of financial shortages of peasants developing modern agriculture or the fund deficiencies of NRR. (2) Resolving the rural financial problem is needed in order to solve the asymmetry of rural credit. Since the Reform, villages in China have faced severe deficiencies in credit investment. What is worse, funds are seriously draining away from villages. It has been revealed that since 1998 the four major commercial banks have siphoned off annually 300 billion RMB in form of saving from rural areas in branches below county-level (Zhang Jie 2002), whereas rural credit unions which are supposed to specifically serve the villages annually transferred out about 200 billion (Ma Zhongfu 2001). The net outflow of capital through rural credit unions by peasants during 1079-2000 was up to 872.2 billion RMB, and 161.2 through postal savings establishments (Song Hongmou 2003). These establishments function like a finance-pump sucking money out of rural areas. Furthermore, a large number of national banks branches withdrew from rural districts. In 2000 the Industrial and Commercial Bank of China withdrew or merged over 4000 offices and stations. 13 tier-two branches and 242 county branches were closed. Large scale capital withdrawals continued in 2001. The Agricultural Bank of China started to close and merge some its provincial branches at the beginning of 1997. During 1998-2001, the number of rural branches of the national banks decreased from 15251 in 1997 to 12529, a reduction of 2722 (17.8%). During 2000-2001 alone some 1839 branches and offices were closed. Since 1998 the Bank of China had closed and degraded 246 county branches. It represented a decrease of 22% compared to the number of 1997 (Chu Fuquan 2005). The Agricultural Bank in particular withdrew extensively from rural regions since the 1990s. In order to get 3

listed on the stock market it further closed and merged its base units. Till the end of 2000, 5759 had been closed. 89 county branches were degraded into stations. During 2003-2006 alone 169 thousand workers were dislocated. 22500 office units were closed or merged. It is fair to say that despite the use of the title of “Agricultural”, the bank’s credit business had now nothing to do with agriculture. (3) Resolving rural financial problem is needed in order to push the integration of the urban and the rural. Since the Reform and the Open-up, China’s rural finance has been reforming itself. It has gone through several major adjustments and reforms. A preliminary financial system integrating the cooperative, commercial and policy-related sectors has been established. Nevertheless, theses financial organizations do not function to expectation. Duan Yingbi, a famous rural issues researcher, believes that the problem lies in the fact that modern financial institutions are designed to meet the demands of urban industry and commerce, which are a far cry from specific rural real-life conditions.[3] In terms of socioeconomic structure, China has a dichotomous structure of urban-rural disparity, which seriously impedes the emergence of an integrated market system. This leads to serious inefficiencies in resource allocation and deficiency in the circulation of resources between the urban and the rural. As rural savings are drained out in one direction, rural economic development is hindered. And peasants remain bound to traditional agriculture. Lacking capital and job opportunities, the peasants choose to head to the cities along the coastal regions to become migrant workers. Rural economy therefore languishes even more. Li Yining believes that the rural finance policy of extracting from the agrarian sector to support industrial development, along with the long-standing dichotomous urban-rural structure have also shaped the dual structure of the urban-rural divide in the financial market. The feature of rural finance repression becomes obvious. Rural economic development is heavily constrained by an underdeveloped rural financial sector. The dual urbanrural structure leads to a defective rural financial market with its negative effects. [4] Accordingly, the problem of rural finance is the result of a dual structure. The problems of rural finance in turn deepen the dual structure even more. The coordination of urban and rural development as well as urban-rural integration

[3]  Jing Rong Shi Bao (Financial Times), 2008-12-15. [4]  Ren Min Zheng Xie Bao (People’s Political Consultative Conference Post), 2008-10-17.


has, accordingly, become a national strategy. A major content of this strategy is to promote institutional and system innovation. 1.1.2  The Theoretical and Practical Significance of the Research In terms of theoretical research, rural finance is a challenging topic. Research results abound internationally as well as in China. Theoretical innovations and their practical value therefore become the concerns of researchers in this field. This research is based upon following reasoning: (1) New perspective. This perspective is premised by the existing fundamental rural economic institution. Its logical point of departure is the peasant household’s financial demand. It aims at exploring which financial institution is most efficient. For added insight, this research extends institutional arrangements to include the household contract responsibility system, and analyze its performances and endogenous mechanisms. This perspective differs from conventional studies based on rural financial market theory, which analyze demand and supply non-equilibrium to find the optimal path. This approach is also different from that of general researchers which usually takes as its starting point the status quo of rural finance in order to realize the objective function by optimizing the financial system. (2) New analytical framework. This research applies new institutional economics to analyze which financial institution is matching the household contract responsibility system. This matching is pivotal on the incentive compatible mechanism which has realized this institution. That is to say how to design an incentive compatible mechanism to satisfy the new institutional arrangement. In order to realize this objective function, this research formulates a peasant household cooperative financial institution which entails least transactional cost, with the most complete and symmetrical information, having positive incentive compatible mechanism and matching the household contract system most. It is not unusual to analyze rural finance applying new institutional economics. However the analytical framework in most of the literature is still limited to general institutional supply and demand relationships. As a result the problem of institution failure lacks theoretical explanation. The 2007 Nobel Memorial Prize in Economic Sciences was awarded partly because of the theoretical innovation of incentive compatibility, which is an important contribution to new institutional economics. Introducing this theory into 5

the present new institutional economics framework can better explain the problems faced in rural financial development and provide an analytical method to solve this complicated equation. (3) New model-building. In this research, based on analyzing rural financial malfunction and identifying the crux of the complication, we propose building an institutional arrangement of rural household cooperative finance with incentive compatible mechanism: peasant credit cooperative and federation of peasant credit cooperatives. This research is different from general theoretical studies. The author tries to elaborate the theory’s practical significance by using pilot experiments as case studies. We choose Fengyang County in Anhui province, the cradle of China’s rural reform, to put theoretical studies into practice. And learning from these experiences, we set up a standard institutional design. Based on these, we propose corresponding policy suggestions in order to optimize the institutional environment and improve institutional performance. Its practical significance comprises can be summarized into two points: First, the proposal and operation of the institutional model. This research aims at solving practical problems. It proposes a rural financial institutional model with an incentive compatible mechanism: the household cooperative financial institution. Whether this institution can realize the expected objective function must be tested in practice. What makes this research distinctive from others lies in the fact that the model is directly applied in practice and its institutional performance is continuously being tested in practice. Through practice, the model not only reveals the existing shortcomings of rural financial institution at present but also proves that the new household cooperative financial institution satisfies the goal of rural finance demand. Second, sample point pilot experiment and its social influence. Unlike general studies, this research is based on combination of theory and practice right at its beginning. Under the tutelage of Prof. Wen Tiejun, the author’s PhD dissertation supervisor, Feng Yang County was chosen as the pilot region of rural financial institution. Starting with theoretical and practical questions, we designed a household cooperative financial institution that encompassed the whole county. We continuously tested the theoretical insufficiency and modified the tested institutional model accordingly. Through this pilot experiment, a series of conceptions about rural financial institution proposed 6

by the central government were put into practice.[5] Furthermore, because of its institutional innovation and assessment on the risk factor of reform, the experiment is influential.[6] (4) Practice-based policy suggestions. This research proposes policy suggestions on the optimization and reconstruction of rural financial institution. These policy suggestions are not merely derived from theories but are instead grounded in the real situation of rural China, taking the system compatibility with the existing financial institutions as its point of departure. An array of suggestions on institutional optimization is proposed based on our institutional design and institutional performance analysis. Although the application of the model is put into practice and applied on a successful case, it is limited to the pilot zone. Without the coordination effect within the system, new institutional performance has not been formed. Usually, the establishment of an institution, be it incentive or imposed, will have a conjoint effect on the existing institution, producing new combination within the system and realize the best institutional performance. The establishment and implement of a single institution must therefore involve modification of the existing institution. This research takes as its objective function the performance maximization of rural household cooperative financial institution, with the policy-orientation of institutional optimization and reconstruction of the existing rural financial institution. 1.2  Review on Rural Finance Literature The literature on rural finance, both international and in China, is so vast that it is almost uncountable. A diversity of different perspectives exists. They can be classified into four categories: First, Theory of Development Model. How can we construct a financial development model in order to realize Pareto equilibrium in financial resource allocation? Taking modern finance theory as the point of departure and the standard market model as reference, researchers provide three kinds of rural financial model in developing countries: market-oriented, non-market [5] T  he author’s essays on rural financial reform are collected into the research reports of the Counsellors ’ Office of the State Council. [6]  Nong Min Ri Bao (The Peasants Daily), 2009-05-04.


and mixed types. Market-model emphasizes credit liberalization while the nonmarket model emphasizes the function of government. The mixed model stresses that under the conditions of market failure, the market should be the major agency, aided by government intervention in form of financial supply, so as to construct a model and system of rural financial development. Second, Theory of Credit Supply. It mainly applies classical economics to analyze the supply and demand relationship in the rural finance market. The theory aims to find out whether the problem lies on the side of supply or on that of demand, or both. It then seeks ways to improve the supply/demand relationship and optimize the supply structure to satisfy the demand function of the credit market. Third, Rural Household Credit Demand Theory. It studies the characteristics of rural household savings and credit, analyzes the objective function of credit demand, and suggests a rural-householddemand-oriented financial organization design theory. Fourth, Institution Design Theory, which is mainly based on new institutional economics, applying the theory of property rights to study a reasonable institutional arrangement of rural finance market. By absorbing the latest economic theories and in regard of institutional design, it proposes an objective function taking as its core the performance of institutional supply and incentive mechanism. 1.2.1  Theory of Rural Financial Development Model There are three major types, namely agricultural credit subsidy theory, agricultural finance market theory and imperfect competitive market theory. (1) Theory of Agricultural Credit Subsidies. This is also known as the “agricultural financing subsidies” theory. It was the leading theory before the 1980s. In 1966, Hugh T. Patrick’s “Financial Development and Economic Growth in Underdeveloped Countries” first problematized the causality between financial development and economic growth. It also raised for the first time the hypothesis of supply-leading and demand-following. This theory supported credit supplyleading rural financial strategy, believing that rural residents, especially the poor, lacked saving capabilities and faced the problem of financial deficiency. Because of the industrial characteristics of agriculture such as income uncertainty, longterm investment and low profitability, etc, the interest rate in rural financing had to be lower than in other industries. It followed that agriculture could not become the financing target of commercial banks which were profit-oriented. In order to increase agricultural production input, alleviate rural poverty, narrow the structural 8

income disparity between agriculture and other industries, and undermine rural informal finance, the theorists advocated the external input of policy-related finance and set up non-profit-making specialized financial establishments to provide funding support. Accordingly, developing countries had extensively implemented rural financial policy corresponding to the diagnosis by this theory. Even though it did foster rural economic development for a while, its shortcomings became apparent before too long. As governments took up the function of commercial lending, the rate of capital recovery became low. Lender moral hazard was also a common issue. Furthermore, as this type of loan interest rate was lower than that offered by the market, the loan was usually concentrated into large rural households or a handful of privileged persons in a rural community. The needs of the majority were therefore not met. And the loss of transaction cost could not be covered by the low interest rates charged. This model was usually unsustainable. (2) Rural financial market theory. Its main representatives are Ronald I. McKinnon and Edward S. Shaw whose main argument is that there exists financial repression in developing countries and that financial deepening is required. McKinnon believes that government intervention and regulation have led to financial repression hampering economic growth and aggravated the dual structure of financial markets, bringing about lower efficiency in the allocation of financial resources. In order to eliminate financial repression, government regulation must be loosened. Economic growth can be promoted by financial deepening and deregulation. This theory has gradually replaced the above-mentioned agricultural credit subsidies theory in mainstream discourse. It emphasizes the function of the market and advocates interest rate liberalization to promote the absorption of savings by rural financial establishments. In contrast to the agricultural credit subsidies theory, it believes that rural residents and the poor have the capacity to save and so require no external investment. The major reason of the low capital recovery rate is the rural financial sector’s over dependence on external capital. The low interest rate policy has discouraged saving, thus impeding financial development. This theory gives complete priority to the market mechanism and objects market distortions caused by policy-related finance. As such, it advocates interest rate liberalization. It believes that a higher interest rate will compensate for rural credit risk and higher transaction costs. It is not necessary to set up a lending 9

system targeting specific interest groups. The theory also believes that informal financial market has its raison d’être and should not be completely banned. This theory is still dominant in most market economies. However it is questionable whether interest rate liberalization alone can resolve the performance problem of the rural financial lending system. (3) Imperfect competitive market theory. Since the 1990s, especially after the East Asia financial crisis, people have realized that financial liberalization policy is not a panacea for developing countries. J. Stiglitz (1997) suggests the theory of incomplete markets. That is to say, the financial market in developing countries is not a fully competitive market, especially given the fact that creditors cannot have complete information about the borrowers. Under this condition, it may be impossible to incubate a market that the society needs if we completely depend on market mechanism. In response to market failure, the government can control loan interest rate to create a “rent effect” of savings, thus fulfilling the expected goal of financial resource allocation. Stiglitz and others (Stiglitz 1997;Ghatak 1996; Van Tassel 1999) have constructed models to elaborate that in group lending, same type of borrowers can group together and effectively solve the problem of ideal selection. According to Hayek’s theory of local knowledge (Hayek 1948), information asymmetry should not become the justification of government intervention. It is possible to depend on the market and competition mechanism to discover and make use of diversified knowledge, reducing asymmetry of the rural financial market. Hayek believes that competition is a process for the discovery of information and for reducing incomplete information and information asymmetry. Although China has advanced market reforms since the 1980s, the rural market is still lagging behind and remains underdeveloped. China’s peasant economy is still based on primitive forms of production. Clearly classical economic theories are formulated based on the context of complete market economy. With 900 million of peasants and individual rural household mode of operation, China’s situation is incomparable with that of capitalist nations, whether in terms of the development of rural market or in terms of its scale of agricultural operation. If the premise of a theory is false, it will naturally not bring about good outcomes in practice. 1.2.2  Theory of Financial Market Supply and Demand Can the objective function of the rural financial market be satisfied? What is the efficiency of rural financial resource allocation? Different researchers have 10

provided different responses to these questions in studying the supply and demand relationship of the credit market. The first type of responses suggest that there exists supply repression in rural financial market. Besley (2001) and Khandker (2003) think that formal finance is deficient in some countries. They find that rural households, especially the poor, mainly rely on informal finance for loan. In conducting field work on China’s rural household credit, Wen Tiejun (2001) discovered that rural households got 63.6% of their financing from usurious loan. The second type of answers believes that there exists demand repression. Zhou Ting and Deng Huanmin (2006) suggest low efficacy is characteristic of rural financial market. For them, the aim of rural finance reform should be geared towards institutional change. The major problem of rural finance is insufficient effective demand. Rural credit union cannot become the main force of rural finance. Under conditions of low market efficiency, state-owned commercial banks are bound to withdraw. Policy-based establishments should be the means for solving market problem. The third suggests the co-existence of supply and demand repression. Mire Devaney and Bill Weber (1995), by assessing a dynamic model of rural banking structure, conclude that the rural banking market in the USA is not completely competitive. Rural banking policy cannot sustainably solve the problems of the rural credit market. Liu Yangliang (2007) believes that we need to reconstruct the rural financial system in order to fundamentally solve the problems in meeting the demand. It should be based on the basic principles of adapting to competition, demand-side incentives and the combination of property rights reform and competition. We should construct a diversified rural financial system which is adaptable with multiple financial demands, catering to all different levels of demand, with complementary functions and appropriate competition. 1.2.3  Rural Household Credit Demand Theory Analyzing the factors affecting credit demand is a relatively complicated issue. Credit demand varies according to the nature of the type of rural households. Rural household is the subject of rural economic activities as well as the subject of rural financial demand. As economic activities involve different contents and scales, financial demands are diversified. According to their financial demands, rural households can be categorized as poor, subsistence and market-oriented households (He Guangwen et al. 2005). Different types of households have different credit needs and face different credit conditions (Hang Xing 2006). 11

Fei Xiaotong (2007) quoted Anthony Saich’s point of view in discussing the rural credit system in China: The characteristics of this system is……both the lender and borrower are not clear about the distinction between the credit for rural production and the loan undertaken to help with family expenditure. That is to say, it is counted in a lump sum entry in the loan account. As a consequence, both the creditor and borrower do not differentiate between loans for productive purpose or for family expenditure. They do not understand that the loan for production should accrue enough profit to pay back the interest and that barring an accident, the family income should be capable of paying back loan for expenditure.” The need for borrowing can be met in two ways: first, from funding via the formal financial sector with contract; second, from informal sector through the mediation of relationships. Gao Fan (2002) believes that these two ways are complementary. If a household can have its need of funding met by the informal sector, its demand in the formal financial sector will be repressed. These two sources of credit funding alternate and involve trade-off. 1.2.4  Theory of Rural Financial Institution The lagging behind of the rural finance is a strikingly weak link in the rural economy of China and seriously hinders agricultural development, rural reconstruction and peasant income growth. Researchers have proposed an array of suggestions to improve the situation and bring about financial innovation. The major suggestions can be categorized into three approaches: marketization, cooperation and diversification. Those who advocate for market-oriented rural financial institution believe that the peasants, including the poor, are capable of taking part in the commercial finance market. The Nobel Peace Prize 2006 was awarded jointly to the Bangladeshi economist Muhammad Yunus and Grameen Bank which was considered a successful example of a rural commercial finance institution. It is therefore believed that the commercial finance institution is totally feasible in backward villages. Wu Guobao (2008) indicates that from a comprehensive point of view, rural finance in China should become commercial in the long run. He points out that cooperative finance was supposed to be the foundation. However in the history of rural credit unions, a sound formal policy-oriented finance had never existed in real. He believes that the so-called policy-supported function of rural 12

credit unions was in fact purely theoretical or served only as a political symbol. He believes that as the general development of rural finance becomes more and more market-oriented, the space of commercial finance will be getting bigger.[7] Guo Hong (2009) believes that the goal of rural credit union reform and development should be to transform the credit unions into small and medium-sized regional joint-stock commercial banks with clear property rights, based on county-level, serving the rural sector. Those who advocate for cooperative rural financial institution believe that China’s rural economy is underdeveloped at present. Agriculture is a weak industry facing great risks. As such agriculture is operated chiefly by small-scale households scattered in vast rural areas, a commercial finance system is not viable. Wen Tiejun (2004) concludes that by the findings in field work, formal commercial finance cannot be fit into nicely with the peasant economy in China, which is characterized by the natural economy with mixed and concurrent operations, in which economic activities are unified with living. The needs of the peasant economy can only be met by cooperative finance. Yan Qingmin and Xiang Heng (2001) indicate that when the characteristics and real-life development of rural economy in China are taken into consideration, cooperative finance is still the best option. Cooperative finance emphasizes cooperation. For those economically weak, geographically scattered peasant households, voluntary association for mutual aid would be a necessary choice. Completely commercial financial operations are still unsuitable for most of the rural regions in China. He Guangwen (2001) believes that despite some institutional defects, cooperative financial organizations have their institutional advantage because of their vitality and resilience. Those who advocate for diversified rural financial institution believe that neither market-oriented nor cooperative institutions alone can effectively solve the problems of rural finance. The establishment of a competitive market is the only way to gradually improve the operation of rural finance. Only by providing good credit conditions and institutional environment can rural finance be oriented toward healthy development, thereby solving the problem of capital deficiency in agriculture among peasants. Only then can the ultimate goal of social and economic harmonious development be realized. When considering the extreme unevenness

[7] 2008-10-19.


of development in different regions, the principle of diversification should also be emphasized. Innovation according to local condition should be encouraged (Zhang Xiaoshan and He Annai 2006). Xie Ping (2001) thinks that in order to satisfy the needs of rural finance, there has to be a construction of a multiple network including policy-oriented banks, commercial banks, credit unions, commercial insurance companies and securities establishments, providing diversified financial instruments including savings and lending, securities financing, stock exchange, property and life insurance, reinsurance, and payment and clearing, as well as other intermediary services. From the above review on the problems of rural finance, we can discover that these theories and their development are the products of particular times and environment. The theory of rural financial development model finds out that different stages in the development of rural market economy should correspond with different adaptable financial forms; the theory of credit market supply allows us to understand the function of financial intermediaries and suggests constructing a new supply-demand relationship from the perspective of the equilibrium between credit demand and supply; the theory of financial institution design realizes that rural financial institutional arrangement must be based on the existing characteristics of rural economy and the reality of existing market failure. In view of China’s particular situation, we find that these theories are studying finance for the sake of finance, without taking into consideration the fundamentals of the existing rural institution, namely the household contract system. We should take China’s long existing fundamental institutional arrangement as the premise and the peasant household as logical point of departure when analyzing the amalgamation of rural financial institutional arrangements and rural economy under the urbanrural dual structure. We offer here a new perspective in studying China’s rural financial institutional arrangement, which takes as its core investigation the vitality of institutional arrangements, i.e. mechanisms, or more specifically, mechanism with or without incentive compatibility. We will examine the performance of the existing institutional arrangement and the reason for its malfunction. Based on these we are going to explore an institutional arrangement with an effective mechanism. In conclusion, the above researches have been fruitful in certain aspects. However, due to the limits of contexts, objects of study and theoretical presuppositions, they do not provide a satisfying answer to the concern of practice in China. We take as our point of departure the current situation of China’s rural 14

economy in this particular stage to study how to construct a financial institution compatible with the incentive of household contract system. We believe this institution will satisfy the financial demand of rural household and improve the Pareto equilibrium of rural finance and realize the goal of sustainable development in the rural economy and society. Such is the purpose and value of this research. 1.3  Framework and Main Contents 1.3.1  Research Framework This research framework is the result of studying an array of related literature and fieldworks on rural finance. Based on these, sample sites were chosen for pilot experiments in institutional innovation. The final framework is based on the results. (1) The Perspective. Although the literature of rural finance is vast, the objective function is always to improve the existing status of rural finance and to realize Pareto equilibrium by adjusting and innovating rural financial resource allocation. Taking this goal as a point of departure, every researcher would have different perspective, coming up with different conclusions or different requirements on improving the objective functions. International researchers are mainly concerned with building a healthy and stable financial market, as well as the utility function of market failure and government intervention. Apart from focusing on the macro-perspective of building a rural financial system, researchers in China tend to focus on the supply-demand of rural finance from a micro-economic point of view. On the supply side, they suggest increasing the amount of formal financial organizations and legalizing informal organizations in order to solve the hypothesis of supply repression. In terms of demand, many scholars suggest solving insufficient demand in rural finance market through multiple channels. The author of this research thinks that it is vital to choose a good perspective. As the existing economic institutions and level of development in China is far from being the same as in other countries, the research conclusion would be unconvincing if the perspective did not adequately reflect China’s real situation. This research adopts the following perspective: under the fundamental institutions of rural economy, namely, the household contract system and the double-deck operation system combining unified operation with diversified independent operation( 统分结合双层经营 ), how to choose an financial institution that matches with them. Accordingly, this research’s analytical point of view is 15

the household contract system, and its logical point of departure is the rural household’s financial demand. The research is going to study the structural characteristics of this basic economic institutional arrangement, the relevance of a matching financial institution, and the problem of their compatibility. (2) The Theoretical Choice. Generally, financial research seeks answers from existing financial theories. However, what researchers come up with by these theories were usually stopgap measures. Researchers have noticed this problem and broadened their research perspective. The situation can be indicated by the transformation from the mainstream economics to development economics and new institutional economics. The problematic is shifted from general equilibrium analysis to developmental factors contribution rate analysis. A theoretical innovation was made possible when the institution was regarded as an endogenous variable in the analytical framework. Coase’s transaction cost theory revealed that an important premise of neoclassical economics was wrong, i.e. the presupposition of zero transaction cost. New institutional economics emerges from this discovery. This research takes into consideration the fact that China’s economic development began with the transformation from a planned economy to a market economy. Rural economic transformation was the beginning of China’s reform whereas the rural household contract system marked the origin of the former. Research on the problems of rural finance must therefore follow this logical starting point to investigate the development and predicament of the rural economy. Under the context of rural economic development, this research explores the problems of institutional matching in the economic system and their transaction costs, and then proposes how to resolve the problem of institutional mismatching or incompatibility caused by institutional reform. (3) Research Flow Chart.


1.3.2  Main Contents This book comprises nine chapters. Chapter 1 is the introduction, which elaborates the importance and practical significance of the problem. Chapter 2 discusses the major theories covered by the research, including peasant economy theory, institutional change theory and incentive compatibility theory. Chapter 3 takes the rural household as its logical starting point and analyzes the rural household financial demand from the perspective of household contract system. Chapter 4 investigates the exogenous financial institutional arrangement by the performance analyses of commercial, policy-oriented and formal cooperative financial institutions, as well as of the new institutional arrangement. The causes of institutional supply paradox are explored. Chapter 5 investigates the performance of endogenous financial institutional arrangements and the causes of institutional supply repression. In chapter 6 we construct a model and design two rural financial institutions: household cooperative finance and federation of cooperative finance, with a comparison with the traditional formal cooperative financial institution. Chapter 7 provides a positive analysis of the effectiveness of rural household cooperative finance institutional arrangements. Chapter 8 presents the case studies of Fengyang County in Anhui province, analyzing the development and performance of rural household cooperative financial institution. Chapter 9 is the conclusion, which proposes policy suggestions for rural cooperative finance 17

institutional arrangement and reconstruction. 1.4  Methodology and Innovations 1.4.1  Research Methodology This research bears the characteristic mark of contemporary times. Under the perspective of the household contract system, it investigates the problem of rural financial institutional arrangement and how we can realize the optimal rural financial resource allocation mechanism. We make use of economics, financial theories and especially the latest development in new institutional economics, applying standard economic analytical paradigms to conduct a systematic and concrete investigation of the research topic. Our main methodology includes: (1) Integration of Theory and Practice. This is the most striking characteristics of our research. On one hand, this research, based on the latest financial theories, applies economic and financial theories to analyze the features and natures of rural economy and derive from it the financial institution that is compatible with the economic institution. On the other hand, from a practical point of view, it investigates the existing problems in rural finance and analyzes rural household economic and financial behaviors through field work. The pilot experiment of financial model is then combined with case studies. The result is compared with the existing institution. The cause of institutional malfunction is thus found and measures are proposed. (2) Integration of standard analysis and positive analysis. In analyzing rural finance, we take the standard analysis method to investigate the operation cost of existing rural financial institution and the reasons of institutional supply failure. The analytical tools of game theory are applied to solve the complicated equation of institutional incompatibility and the performance of formal and informal financial institutions. Accordingly a new financial institution model is designed, the rural household cooperative financial institution. The scientificity of the model is tested by applying it in practice and conducting positive analysis. The empirical results of the model are summarized, after which the model is modified for further experiment. (3) Comparative analysis. It includes historical comparisons, analyses of real situations, and concrete comparison of rural formal and informal institutions. Through comparison, we have a broad historical and cross-country perspective. The dynamics and performance of rural financial institutional change is thereby analyzed multi-dimensionally. Insights with practical 18

significance are therefore inferred and summed up, providing a useful reference to solve the problems of rural finance and improve institutional model design. (4) Case studies. This research chose Fengyang County in Anhui province as the pilot experiment zone. The problems and models were tested and proved in the pilot zone. By concrete analysis of the cases, the model and the scientificity of the premises are further tested. Furthermore, other methods such as quantitative analysis, questionnaire survey and game theory analytical tools are also applied. 1.4.2  Innovations The main contribution, or the innovation this research attempts to make, is to provide theoretical and positive analyses of the rural financial market practices in China. It starts with the theories in the existing literature, which have not been successful in explaining the realistic problem and reveals that the hypothetical premises have not been properly verified. This research then makes innovation in the following aspects: (1) Applying related theories in economics and finance, this research analyzes the situation in China’s rural economy and investigates the correlation of household economic behaviors and financial behaviors under the perspective of household contract system. It also elaborates the mismatching of financial institution and rural economic development, and proposes the reconstruction of rural financial institution. (2) This research applies new institutional economics to analyze the optimal option in the institution arrangement of rural finance. The matching financial institution that adapts to the household contract system must be the institutional arrangement with the lowest transaction cost and optimal information symmetry. This institution must be endogenous to rural households. Based on the cooperative financial institutional arrangement with informational symmetry among rural household, we propose a fundamental rural informal institutional model, the peasant household cooperative financial institution. (3) Based on the performance analysis of rural formal and informal cooperative financial institutions, and the household cooperative financial model, we propose a model that is compatible both with exogenous and endogenous 19

financial supplies as well as formal and informal financial institutions: the rural cooperative financial coupling institution. (4) We chose the cradle of China’s rural reform, Fengyang County in Anhui province as the pilot experiment zone of our theoretical model. The experiment results were applied to examine the performance of the model and further modify the hypotheses. It can serve as a standardized experiment case for rural financial research. 1.5  Prospects 1.5.1  Institutional Supply In order to establish a modern rural financial institution that is adaptable to the rural economy, we suggest the following approaches. First, the problem of rural finance institutional insufficiency must be resolved. Based on China’s rural economic conditions, a diversified rural financial system should be established. China has a variety of socio-cultural geographical conditions and different levels of economic development among different regions. Only a diversified rural financial system that is adaptable to particular local needs can satisfy the diversified financial demand in rural regions. In order to build a diversified rural financial system, the entry criteria of rural finance must be relaxed. While the function of formal financial institution is emphasized, the development of informal finance (also known as “folk” finance) must also be appreciated. Informal private lending must be normalized and channeled toward healthy development. Qualified rural specialized cooperatives should be ratified to conduct credit cooperation. Second, the existing rural financial institution must be optimized, especially in terms of building a risk sharing mechanism and enlarging the platform for associating. Rural credit markets entail higher risk and transaction costs. It is therefore important to establish a risk sharing mechanism and to encourage financial innovation that lowers credit cost. To lessen risk in rural finance, a multi-level risk sharing mechanism must be constructed. The building of a rural credit system must be accelerated. A rural credit collateral mechanism supported by the government, with multilateral participation and that is market-oriented should be constructed. Effective collateral categories should be enlarged. The rural insurance industry must be developed while the policy-supported rural insurance system has to be improved. The establishment of rural re-insurance and disaster risk diversification mechanism should be accelerated. The agricultural commodities futures market 20

must be strengthened. In order to solve the problem of high rural credit cost, based on enlarging the fluctuation range of loan interest rate by rural cooperative financial establishments, we must advance innovation in rural financial products and services. The rural micro credit and joint household guarantee loan should be promoted. New collateral forms can be innovated. Financial instruments based on purchase order and insurance policy are to be developed. The operation cost of informal lending is usually less. It can feed the demand for rural finance. Informal private lending should be normalized and guided into healthy development. The county (municipal) corporation legal personality of rural credit union must be secured because the rural credit unions at county level are usually smaller in scale, capable of solving the problem of information asymmetry and lowering transaction cost. Third, the problem of institutional legality and compatibility should be resolved. That is to say rural financial institutions represented by peasant credit cooperative should be ratified. Considering the practical situation of diversified units that are geographically scattered, registration may be permitted in local administration of commerce and industry, like generic individual business. Then the registration is to be filed in the local financial regulatory authority. In this way, rural household cooperative finance can be compatible with the state’s rural finance. They can complement each other to form new institutional advantages, allowing optimal allocation of rural financial resources, promoting hand in hand the sustainable development of rural economy. Due to time limit, this research does not go deeply into the above-mentioned forms of institutional supply. It is hoped that in the future research, household cooperative finance institution can be incorporated into rural system as a whole for further investigation. 1.5.2  Problem of institutional Model Pilot Experiment This research has experimented on two institutional models. As these two institutions are confined by different external conditions, the experiment was not totally up to the expected ideal state. In other words, we could not conduct a full across the board experiment as we hoped. As the central government’s policy on rural finance is increasingly relaxed, cooperative finance institution experiments, promoted by local governments, are developing strongly, even though without the permission of related financial regulatory authorities. However, the administrations above the county level are vociferous in questioning their legality 21

and often demand banning them. The institutional experiment of peasant household cooperative finance consortium can only be conducted with the permission of the financial regulatory authorities. Taking this into consideration, the experiment was supposed to be conducted in two phases in terms of institutional arrangement. Phase 1 would be in the form of trade organization: federation of cooperatives, whereas phase 2 would be in the form of financial organization. Phase 1 has been conducted with initial results. However phase 2 has not been advanced because of a lack of permission. According to the original plan, the federation of unions would be operating for one to two years. Then the financial organization would apply for permission. The federation would then be transformed into an operating consortium. Compatible cooperation between rural cooperative finance institution and formal finance institution (including various agriculture-related banks and organizations) would be realized. A new financial institution would be established. Nevertheless, due to limitations of time, the unfinished experiment is hoped to be studied in future researches.


Chapter 2  Theories of Peasant Household Cooperative Finance Before studying rural financial activities, especially the institutional arrangement of cooperative finance, we must review the related theories in this field and find out their relevance to the problem at hand. Doing so can provide us with analytical tools and allow us to set up an appropriate logical analytical framework. With reference to the objectives of this research, the main theories of relevance would be peasant economy theory, institutional change theory and incentive compatible mechanism theory. 2.1  Theoretical Survey on the Peasant Economy in China under the Household Contract System The basic principle of economics has it that economic development determines the development of finance. Our logical point of departure, therefore, is to investigate how to choose an endogenously vigorous financial institution that is adaptable to the economic development level and the mode of development. The prevalent theory of the peasant economy is mainly based on the concepts of “morals” and “rationality”. Nevertheless these two concepts are purely theoretical and quite remote from the reality of the peasant economy. The presupposition of the morality economy of the peasants puts too much emphasis on the moral outlook of the rural family. It holds that security is the highest value of family and implies that the rural family naturally is disinclined toward investment. In reality, this hardly explains the peasant’s economic behavior. In countries where family farms are prevalent, they have become an entity of autonomous business operation and investment. The main goal of the family farm has been to move away from simple reproduction toward extended reproduction. Similarly, the “rationality” of the peasant is also a theoretical presupposition. In a world of information asymmetry, people often find it hard to make rational choices. That said, the basic functions of the family have not withered. Seeking security and averting risk remains the major target of family farms, even though these farms are no longer the same as the rural households in traditional societies. (1) The nature and characteristics of the Chinese peasant economy. According to the Marxian point of view, the peasant economy refers to the mode of individual 23

small-scale agricultural production adaptable to the rural laborers who have ownership of their labor conditions or assets. This mode of production is usually premised by geographically scattered arable land or other means of production. Its main characteristics include: ① the individual family being the basic unit of production and consumption; ② these family units being isolated, geographically scattered and self-sufficient in terms of production; and ③ being based on the small-scale ownership of the direct producer. According to these criteria, the mode of production of the present household contract system in China represents the main characteristics of the peasant economy. Wen Tiejun (2001) believes that at present the rural economy in China remains typically a peasant economy. Land and labor are the fundamental factors of the peasant economy. After the dissolution of the People’s Commune system, the mode of operation of agriculture in China has in practice returned to the traditional mode of a peasant economy. Through the reform centered around the rights of land as an incentive mechanism, this mode of production has encouraged the peasant’s labor initiative in production, leading to a short period of fast growth in agriculture. Nevertheless, the productivity that can be accommodated by this mode of production is limited. Rather than facilitating agricultural development, the present rural land contract institution is more about stabilizing rural society by securing peasants’ subsistence. It is reflected in the increasingly serious “tripartite agrarian problems”(san nong wen ti) concerning the peasants, the agriculture and the rural areas. We can investigate these problems along the two dimensions of time and space. First, the effects of the practice of land contract system in time: we note that after an initial period of expansion in cropproduction and the boom of township enterprises, rural developments came to a standstill and even descended to a low ebb; second, the spatial dimension contrasts the development of the urban vis-à-vis the rural sector: it is apparent from this comparison that the peasants’ income growth lacks momentum the agricultural industry is debilitated, and the rural economy stagnates. The peasant economy cannot satisfy the requirements of developing a modern agriculture and the modernization of agriculture. First, in terms of mode of production, it is scattered and not in the form of large scale farm production or organized collective production, failing therefore to provide the conditions necessary to achieve economies of scale. Second, the peasant economy is inefficient. As the household mode of production applies mainly manual labor instead of state-of-the-art production factors such as advanced machinery, rural 24

labor productivity is not easy to increase; third, in terms of its mode of operation, it is traditional, self-sufficient and barely market-oriented. The household is the production and consumption unit. They produce for themselves as well as the market. However, for-market production is based on the surplus after the family’s needs have been satisfied. In retrospect, the initial motive for implementing the household joint-production contract system in 1978 was to meet the staple food needs of the households, the village collectives and the state through the crop production of the family as the basic unit. In the 1980s, the township enterprises were set up initially to satisfy the peasants’ needs, for example the bricks for building houses and clothing, etc. After that these enterprises became gradually market-oriented. (1) The Chinese peasant economy in international context. Put into the international context, three remarkable differences can be pointed out between the present Chinese peasant economy and agricultural production in other countries. The first concerns the market-oriented mode of production. A striking contradiction encountered by China’s Socialist New Village Reconstruction is that existing between the peasant economy consisting of 240 million peasant households and the ever-changing market. The peasant economy is incompatible with the demands of high specialization and organization. More than 100 years ago, Marx elaborated three major contradictions between the peasant economy and the market economy: the contradiction between the former’s scattered mode of property ownership and the latter’s concentrated resource allocation, between the former’s self-sufficient mode of consumption and the latter’s universal exchange relationships, and lastly between the former’s small-scale production and the latter’s huge demand for a great quantity of low-cost material supply. The outcome of these contradictions was the defeat and destruction of the peasant economy. At present, the agricultural production in advanced countries is highly market-oriented. In line with this, the industrial model has been introduced into agricultural production. What to produce and how to sell are dictated by the market’s demand. A reasonably specialized and systematic organization of market behavior is accordingly shaped. A developed network of promotion of species, branding and marketing is formed. In the marketing of products, production is conducted according to purchase orders. There is also a relatively developed futures market. Some products cater not only to domestic but also to international demand, following the market rules dictated by WTO. 25

Second, concerning the scale of production. The degree of industrialization in China’s agricultural production is relatively low. The scale of production is small. Whether in North America’s family farms or the household production under agricultural cooperatives system in East Asia, scale production, industrialization and market-orientation has been connected into a well-specialized system of large-scale production, processing and marketing. In China, rural areas stretch across a vast territory. While the market is underdeveloped, small scale production is satisfying the peasants’ needs for subsistence and is also a natural choice to diversify market risk. At present the State is subsidizing staple food production. Under this policy, the peasant households choose to further distance themselves from the market. To guarantee food security, traditional simple reproduction of agriculture is subsidized. The relative efficiency of agriculture remains unimproved. Essentially the situation is still what Phillip Huang refers as “development without growth”. Third, concerning the organization of production. The mode of organization in agricultural production in China is characterized by scattered small-scale single household production, which is typical of the peasant economy and has become the bottleneck hampering agricultural modernization. The organization of peasants has been quite successful in some countries in East Asia, for example, Japan and Korea. The reason why Japanese agricultural products are competitive on the international market is intimately related to the well-developed organization among peasants. In Japan there are various agricultural cooperatives of all kinds, up to the Japan Agricultural Cooperatives. These highly developed organizations have taken the duty of market specialization, effectively connecting individual households with the market. In a sense, individual household functions as workshops within the large scale factory of industrialized agriculture. What to produce, how to produce and for whom, is no longer determined by one’s own family, but dictated by the cooperatives or the JA. They have to take up different tasks to fulfill organizational target, in order to maximize profitability under the market’s law. Household production and operation under such a highly organized and developed service system, has completely broken through what Alexander Chayanov referred to as a “moral economy” of the peasants. In other words, the security function of the family has been replaced by the expected returns of the market and advanced organization. This is the “thrilling leap” that breaks through the peasant economy. This family farm mode of production is completely different from the household production in China. Wen Tiejun refers to such a system as the Farmer Economy 26

instead of the peasant economy. The farm as a production unit is related to modern agriculture both in terms of scale and technology. The first factor a farmer takes into consideration to improve labor productivity is modern technology. He or she may try to increase the level of mechanization. Although the farms already achieve an economy of scale, they will group together to form a trade organization, which is a common practice in the agricultural mode of operation in the West. It is apparent that the Chinese peasant economy is a relatively backward mode of production. This mode is incompatible with the market mechanism. Given this, we must therefore come to the judgment that the financial institution accompanying the present peasant economy must match and adapt well to its needs. . 2.2  Institutional Change and Rural Household Cooperative Finance How has the present rural financial institution come about in China? Is it an effective institution? The present cooperative finance is represented by the rural credit unions. However, does it imply that this institutional arrangement best represents the rural cooperative finance? What is its function in the rural financial system? Why are the financial needs of the peasant households not satisfied within this institutional arrangement? We hope to find the answer in the various theories about institutions. 2.2.1  Theory of Institutional Change The relevant concepts include institutional environment, institutional arrangement, primary action group, secondary action group and institutional device, etc. Institutional environment refers to an array of basic political, social and legal rules that facilitate production, exchange and distribution. It can also be considered the fundamental institutional arrangement. It is the fundamental institutional regulation that determines and influences other institutional arrangements. Unlike the fundamental institutional arrangement, the institutional arrangement here refers to the primary institutional arrangement. Primary action group refers to a decisionmaking unit. Its decision will determine the process of institutional innovation. This unit can be an individual or an organization composed of many. Secondary action group refers to the institutional arrangements that help the primary action group to acquire gains. Action group, be it primary or secondary, is the subject of institutional change. Primary action group is the innovator, planner and propeller 27

of institutional change whereas the secondary action group is the implementer. Institutional devices refer to the documents or means used by the action groups in the new institutional arrangement to acquire gains that are exogenous in the existing institutional arrangement. (1) General Model The most representative model of institutional change is Douglass C. North’s model. Its main contents are as follows: First, the precondition of the model: A nonequilibrium institutional structure is the precondition of institutional change. North (1981) thinks that the reason for innovation in institutional arrangement is that the potential benefits cannot be realized under the existing institutional arrangements. The actors therefore request new institutional arrangements. The precondition has it that the potential gains of the new arrangement may increase. The organizational or operational costs of the new arrangement may change. Alteration in law or politics may affect the institutional environment, making possible the redistribution or taking advantage of the existing external gain by some groups. Second, the model presupposition: A basic premise is the expectation of the potential gains through institutional change by the subject who propels the change. The potential gains are the external gains, the benefit that cannot be acquired by the subject in the existing institutional arrangement. The goal of the change is to internalize the gains existing outside the present arrangement. Third, tiers of institutional arrangement: An institutional arrangement consists of personal and organizational tiers. The latter can be further differentiated into governmental and non-governmental organizations. Fourth, time-lag in institutional change: The expected gains of the institutional innovation may become greater than the expected costs. However, due to interest conflicts and impeding factors, delays and lagging may be encountered in institutional change and innovation. North indicates the cognitive or organizational time-lag, invention time-lag, menu time-lag and initiating time-lag. Fifth, the general process of institutional innovation: Main procedures: the emergence of the primary action group → the primary action group proposes institutional innovation schemes → the primary action group makes the optimal choice among a number of new schemes with positive gains → the formation of the secondary action group → the primary and secondary action groups work together to make the scheme accepted and put in practice. 28

(2) Main models: The model of institutional change refers to the sum of form, speed, breakthrough, time path, etc, taken by the subject of institutional innovation in order to realize a goal. The forms of change can be classified as follows: First, induced or imposed change. Induced institutional change means the innovation is advocated, organized and put into practice by a single person or a group of people in response to the chance made possible by the existing institutional unbalance. Imposed change is introduced by the government’s order or promoted by law. Second, gradual or irrupting change. Gradual change refers to the mode of change in which the process is relatively balanced. The transition between the old and new institutions is smooth without causing much shock. Irrupting change implies rapidly abolishing or destroying the old institution and then formulating and implementing a new one. Third, active or passive change. Active change means some subjects take the initiative to change or innovate in respect of an existing institution out of the consideration of their own interests. Passive change refers to the process in which after some subjects have launched an institutional change, those subjects previously lacking incentive to change are under the influence or impact of the reform and forced to take the institutional change. Fourth, partial or overall change. Partial change refers to a reform taking place in one aspect or on one level independent of other institutions, or in the institution in some regions of the country independent of other regions. Overall change refers to a change in which within a certain fields of the society, various institutions are reformed in coordination. (3) Path Dependence. North believes that after an institutional change moves toward a path it may lead to a dependence on this path. The trajectory of change is mainly influenced by three factors. First, the factor of increasing gains which can be viewed as the process of self-reinforcement or positive feedback; second, the factor of incomplete market, that is to say, the existence of incomplete information and transaction cost. The subjective model of the actor will be revised by the incomplete information feedback and the ideology of the existing path. It will lead to long-lasting path dependence and dominance of undesirable institution; finally, the factor of interest. When the negotiation powers of the major political interest blocs stay relatively balanced, the social institution will be locked up in a stable state for a long time. The interest blocs will tend to secure their present 29

interests at hand and cling to path dependence. There are two extreme forms of path dependence. First, an effective institutional evolution may allow the organization under environmental uncertainty to choose to maximize the goal, conduct experiment, establish a feedback mechanism, identify and then exclude ineffective choice, protect the property rights of knowledge, resulting in long-term economic growth. Second, an institution may bring about increasing gains at the beginning. It then starts to impede the development of productive activities. In order to protect its invested interests, the interest bloc will try hard to maintain the status quo. The society is bound by ineffective institutional arrangements. (4) Principal-Agent System. This theory begins with the problem of principal and agent having divergent goals, as well as the existence of information cost between them, and the cost of supervision. Then the principal has to consider which institution to encourage the agent to reach the simultaneous optimization of each other’s utility function. The model includes two conditions. The first is the moral hazard model of hidden actions. The second is the adverse selection model of hidden knowledge. 2.2.2  The Causes of Institutional Change (1)   Transaction Cost: concept and nature. The concept of transaction cost was first proposed by Ronald H. Coase. He refers to all the costs needed for the running of an economic system. Steven Cheung defines it as the “institutional cost”; Joseph Stiglitz defines it as the increased cost when conducting transaction, including money, time, or a kind of inconvenience. Here we take the definition by E.G. Furuboton (1991) in his New Institutional Economics: transaction cost is the cost of transactional activities. Whereas production activities can be represented by a production function, transactional activity can also be analogously represented by a transaction function. The nature of transaction cost can be described in four ways. ① Transaction cost is also opportunity cost. Due to resource scarcity, people have to choose their ways of transacting. Transaction cost therefore implies opportunity cost. Given a chosen technological condition with defined expenses, in a production unit, it is still able to choose between modes of organization. Each mode entails a corresponding transaction cost. ② Transaction cost is the result of knowledge and information asymmetry between economic subjects. It is the resource wasted during interest conflicts and mediation. Economic subjects have access to unequal amounts of 30

information. Due to differences in specialization and time-space conditions, an individual will show differences in terms of knowledge and experiences. As a result, no economic subject can know completely the qualities of others’ labor and products. Nor can he or she know them without cost. The transaction cost may increase drastically because of the interest conflicts between the economic subjects, or that the differences of information, knowledge and experiences between economic subjects are taken advantage of in an opportunistic way. ③ It is impossible to eliminate transaction cost. The reason is that society has increasingly become specialized. It is impossible to completely erase the differences between individuals. In practice, people’s understandings are always different. Any measures taken can only lessen but never eliminate the differences; technological advances can only overcome to a certain extent the difficulties in human interaction across time and space. Technology can never eliminate the obstacles by time and space in transaction; moreover, economic subject is acting out of self-interest. Formal institution such as law or informal institution like customs and habits can constrain and guide individuals. Nevertheless, as long as there is resource scarcity, selfinterest will not disappear. Opportunistic acts become economically reasonable. ④ Due to the existence of probability and uncertainty in any economic activity, people can only give an estimate in assessing the types and amounts of transaction cost in a situation according to incomplete knowledge and experiences. Calculation can only be conducted in time and space. As it is impossible to evaluate all the possibilities of combinations in terms of institutional structure and technological condition of production, the transaction cost as opportunity cost is elusive and unpredictable. (Wu Shanlin 2001) (2) Analytical paradigm of transaction cost. When the concept of transaction cost is generalized, its implication is extended to the operation cost of economic system and lays the foundation of economic analysis. Classical economists did not consider the cost of market operation. New institutional economists discovered that there were costs involved in the operation of the market. The transaction cost is the operation cost of economic institutions. Applying the concept, economics therefore can explain realistic problems. In “The Nature of the Firm” and “The Problem of Social Cost” , Coase proposes what is known as the Coase Theorem, that is to say, If transaction cost is zero, then no matter how property rights is assigned, an optimal allocation of resource can be achieved through market exchange. If it is not the case, i.e., transaction cost is positive, then different assignments of property 31

rights will lead to different levels of efficiency in resource allocation. Compared with classical economics, the difference in the analysis of transaction cost lies in the variation of constraints condition. Cheung thinks that there are three basic economic propositions in the paradigm of transaction cost. First, the hypothesis of maximization under conditions of constraints; second, the downward sloping demand curve, including diminishing marginal productivity; third, cost is the highest valued choice or opportunity cost that is given up. According to Williamson (1985), the paradigm of transaction cost can be summarized as follows: the transaction constitutes the basic analyzable unit. The key to the differences in transaction costs are the frequency with which transactions recur, uncertainty and asset specificity; various general governance modes are defined by various features. Each mode contains discrete structural differences in costs and competitiveness and matches with different contractual law; the modes of correlation between transaction and governance structure varies but the common purpose is to minimize transaction costs; institutional environment is regarded as a parameter of displacement trajectory. Its variance leads to change in governance cost; comparative institutional analysis can be made between feasible available schemes. Inefficacy test on the scheme is a sort of remediation or rectification. John Groenewegen (1984) expresses the analytical paradigm in a more concise way. After the natures of transactions have been identified, the problem of which governance structure is to be adopted can be explored from the view of transaction costs minimization. Upon the simplified assumptions, the transaction and the governance structure is to be matched. Then it is to be verified by positive research. 2.2.3  The Historical Trajectory and the Causes of Rural Financial Institutional Change In regard to the history of the rural financial institution, its emergence can be traced to the 1950s when the new republic was just founded. Rural financial institution was born out of the need for rural economic institutional change. In the February of 1953, the Central Government put forth the Resolution on Agricultural Production Cooperation, in which rural cooperatives were promoted in three forms: rural credit union, agricultural production cooperative and rural supply and marketing cooperative. The agricultural production cooperative movement was rapidly pushed forward. At the end of 1954, there were totally 480 thousand agricultural production cooperatives all over the country. The number of credit 32

unions was up to 126 thousand. They were set up in 70% of townships. Under this condition, the People’s Bank of China submitted to the Central Government in the August of 1954 the Report on the Setting-Up of the Agricultural Bank of China. And the Bank was established in 1955. The emergence of rural credit unions preceded the establishment of the Agricultural Bank, in response to the needs of agricultural production cooperation. In the July of 1994, according to the State Council’s Resolution of Financial System Reform, the policy-related business and the commercial business of the Agricultural Bank were separated. In the November, the Agricultural Development Bank was set up while the Agricultural Bank of China gradually transformed into a commercial bank. After that, the three-sector financial system of China took shape, including the cooperative financial institution, the commercial financial institution and the policy-oriented financial institution, which lasts till today. The rural financial institution in China firstly took shape in the form of rural credit union. This form of credit union soon became a government-led cooperative finance institutional arrangement in the process of the conversion of the cooperatives towards the people’s communes. Its administration was managed by the Agricultural Bank of China. Till the early 1990s, credit unions were the grass-root organizations of the Agricultural Bank. Most of the savings had to be transferred to the Agricultural Bank. They represented the Bank’s grass-root agents. Their main function was to absorb savings from the peasants and circulate them through the Bank for balancing loan allocation in the country as a whole. This model continued till 1996. The credit unions were afterward managed and supervised by the People’s Bank of China. This change in the management of credit unions represents the state’s regulation and institutional arrangement in response to the demand of rural financial services. Before the emergence of the People’s Commune system, rural economic organizations were various kinds of production cooperatives. The financial institution that served these economic organizations originated from their endogenous financial needs. Credit unions became an endogenous financial institutional arrangement. Nevertheless, after the cooperative organizations were forced to transition to people’s communes, the financial organizations, in the service of the economic needs, had to transition to the communes and became the official organizations of the Agricultural Bank management. Despite the implementation of the household production system and the abolition of the people’s commune, rural credit unions have not 33

returned to the function of an endogenous cooperative finance. They became independent organizations as a category of official financial establishments, under the supervision of the People’s Bank. In essence, this institutional arrangement amounts to a government-led financial organization. Did rural cooperative finance ever exist in China? Or in what form did rural cooperative finance exist? This is a question any research on rural finance must ask. Apart from official finance, or without the support of official finance, do peasant households have access to financial products? The answer is affirmative. Officially, apart from non-interest-bearing financial products, all those forms of unregulated finance involving interest are regarded as “usury”. Strange as it may seem, this socalled “usury” has existed for a few thousand years. In terms of the supply form of financial products, all kinds of rotating savings and credit associations, pawn shops, money houses (qianzhuang), and funds were civil organizations providing supply. They were not led by the government. On the contrary, they have long been suppressed by the government. The policy since 1949 has been to ban and clampdown on such money-lending agencies. These civil organizations were mutual aid financial organizations voluntarily set up by the peasants. In terms of organizational form, they belong to endogenous cooperative financial institution. After the Reform, there once existed rural cooperative funds as non-government organizations. For a period of time (1984-1999), they were recognized and supported by the government. Although these kinds of cooperative funds had the nature of cooperative finance, most of them were dominated or directly organized by the township governments and village committees. Strictly speaking, they were not real cooperative organizations among the peasants, whether in terms of initiators or participants. For a long time, the cooperative finances that are really initiated and participated by the peasants have been under the government’s supervision or clampdown and have found it hard to survive. It can be said that there is a shortage of such institution under the present rural financial system in China. Can it be legalized? Can this institutional arrangement be permitted legally so that it can bring about innovation in rural financial system to better service the financial demand of the peasants and the rural economic development? We are going to explore these questions.


2.3  Incentive Compatible Mechanism Can an institution be operating efficiently? Can it motivate the participants to allocate resources efficiently so as to achieve the goal expected by its designers? Traditional economics is incapable of answering these questions. In recent years, the new institutional economics has made breakthroughs in this field. In 2007, Leonid Hurwicz, Eric S. Maskin and Roger B. Myerson were awarded the Nobel Prizes for Economic Sciences for their innovative contributions in mechanism design, incentive compatible mechanism and the Nash implementation of social goal. These theories can provide us with a framework to investigate how to design a rural financial institution under the household contract system to achieve the goal of incentive compatibility. 2.3.1  Mechanism Design Theory Mechanism design theory is fundamentally different from the traditional economic approach. According to Adam Smith’s assumption, the invisible hand of market can achieve the most efficient resource allocation in ideal situations. However, in the real world, the conditions are not ideal. There exist various constraints to prevent markets from functioning optimally. In a word, the market is prone to failure. Under conditions such as imperfect competition, incomplete information, externalities, public goods, increasing returns to scale and the indivisibility of commodities, etc, market mechanism may fail to achieve the most efficient resource allocation automatically. Take incomplete information as an example. We face a society of incomplete information. Nobody can completely grasp all the private information of others. In this situation, people tend to diversify their decisions. However, the information about personal preference and available production technology are controlled by numerous participants. They may tend to conceal the true information they have and maximize their personal gains by making using of private information. Considering the society as a whole, it may result in inefficiencies and waste in resource allocation. If the market mechanism is not perfect, are there other mechanisms to replace or improve it and guarantee effective resource allocation? Or more generally, given an economic environment, are there mechanisms to guarantee the realization of a social goal (usually referring to Pareto optimality)? If these mechanisms do exist, which one can achieve the goal by using less information or at a lower cost? 35

Generally an economic mechanism is judged according to three basic criteria: effective resource allocation, effective information use, and incentive compatibility. The effectiveness of resource allocation is usually assessed by the Pareto optimum; efficacious use of information implies less information cost; incentive compatibility seeks the convergence of personal rationality and collective rationality. The problem thus becomes which economic institution can satisfy the above requirements at the same time? In order to satisfy these requirements or come close to them as much as possible, how should we design the operation of an economic mechanism? Based on the mechanism design theory initiated by Hurwicz and developed by Maskin and Myerson, economists are now better equipped to answer the above questions of theoretical and practical significance. The general problem of mechanism design theory is as follows: given an economic or social goal, and under the decentralized decision-making conditions of free choice, voluntary exchange and incomplete information, how is it possible to design an economic mechanism to ensure that the personal interests of the economic activities participants cohere with the designer’s goal? This research approach and methodology is different from traditional economics, which regards the market mechanism as known and studies its mode of allocation. Mechanism design theory takes the social goal as the known, and seeks the economic mechanism capable of realizing the goal. The problem becomes one about designing a concrete game form to achieve the expected goal of allocation while allowing participants to interact with each other according to their self-interested choices of strategy, each under his or her respective constraints. The mechanism design usually involves two aspects: informational efficiency and incentive compatibility. Informational efficiency is about how much information is needed by an economic mechanism to realize the desired social goal. It relates to the problem of operation cost. A designed mechanism is expected to require less information about the consumers, producers and other participants of economic activities. That implies a lower information cost. Any design and execution of an economic mechanism requires information transmission which incurs a cost. For the institutional designer, the less the dimensions of information needed the better. Incentive compatibility is a key concept suggested by Hurwicz in 1972. His definition is as follows: given a mechanism, it is incentive compatible if the participants’ dominant strategy balance can be achieved when they truthfully reveal any private information asked for by the mechanism. In this situation, even if each participant makes his or her personal 36

goal out of self-interest, the implementation of the mechanism will result in the achievement of the goal expected by the designers. (He Dexu et. al. 2007) In the real world, information is distributed among the producers and consumers. Each of them has his or her private information. Information is therefore incomplete. In a market competition mechanism, participants are making decision separately. Each of them makes decision about production and consumption depending on the information of supply-demand available in exchange. Mechanism design theory regards economic mechanism as a process of information exchange and adjustment. In a unified model and information framework, it investigates the information cost of various economic mechanisms. Mechanism design theory believes that it is possible to judge in practice whether a mechanism is good or bad according to the size of informational dimensions of an economic mechanism. Mechanism design is a process to find the solution to realize a social goal while minimizing the information cost. For example, if the goal is to achieve Pareto optimality in resource allocation, then competitive market mechanisms can guarantee its realization. However, is the competitive market mechanism most efficient in terms of economic information? Given a neoclassical economic environment, are there other sorts of decentralized decisionmaking mechanisms capable of achieving optimal resource allocation at less information cost? In the 1970s, Hurwicz proved that in an ideal neo-classical environment of pure exchange, competitive market mechanism can achieve effective allocation by the least information. By relaxing the assumptions of neoclassical economic environment, mechanism design theory further investigates the economic mechanism of decentralized decision-making that can achieve optimal resource allocation under non neo-classical economic assumptions such as in the case of indivisible commodities and non-convex sets of preference and production functions. Hurwicz believes that an economic mechanism is a communication system in which participants exchange information. In this mechanism, each participant takes strategic action, for the maximization of expected payoff (efficacy or gains). He or she can hide the private information unfavorable to him or her if exposed, or spout misinformation. An economic mechanism functions like a machine that collects and processes the information. The rules of this communication game are defined. That is to say the machine collects information and then correspondingly produces outcomes. Generally, these outcomes are the equilibrium solutions of the 37

communication game. So the comparison of different mechanisms involves the comparison of different solutions to the communication game. 2.3.2  Incentive Compatibility In scrutinizing the classical pure exchange economy, Hurwicz discovers that in order to design an optimal mechanism for a social goal, we must list out an array of feasible mechanisms and predict the equilibrium criterion of the participants’ behavior. However, if the equilibrium criterion is the dominant strategy equilibrium, the outcome is negative. It is impossible to find a system for allocating resource which is individually incentive compatible and which yields Pareto optimality. It is known as the Hurwicz impossibility theorem. The criterion adopted, the dominant strategy equilibrium, is a strong assumption while the criterion for resource allocation is Pareto optimality. We must relax the criteria if we want to achieve a condition of incentive mechanism. The basic assumption of modern economics is that everyone subjectively pursues self-interest and acts out of it. Mechanism design theory takes this assumption one further step under the condition of incomplete information, postulating that the participants will generally tend not to reveal the information about their economic characteristics unless it is beneficial to do so. When the economic information is incomplete and it is impossible or unsuitable to directly handle, people have to make decentralized decisions for resource allocation or other economic decisions. Under this condition, the designer of institution or rules does not know all the individuals’ information, a basic principle is to make sure that the mechanism affords each participant with the incentive to maximize his or her personal interest while achieving the designer’s goal. This is the question of incentive compatibility in mechanism design theory. Specifically, let us assume that the mechanism designer (the principal) has an economic goal as the social goal, for example, the Pareto optimal allocation, the maximization of social welfare, or the goal pursued by an economic sector or enterprise. The designer must consider what mechanism or rules of the game to take to make sure that the participants take part in the game, and motivate them to realize the goal under the presupposition that they act out of self-interest. Obviously, incentive compatibility is a revealing concept. Incongruence of individual interest and social interest is the normality. It is realistic to assume that an agent will tend to conceal information about his or her economic characteristics 38

under conditions of incomplete information and the pursuit of self-interest. In many situations, telling the truth is not necessarily the dominant equilibrium strategy. When the others are telling the truth, one may take advantage of it by concealing his or her preference to manipulate the outcome. Hurwicz (1972) proves generally that in a personal economic environment, under the condition of participatory constraint (i.e. the allocation outcome is personally rational), there does not exist an effective decentralized economic mechanism(including market competition mechanism) which can result in a Pareto optimal allocation while encouraging people to reveal their true information. That is to say, it is impossible to achieve at the same time a Pareto optimal resource allocation and a truthful revelation of preferences. In mechanism design, it is therefore often necessary to give up the dominant equilibrium assumption, in order to come up with a mechanism capable of Pareto optimal allocation. And incentives must be taken into consideration in any mechanism design. Incentive compatibility thus becomes a key concept in mechanism design theory, even in modern economics. It is an unavoidable problem in practical economic design. 2.3.3  The Application of Mechanism Design Theory and Its Implication to Financial Theory Mechanism design theory allows researchers to systematically analyze and compare various institutions under less rigorous assumptions. Furthermore, it can include many existing theories, like auction theory, regulation theory, social choice theory, etc, into a unified modern analytical framework. It can also provide explanations to many real-life problems and thereby have profound influence on economic policy and market institution. As all economic mechanisms can be studied collectively in a unified model, the research objects of mechanism design theory can be as large as the general equilibrium design of economic institution as a whole, or as small as a partial equilibrium design of an economic activity. Its research range covers the planned economy, the market economy and various kinds of mixed economic mechanisms. Moreover, the “designer” refers to a variety of agents. They can be the policy makers of macro-economic policy or the designers of institutions, and also the managers or directors in a micro-economic unit. The application of mechanism design theory is therefore wide-ranging. Economic policy-making and institution design, as well as the organization and management of enterprises can also be included into a unified analytical framework. It is 39

highly valuable in explaining and applying to real-life problems. Compared with traditional theory, mechanism design theory does not merely indicate the dilemma of impossibility. Most importantly, it shows a path to get out of the dilemma. The key is to design a mechanism or rules which make the agents willing to reveal their preferences and make it possible to achieve the social goal by a mode of behavior determined by personal preferences and economic mechanism. Mechanism design theory is of equal significance in setting up an effective financial institution and organization. China’s economy is at present in a period of transformation. How can we establish a financial institution adaptable to the rural economy? Is this institution equipped with an incentive compatible mechanism? In light of the constant reform failures after endless adjustment in China’s rural financial policy since the Reform, what is an effective institution we should build in contemporary financial reform? Should the institutional supply be imposed or induced? While the standard neo-classical economics is not applicable to these questions given the specific economic environment in China, we need a unified framework and basic criteria to compare different economic mechanisms, and a general theory to judge their relative merits. Mechanism design theory is no doubt the best option in this regard. By the generalization of mechanism design theory, we come to a conclusion: because of information asymmetry and a lack of endogenous incentive compatible mechanisms, it is difficult to achieve Pareto efficiency by a government-led imposed financial institution supply. Furthermore, it has to pay a high information cost in realizing its organizational goal.


Chapter 3  Analysis of the Peasant Household Financial Needs Under the Household Contract System 3.1  Analysis of the Founding Causes and Nature of the Household Contract System In China, a rural economic institution based on the household contract responsibility system had been put into practice since the Reform. The very institution was written into the Constitution in 1999, affirming its contents as the household contract operation and the double-decked operation combining unified operations with diversified independent operations. The institution has provided incentives to and greatly motivated many peasants, bringing enormous changes to rural economic development. At the same time, the existence of this institution has also been contested by some scholars. At the beginning of its operations, some blamed it for demolishing the form of land production management under the people’s commune system. After the institution had been well established, some asserted that it has not been reformed adequately in accordance with the principles of land marketization and property rights, therefore hindering the further development of the rural market economy. This chapter aims to apply institution change theory to discuss and analyze the core contents and nature of this institution, the rural economy born out of it and its social impact. It also seeks to explore how, under the very institution, one can constitute a matching rural financial institution. 3.1.1  The Founding of the Institution of Rural Household Operation and the Double-Decked Operation and its Reason The institution of the household contract operation and the double-decked operation initially came from the household contract responsibility system, which originated in Fengyang County, Anhui Province. In October 1978, 18 peasant households from Xiaogang Village of Fengyang County signed with their finger prints a “life and death” liability contract stating the “all-round production task responsibility” for agricultural production. It concerned mainly allocating a lot of the collective land to each household. The lands formerly belonged to the collective ownership of the production brigade under the people’s commune system. Upon the contract each household agreed that they would pay fully in agricultural production what was requested by the state and would reserve enough for the collective. Then 41

what remained from their production belonged to themselves. In this way, the institution of collective production and collective distribution under the people’s commune system was disintegrated. The institutional change mainly went through three phases, briefly reviewed as follows: First Phase (1949-1978): exploration and denial of the institution. During that time the main economic institution in China was the socialist institution implemented through three major reforms. The rural agrarian reform had transited from land privatization to land cooperatives, then to higher-stage cooperatives, and eventually to the people’s commune. This phase marked the most frequent and radical changes in agrarian institutional reform. In order to consolidate the new regime, the state accelerated the process of reforming non-socialist ownership. Overtly radical policies, particularly the Great Leap Forward, caused serious problems in regard to economic development. The problem of adjusting rural agrarian institution was raised. It was considered a sensitive issue. On the one hand, in some places more and more villages left the cooperatives, or expanded their self-holding land; on the other hand, the central government attempted to readjust agricultural policies to fit the circumstances, such as its revisions of economic policies in the 1960s. Generally speaking, nevertheless, land policies in rural areas represented an institutionalized deprivation of rights through centralization by the state. This was made possible by the strict household registration system in urban and rural areas, as well as by other means. Second Phase (1979-1983): disputes surrounding the institution and its establishment. A major attempt was made during this period to practice land contract system within the people’s commune system. A benchmark event during this time was the experiment with agricultural “All-Round Production Task responsibility Contract” at Xiaogang Village of Fengyang County, which became the later household contract responsibility system. The system was initially disapproved by upper-level officials, and the People’s Daily ran a headline article expressing negative opinions about the system. In the CPC 11th Third Plenary Session that took place in December 1978, the Resolution on Some Issues Regarding Accelerating Agricultural Development (Draft) was adopted. In this document the practices of production responsibility system and quota pay system under the people’s commune system were affirmed, enabling the continuation of the practices. The rural responsibility system during the period included mainly professional subcontracting, production contracted to groups, production contracted 42

to households, etc. In September 1979, The CPC Central Committee’s Resolution on Some Issues Regarding Accelerating Agricultural Development was passed in the 11th Fourth Plenary Session. In the Resolution, the previous statement that read “land allocation for single operation is not allowed, nor production contracted to households permitted” was revised to “land allocation for single operation is not allowed, nor production contracted to households permitted, with the exception of particular needs for some sideline production as well as single, isolated households in remote, traffic-inconvenient mountainous areas.” In September 1980, the Central Committee distributed the notice Issues Regarding Further Strengthening and Improving Agricultural Responsibility System, in which it affirmed various kinds of responsibility system emerging in different places, stating “production contracted to households is allowed, so is production-task contracted to households and the practices should be maintained and stabilized for a long period.” In January 1983, the Central Committee pointed out in Viewpoints Regarding Current Rural Economic Policies that the foremost missions for current rural work were, firstly, to stabilize and improve agricultural production responsibility system, and secondly, to implement the separation of administration from business management. The household contract responsibility system which was centered on land contract operation was soon implemented throughout the country, and the people’s commune system disintegrated as a result. Third Phase (1983-present): the full implementation of the system, its improvement and consolidation. During this period, four benchmark documents and statutes have come out, confirming the status of household contract system as the definitive basic rural economic institution. In January 1984, the central government issued Notice Regarding Rural Tasks, and made it clear that the rural land contract period should generally be longer than 15 years. This is an important document recognizing the rural land contract responsibility system for its stability and long term. In November 1991, the Resolution on Further Strengthening Agricultural and Rural Tasks was passed in the CPC Central Committee’s 13th Eighth Plenary Session, in which the responsibility system based on household contract and the double-decked operation system combining unified operation with independent operation were confirmed as long-term and stabilized basic system in rural collective economic organizations. The second benchmark came out in January 1993, when the CPC Central Committee and the State Council presented Measures Regarding Current Agricultural and Rural Economic Development. This 43

document stated that the responsibility system based on household contract and the double-decked operation system are the basic economic institutions for China’s rural economy, and shall be stabilized and continuously improved for long term practice. When the contract for an arable land comes to term, it can be extended for another 30 years without change; the right to use land can be transferred to another party with proper compensation pursuant to law, for appropriate scale operations. This can be considered as the programmatic document for rural economy: it summed up years of experience in the practice of household contract responsibility system in rural areas, extended and improved upon it, and laid the foundation for the institution and policies of future work in rural areas. The third benchmark is the Law Governing Land Management in the People’s Republic of China promulgated in April 1998, which stated that for the first time “land contract in rural areas shall remain unchanged for 30 years”. This was confirmed by law, and written into the Constitution in 1999. In the 15th Third Plenary Session in October 1998, Resolution on Major Issues Regarding Agricultural and Rural Task was passed, in which the household contract responsibility system was changed to the system of household contract operation and double-decked operation combining unified operation and diversified independent operation. The main reason for which the peasants innovated and established the household contract operation system, and its later affirmation and promotion by the central government is that the system is in accordance with current productivity level, and it follows the rules of economic development. This is a typical case of induced institutional change. From the perspective of traditional economics, we may find it hard to explain how, without any change in rural production factors, the rural economy could experience tremendous development simply because of the practice of household contract responsibility system. However, new institutional economics informs us that an incentive compatible institution can change previous resource allocation relationships. When the household contract system is practiced in rural areas, even though existing development factors such as land, labor and others do not vary, the relationship of production between land and peasant household has been changed: land is freed from the former collectivized programs of collective management, collective distribution and collective operation, and entrusted to the peasant households. This is an incentive system, one based on the principal-agent system. As we trace the evolution of the land-production relationship, we see that it is itself the outcome of an induced institutional change. From the initial “production 44

task contracted to groups,” “production contracted to groups” to “production task contracted to households” and then “production contracted to households,” it eventually evolves into the practice of individual household land management linked up with the food production responsibility. Why would there be such a significant change to the land management system? The key is that this institutional change brings potential benefits to grass-root peasants. For that reason, the driving force or primary action group to push for this institutional change would no doubt be the grass root peasants. In the documentation of the central government, it is lauded as “the innovative spirits of the peasants.” But this system has to be eventually recognized by the central government—what the new institutional economics refers to as the secondary action group. 3.1.2  Analysis of the Nature of Land Institution under the Household Contract Operation System Scholars do not always agree with one another concerning the nature of the rural household contract system. Some scholars see it as an adjustment of the institution relating collective land to individuals, and others see it as a change of land institution. According to the current Land Law and Rural Land Contract Law in China, it is clearly stated that the ownership of rural land belongs to the village collective, and the peasants can contract arable plots for the term of 30 years. For this reason, the household contract system should not be seen as a change of the institution of land property rights, for no change has been made to the land propriety rights system, whether at the level of the state, the collective or the peasants. No mutual adjustments have been made to affect property rights relationship either. In this sense, what is the essential quality of the household contract system as the basic rural economic institution? Why has it gained overwhelmingly wide support from the peasant households ever since it was put into practice? In my opinion, following new institutional economics, this institutional change should be considered under the principal-agent system, and it is a virtual land institutional change without involving land property rights. The reasons for which it should be categorized as land institutional change are as follows: First of all, seen from the aspect of land use rights, the peasant households have the right to contract and use arable land for 30 years. Within this period of time, with the exception of disposition of property, the peasants have the full right to use the land in any way as long as no change of land status is involved. Secondly, from the relation between 45

land use rights and property rights, it is clear that a piece of land without use rights would not be valuable in the aspect of property rights. Thirdly, the ultimate value of land is realized through its use. Fortune is created through the use of land, and land property rights are merely the embodiment of land market value. Fourthly, that the land use right is assigned to and measured according to individual household is tantamount to the “equal land distribution” system: this is the core content of the institution, and it is the most direct representation of the peasants’ interests. The household contract system, in reality, is an act of abalienation of the collective land use rights, a land institutional change without involving property rights. It makes adjustments to the land management relationship between the peasants and the village collective; in reality it can be seen as an institutional arrangement made under the people’s commune system—an arrangement in which the peasants are entrusted with the production and management of the collective land. Since the management of the core means of production —land—were changed, the people’s communes were forced to disintegrate. The principal-agent relationship refers to the relationship established through contract between a principal and an agent acting on behalf of the principal’s interests, and the agent is authorized to make decisions for the principal accordingly. This contractual relationship is mainly one based on economic interests. Two basic points of the principal-agent theory are: first, that in any contracts with incentive mechanism that maximizes the principal’s expected utility, the agent has to take partial risk; if the agent is risk neutral, optimal incentive outcomes could be obtained when he or she is allowed to undertake full risk (Zhang Weiying et al. 1994; Hua Jinyang, 2002). The theory of incentive compatibility, proposed by the 2007 Nobel economics prize laureate Leonid Hurwicz, further develops the principal-agent theory by including information as an important factor, thus revealing why the incentive compatibility mechanism can be optimal in resource allocation. Seen from the aspect of mechanism, the household contract system is in essence an outcome of such an incentive mechanism. Under the former People’s Commune system, a non-cooperative game relationship was formed between the peasants and the collective due to information asymmetry in production operation and benefit distribution. For the peasants, who were the participants of production operations, the best strategy to cope with the situation was to “stay lazy.” Under the household contract system, the peasant households become the subjects of production operation. Both in terms of production and 46

distribution, information symmetry is achieved, which gives the peasants positive incentives. From the aspect of agency contract relationship, the “independent operation” in the household contract system means land operation right is entrusted to the peasant households, through the signing of agreements to carry out obligations; the “unified operation” in the double-decked operation means the state still maintains the original super structure servicing the rural economy, and it is a cooperative relationship between the entrusting (the principal) and the entrusted (the agent) parties. This cooperative relationship fully reflects Hurwicz’s incentive compatible relationship. From the above analysis, we can draw a quick conclusion that the institution of rural household contract operation and the double-decked operation is in essence a system arrangement centered around an incentive compatible mechanism. It is an institutional innovation based on the principal and agency agreements applied to collective land, originating at grass-roots level, arising out of the peasants’ needs, and recognized and promoted by governments at all levels. It is an induced institutional change. 3.1.3  Analysis of Economic Relationship among the Peasant Household, the Village Collective and the State Land in ancient Chinese society had always been a most sensitive issue and a great concern for all dynasties. Very often, social change started from changes in the land system. Today the issue is as poignant as ever. In his study of rural issues, Wen Tiejun and Zhu Shouyin (1996) draw the two following conclusions. First, the available arable land per capita in China is a highly scare resource. Second, the dual socio-economic structure of urban-rural divide results in serious social contradictions. At the early days of its founding, with a picturesque language, the peasants described the household contract system as being constituted by the following requirements: “pay all the state requests, reserve enough for the collective, and save the remaining for oneself,” which vividly illustrated the relationship between the State, the village collective and the peasant household. From a legal perspective, the system of household contract operation and double-decked operation as a basic rural economic institution is written into the Constitution, as an embodiment of the supreme will of the State. On the basis of this fundamental law, more precise measures of practice are presented in such laws as Land Law and Law Governing the Use of Rural Land. These laws and 47

regulations clearly define legal demands of the State regarding land use. At the same time, through the system of the double-decked operation, the service and management relationship between the super structure of the state and the peasant households is further represented. Ever since the implementation of the household contract system, the State has been adjusting its economic relationship with the village collective and the peasant household, and there are three stages for the evolving relations. First stage: the peasants were obliged to deduct from their production revenue to pay three items of levy and fee to the village administration and five items to the countytownship-level administrations for public programs. Second stage: the peasants paid agricultural tax. Third Stage: the State exempts the peasants from agricultural tax. The different institutional arrangements of benefits distribution have reflected the direct interest relationship between the State and the peasant household. When it comes to the relationship between the peasant households and the village collective, as mentioned earlier, it is a principal-agent relationship based on the production factor of land. The peasant households operate on the land for agricultural production, but the land use rights do not change: they are still in the hands of the collective. The peasant households are only given use rights for a fixed term. Pursuant to law, the collective can claim back the land when the term expires, or make rearrangements according to the collective will of villagers. Apart from land relationship, another aspect of the economic relationship between the peasants and the collective is that the peasant households are seen as economic units of the village collective. In regard to distributing diverse benefits or contributing to diverse public welfares and public expenditure costs, they share the same rights and obligations. As to the relationship between the peasant household and the state, during the people’s commune era, the peasant households were not considered production units, for the means of production belonged to the three tiers of communes, brigades, and production teams. The relationship between the State and the peasant household did not directly reflect in the interest relationship without going through the mediation of the communes and production teams. This institution not only reflected Marxian classic thinking about socialist ownership but also revealed a strong will of the state—what Justin Lin Yifu refers to as the State’s control of agricultural surplus under the strategy of developing heavy industry. For the realization of such strategic objectives, strict demographic flow control between 48

urban and rural areas was put into place; as a result, household registration system was implemented. Therefore, before the practice of household contract system, the State expropriated the benefits from the rural, and at the same time acted as the distributor. On the major issue of staple food surplus, through unified planned purchase and marketing, the State had absorbed the surplus into its treasury. In the face of the problems of food shortage in some regions, the State arranged for food relief. Ever since the practice of household contract system, whether the State has “taken more and given less” or “given more and taken less” has been a central issue. Now that peasant households are the basic production and accounting units, their production interests are dependent upon the re-distribution among the State, the collective and the individual. There are several advantages for this system. Firstly, it details rights and obligations among the State, the collective and the peasant household. The three parties are bound tightly to one another by land, and their respective rights and obligations are measured accordingly. Secondly, it reflects the incentive compatible mechanism. Since the re-distribution of the fruits of labor is no longer dominated by the people’s commune, but by laborers themselves, laborers become much more proactive in their undertakings. Thirdly, although the peasants do not have land property rights under the household contract system, they can secure their rights of operation and earnings. As a result, through grass-root induced change, institutional change occurs. Since the contract system has been put into practice, evidence has also shown that the cost of this institutional change is far less than its benefit. In spite of its enormous influence on pushing forward economic development in rural areas, this system is not without its disadvantages, and is reflected mainly in three aspects. The first and central problem is that the system is not designed to reflect the contents of property rights. It only entrusts to peasants the land as a production factor—their greatest concern—in the form of principal-agent agreement. The separation of operation rights and use rights is unsettling for the peasants, and affects their willingness for long-term investment. Secondly, due to the lack of land property rights, there is no mobility of land as production factor, and this discourages the peasant households to transform from traditional to modern agriculture. Land in turn becomes a shackle preventing the peasant from becoming a free man in the market. Thirdly, in the implementation of the institution, its exteriority is not taken into consideration; that is, there is no incentive mechanism for the supply and demand of public goods in rural areas. As a result, there have 49

been supply shortage problems for public goods in rural areas ever since the implementation. The central government realized the problems and consequently proposed to implement the double-decked operation alongside the contract system. Public goods supply can be ensured through strengthening “unified operation,” in order to fix the drawbacks of “independent operation” for a sustainable development of rural economy. From the above analysis we can draw the conclusion that be it the people’s commune system or the household contract institution, they are both the options of interest institution under the state’s will. While the people’s commune is a coerced imposition, the household contract system is an induced institutional arrangement. In both cases, the interests of the state, the collective and the peasant household are deployed in the same way, the difference being that under the people’s commune institution the State was the distributor of interests, and under the contract system the peasant households are the ones to assume the task. It means that the peasant households become extremely motivated when they can dominate the distribution. But at the same time, due to the imbalance of interest relations among the State, the collective and the peasant household under the institution, cooperative games and non-cooperative games continue to be played. 3.2  Analysis of the Peasant Household’s Economic Behavior under the Household Contract System We have discussed earlier the nature and characteristics of Chinese peasant economy, and investigations and analyses have been made particularly on the propositions of “morality,” “rationality” and “involutionary” with regard to the rural economic realities in China. In the following section, we will further analyze the economic behavioral characteristics of the peasant household as a basic production unit, under conditions of the household contract system. From this study we expect to gather information as references for the suitable rural financial institutional arrangements compatible with such economic behaviors. 3.2.1  Analysis of Family Functions Family analysis has been the domain of sociology, rarely of economics. Neoclassical economists equate family behavior to individual behavior; they investigate only family income and expenditure, not other family activities. In so doing they 50

in fact annul the economic analysis of the family institution and family behavior. Traditional socialist economists centered on the State and government behavior. Not only was the economic analysis of individual behavior neglected, the studies of family institution and family behavior were also ignored. This is to say that in both orthodox economics, there is not much space left for family analysis. Since the 1970s, Gary Becker has published a series of influential papers and works, applying the methodology of economics to family analysis. He made some breakthrough in traditional economics and become an important founder of family economics. In his family theory framework, Becker sees family as an enterprise, with the goal of pursuing family efficiency and maximum production—a similarity he shares with the “Schultz-Popkin” proposition of the rational peasant, in the way that much emphasis is put on individualism and the maximization of family benefit. Becker’s theories are not flawless, nevertheless, and he fails to explain or does not explain some issues concerning the family, particularly family life as a unique and important aspect of human social economic life. For instance, the status and function of family as well as family behavior would differ among Eastern and Western societies, and Becker’s explanation of differences in different stages of social and economic development is obviously far from satisfying. To take another example, Becker insists on the hypothesis of the behavior for maximization, and extends the maximization of benefit to that of utility, and uses it to explain problems about the “marriage market” and “family production.” His explanation would seem superficial in some aspects, for it lacks a basic framework of benefit structure analysis and individual differences, to such an extent as to compare family behavior in human society to animal behavior. Despite the drawbacks of Becker’s family studies, he provides a useful theoretical perspective for our analysis of family economic behavior. Since the household contract system has been in practice in China, the family has occupied the central place in the peasant economy, as an independent two-in-one production and consumption unit. Family functions can be explored from the following three aspects: (1) Survival Function: whether in traditional or modern Chinese society, survival is the foremost priority. We can readily demonstrate this when we trace the factors responsible for originating the household contract system, which was established by 18 peasants of Xiaogang Village, Fengyang County, Anhui Province in 1978. Working under the people’s commune system, their survival was threatened when famine came as a result of food shortage. To live through the 51

crisis, they distributed collective land to each household, using their finger prints to authenticate the transactions and risked the political danger of capital punishment or life in prison. The act catalyzed a great change in China’s rural economy. The core content of this institution was to free the essential production factor of land from collective control, through a principal-agent agreement, and granted land use rights to peasant households. The land that Chinese families have depended upon for the guarantee of their survival for thousands of years was once again “returned” to them through system reform. Even though the peasant households do not get full property rights, they do possess actual land operation rights, and can fully dispose of the assets derived from the land. This is the fundamental reason why the peasant households embrace and support this policy. As to how effective the system has been, hundreds of millions of peasant households are able to meet the goal of being self-sufficient in food production, through independent land operations. It solves once and for all the problems of food and clothing that have plagued the People’s Republic for many years since the founding. (2) Security Function: ever since the implementation of the household contract system, the rural economy has not yet found its way to develop sustainably beyond the initial goal of staying warm and fed; on the contrary, the serious tripartite agrarian problem has emerged. Many scholars have explored and studied this issue. Wen Tiejun observes that the emergence of such problem results from: First, the constraint in the country’s fundamental realities, i.e., arable land is a highly scarce resource in relation to the size of the population. This in turn causes a constraint: the welfare function of the peasants that arable land has to bear is far more than its production function. Second, the institutional conflicts, i.e., the binary socioeconomic structure of urban-rural divide. What interests us here is the fact that this observation basically goes with the functional needs of family. In traditional culture, Chinese families respect elders and cherish youngsters, praise filial piety, and pursue the harmony and equality of family members. It is a basic principle for families to commit to sharing good moments together and persevering together in bad times. This is drastically different from the individualist, opportunist, risk taking and innovation pursuing culture in Western families. Even when today’s China started the process of marketization, family culture did not change, and marketization has only worked on the changing exterior environment of living. Within the peasant households, all risks taken to pursue profits are not only unacceptable for the family, but also rejected by village culture. In addition to the 52

impact of the cultural bond, another important factor is the social security system in rural regions. As rural family members cannot enjoy the same benefits that city residents have with endowment insurance, unemployment insurance, medical insurance etc., the family has to assume responsibility for such contingencies and be the caretaker for the living, the elderly, the sick, and the deceased. To minimize these assurance costs, families have to be risk averse. This is why peasant households cannot break through the bottleneck to transform from inefficient traditional agriculture to high-return modern agriculture, even after the implementation of household contract system. (3) Development Function: under the premise of satisfying survival and security functions, peasant households in China do not give up the pursuit of development but on the condition that this will not jeopardize their survival and security. This development function is based on the objective of family needs, and it includes mainly pressure from family welfare assurances, pressure from inelastic family overhead expenses, and pressure from family’s adapting to changed living conditions. In regard to pressure from inelastic family welfare assurances, without the guarantee of income growth and regular savings, such issues of birth and old age, illness and death cannot be resolved. Similarly, without income guarantee, inelastic family overhead expenses such as education, wedding and funeral, village-style betrothal gifts, expenses in accordance with rural rites and customs, ‘face’-based consumption, etc. cannot be afforded, and family survival would be endangered. The above issues show how development follows traditional family culture. Today as the rural economy is transforming, new changes are taking place due to development brought about by market competition. Peasant households compare and compete because of the development and changes of neighborhoods, and a new social phenomenon appears. Some researchers call it “effect of imitation.” This effect can explain why in some rural areas the phenomenon of economic imbalance emerges. Apart from the needs of survival and security that might constrain the functioning of family development, other crucial conditions, i.e., development factors, are needed and in the case of peasant economy, they are labor and capital. Therefore rural credit as one major means to the formation of rural capital plays a direct and decisive role for the development function of rural families.


3.2.2  Analysis of Income Behavior Since the implementation of the household contract system in China, peasant income has greatly increased, especially during the first 10 years of its practice. In the 1990s, peasant income ceased to grow, and remained at the same level. It is beyond the scope of this book to analyze the causes from a macroscopic perspective. Rather, through investigation into the precise composition of peasant income, we might be able to formulate some general rules showing how the peasant households obtain family revenues.


Agricultural Production Income (RMB)

Non-Agricultural Production Income (RMB)

Family Agricultural Operation Income (RMB)
















































































































































































1144.8 3 76.15










1479.4 9 98.25































































































































Family-Operated Secondary/ Tertiary Industry Income (RMB)

Non-Production Net Income (RMB)



Family-Operated Secondary/ Tertiary Industry Income (RMB)

Net Income by production (RMB)



Wage Income (RMB)



Transfer and Property Income (RMB)


Family Operation Net Income (RMB)

Table 3-2-1 Composition of Farmer Income in China(1978—2006)  

Data Source: Compilation of related data from China Statistical Yearbook of previous years 55

From the above Chart 3-2-1, we can see that the composition of peasant income has transformed from one based mainly on agricultural income to multiplesources of income. Family operation net income, agricultural production income and family agricultural operation income have always been the major sources contributing to Chinese peasants’ average net income, but their growth rate is far lower than the growth rate of average peasant net income. Non-production income, transfer and property income have always occupied a lower percentage in average net income, so their function of increasing peasant income is not evident. Wage income, non-agricultural production income, family non-agricultural income and family operated non-agricultural industry income do not occupy the majority of average income, but it is evident that they have contributed to income growth. Through analysis, we see that the importance of family operation is decreasing, due to its connection to the agricultural sector. Family-operated non-agricultural industry income, wage income and non-agricultural production income therefore become the major sources for income growth in peasant households. 3.2.3  Analysis of Consumption Behavior In regard to farmer household consumption, the author once conducted a “Survey on Thousands of Peasant Households Building New Villages” in Fengyang County, Anhui Province. The result shows that the peasant households list their consumption priority in the order of: education, house construction, wedding and funeral. According to what we get from their annual consumption priorities, we can categorize the consumption behavior into four kinds: survival consumption (clothing, food, housing, transportation), assurance consumption (birth and old age, sickness and death), consumption about face (wedding and funeral) and development consumption (children’s education). The analysis shows that for the peasant households, the two former categories are important family expense categories no matter how much the family income might be, and we call it inelastic consumption. Ever since the practice of household contract system, basic food and clothing issues have been solved, and beyond that point, housing became the biggest expenditure item, for it is what distinguishes rich peasant families from poor ones, or a benchmark indicating revenue differences. No matter how rich or poor the family is, the peasants would mostly see housing expenditure as their major consumption item. It has something to do with satisfying the need for higher life quality, and it also has a direct connection with traditional 56

rural culture’s emphasis on “house gate and standing” and the rural customs that good houses bring vigorous offspring and prosperity. The second inelastic consumption item is for medical care. Before the implementation of the new cooperative medical and healthcare system, 70% of peasant households fell into poverty after spending on medical treatment (survey and research data of 2005). Once there was a serious illness issue, the peasant households had to use family savings to deal with medical expenses, and if all savings proved not enough, they turned to informal finance for aid. If this was still not enough, the peasants could only give up medical treatment. Some poor farmer families would rely on folk recipes or herbs, or even witchcraft to stay alive, if they did not have money to consult doctors. The third and fourth categories of consumption are called elastic consumption: they are very common in rural areas, yet they are considered more elastic compared to inelastic consumption; that is, if elastic consumption conflicts with inelastic consumption, the former will be reduced to make room for the latter. To take a closer look, the consumption undertaken to maintain one’s ‘face’ is quite a unique form of cultural consumption in rural areas, and the wealth of a family and its rural social standing are mainly expressed through these kinds of consumption. In wedding and funeral consumption, the capacity to spend can make families distinctive: the richer the family, the more emphasis they put on conspicuous consumption. Even poor families cannot reject it. Having to count between “face” and consumption costs, some poor families would rather borrow money to save “face.” Development consumption usually involves long terms, mainly including children’s education, career training, etc. As this kind of consumption takes a long time with uncertain investment returns, different families hold different attitude towards it. Before the State implemented the 9-year obligatory education system, some poor families would reduce such spending, and the children would have to drop out of school. After the implementation, some poor families still stopped children from continuing with school after they had finished the 9 obligatory years. Many students actually obtained admissions from technical schools or universities, but they had to give up advanced studies for the families could not afford their education. Some families see children’s education as an excessive expenditure. Since jobs do not come easily to college and university graduates and non-graduate positions elsewhere might pay just as well, they tend to opt for short-term profits as a better strategy for the family behavior game. From the above peasant household consumption analysis, we see that apart 57

from development consumption, all three other consumption categories cannot bring expected future benefits to the family. Still, peasant households cannot avoid such consumption, especially inelastic consumption. In the event that households cannot afford to pay for their consumption needs, what concerns us here is the fact that they would have to increase debts to resolve the issue. These debts are in reality the rural financial issues we are studying; that is, the institutional supply options the peasant households have in order to meet their financing needs. In formal finance, to obtain expected profits with adequate risk management is the basic operation model, but for peasant households, the expected return for consumption is not always projected. Family consumption financing apparently is not compatible with rural formal finance. 3.2.4  Analysis of Investment Behavior What we designate as investment here concerns economic behavior of peasant household’s autonomous decision to invest capital and production means for production operation in exchange for material gains. Since the practice of household contract system began, peasant households have become independent investment subjects. In the past they took instructions from the collective for planned production, and now the decision is completely theirs for their individual production operation. At this stage, due to the lower level of marketization in the rural economy, where there is virtually no economic investment option, peasant households mostly invest in traditional agricultural production, including crop farming and breeding, with very few peasant households starting to operate in secondary and tertiary industries. To facilitate investigation and analysis, we take as criteria the investment scale and production cycle of peasant households. In this way, we classify the production operation behavior of households as either simple reproduction or expanded reproduction. (1) Simple reproduction: simple reproduction of peasant household refers to seasonal production operations of traditional agriculture. According to the author’s long-term investigation in rural areas, the major investment of peasant households in expanding reproduction includes seed, chemical fertilizer, pesticide, plastic film mulch, poultry fodder, greenhouse tent with iron frame, farm cattle, agricultural tools, etc. This kind of investment has the following characteristics. First: shorter cycles, generally one season, the longest being one to two years. Second: Higher security. Third: lower costs. Barring factors beyond human control such as the 58

climate, natural catastrophe, etc., the peasant households are generally quite skillful in managing the investment; particularly in traditional food production, they have already achieved the objective of maximized investment marginal benefit. For instance, food production yields have been growing at a steady pace since the practice of the household contract system in 1978. But the return rate for such a simple investment is low. In 2006, we conducted an investigation in Fengyang County of Anhui Province, calculating the output effectiveness for crop farming of wheat and rice per acre as shown in Chart 3-2-2: Table 3-2-2 Output Effectiveness per Acre Land of Wheat, Rice Unit: RMB Species (per acre) Seed

Chemical Fertilizer


Transportation Processing

Revenue(Labor Costs Not Included)













Why would such inefficient simple re-investment become the main production mode for peasant households? We need to study this carefully. We draw a simple conclusion from the field trips: the lack of market risk. When the households select investment modes for production operations, they are more inclined to control risks than to pursue profits. Especially after the state gives subsidies for staple food farming, the peasants are further encouraged to engage in such an inefficient investment behavior. There are two factors with direct impact on their investment psychology that explains why peasants prefer traditional agriculture to high-profit enterprises: foremost among them are the lower investment costs. Compared to costs of investing in modern agriculture and secondary or tertiary industry, peasant households tend to choose those that minimize loss value. Secondly, in terms of investment feasibility, the difficulty to raise investment capital is another major issue. Without outside sources for financing, the peasants often find themselves deciding upon simple reproduction after assessing their own conditions. The first issue most households encounter after making a breakthrough in traditional industry investment is the problem of having insufficient capital. If formal finance cannot help them solve the problem, the peasants can only turn to risky and usurious loans, which is often contradictory to the security function of the family. Many families therefore abandon risky investments and resort to simple reproduction repeatedly. (2) Expanded reproduction. It refers mainly to modern agriculture or 59

secondary and tertiary industries that peasant households undertake, with expanded investment scales, longer production cycles, and higher investment costs. Those households engaging in expanded reproduction are often called wealthy households such as crop farming wealthy household, breeding wealthy household, corporate (factory) wealthy household, etc. Even when these households choose to undertake traditional agricultural activities, their investment is often the multiplication of simple reproduction in terms of scale and production technology, and production benefits are obviously higher. Still, wealthy households face financing pressure when they invest. How these wealthy households emerge, and why they can break through the bottleneck of financing—these are key issues concerning expanded reproduction in rural areas. According to information gathered from field trips and surveys in rural areas, there are mainly three kinds of wealthy households. First, they have accumulated considerable savings to start enterprises, from their previous jobs in other places. Second, they can find financing guarantors within family circles. Third, they have special support from the local government. After all, such peasant households that meet the above qualifications to engage in expanded reproduction are far from numerous. Through the analysis of their investment behavior, we observe that for a long time, an enormous number of rural households stay at the level of repeating simple reproduction, refraining from expanded reproduction due to the interior factor of the family’s risk-averse inclination, and the exterior factor of capital financing constraints. If this issue remains unresolved for a long time, there is little chance that we will see further growth of peasant incomes, agricultural development, and economic prosperity in rural areas. Or worse, the tripartite agrarian issues might follow a downward spiral turn, and the objective of new rural reconstruction eventually may become as empty as “armchair strategy.” 3.3  Analysis of Peasant Household Saving Behavior under the Household Contract System 3.3.1  Saving Need Saving is a universal need for the peasants. With the practice of land contract system in rural areas, basic food and clothing issues have been solved, and more and more rural families start to have monetary saving. Unlike urban residents, the peasants generally do not hold savings in the form of bonds, stocks and other 60

financial products, but in cash. According to the “Investigation on Thousands of Peasant Households” of Fengyang County, over one half of the households put their main savings in post offices, and the remaining in credit unions, savings station of the Agricultural Bank, and at home. This type of deposit preference is determined largely by convenience; for those who put their money at home, they are used to having access at any time. Very few peasants care much about higher or lower interest rates in formal financial institutions; wherever they deposit their savings— in post offices or credit unions—it is more about the convenience of depositing and withdrawing. Some wealthy households that undertake secondary, tertiary industry or breeding would provide high-interest rates——from the monthly rate of 0.8% to as high as 40% ——to attract deposits, as a way to raise funds from private savings. The peasants who put in their savings know well about the risk of such high interest rates. On the one hand, they are seduced by higher rates, and on the other they might be forced by the particular conditions of rural areas. Each year, there are considerable disputes resulting from such high-interest-induced savings introduced by a handful of wealthy households. Since wealthy households still find it hard to finance, they have to raise capital from the unregulated financial sector, apart from regulated financial institutions. As for the peasants, since they do not have feasible rural financial products to invest in, putting capital into the hands of wealthy households is a way to invest their savings. For the peasants, saving function is a preferred choice from the perspective of investment. The basic principle of rural families is to save whenever they can, in case of future contingencies. This type of saving is compatible with the theory of peasant saving as a protective mechanism, i.e., the consumption-saving nexus. Given an income generating process, because of inherent structural uncertainty, the family may deliberately reserve a considerable part of the resource as a way to cope with unexpected adverse situations. The resource has to be easily transformable into a form of consumption or investment (Cao Heping, 2002). 3.3.2  Saving Motive Analysis The saving motive refers to the reasons for which a person saves money instead of spending, i.e., the objective or goal of saving, and it determines a person’s saving behavior. John Maynard Keynes gives very vivid descriptions regarding the propensity to save. According to him, there are eight motives that people refrain from spending: precaution, foresight, calculation, improvement, 61

independence, enterprise, pride and avarice. Keynes further explains the saving motives: precaution—to build up a reserve against unforeseen contingencies; foresight—to provide for an anticipated future need; calculation—to enjoy interest and appreciation; improvement—to enjoy a gradually increasing expenditure; independence—to enjoy a sense of independence and the power to do things; enterprise—to secure a masse de manoeuvre to carry out speculative or business projects; pride—to bequeath a fortune; avarice—to satisfy pure miserliness, i.e. unreasonable but insistent inhibitions against acts of expenditure as such. According to studies in China, those with lower incomes have a greater propensity to save than those with higher incomes. Although the total amount of savings deposits for the former is far less than the latter (the fact that the majority of savings amount in China is concentrated in the hands of the privileged 20% of the population is a statement), the former can be counted as “firm savers,” for they continue to put money into banks, and their saving behavior is much more stable than the latter. Because of this, interest rate adjustments will have different impacts on them: generally, higher interest rates mobilize saving motives of high-income earners, and they put more money into banks; lower interest rates discourage highincome earners from saving, and they tend to withdraw savings and turn to more profitable investment such as stocks, futures, etc. No matter how interest rates fluctuate, the saving behavior of low-income earners seldom undergoes visible changes. This is because they hold only limited amounts of money, and they also hold different saving motives from high-income earners. For low-income earners, the main objective for saving is not for interest and appreciation, but as “nonproductive saving” for protection in case of needs in current and future daily life. In the lower stage for economic development, saving behavior is only a kind of “surplus” behavior after consumption. What remains after consumption is put into saving; in other words, it is neither deliberate saving nor excessive spending, or an act out of the fine virtue of thrift, i.e., saving for saving’s sake, which may therefore be termed “passive saving.” Under such conditions, it is impossible to attach a clear objective or motive for saving. As a depositor’s monetary income grows, the surplus after paying for consumption expenditure increases more and more. It is no longer an extra sum without importance, and it might play an important role in improving the life to come. At this time, the depositor no longer adopts a passive attitude towards the money, but actively plans for its usage. At the same time, saving behavior no longer means the surplus behavior after consumption 62

behavior. Rather, saving and consumption proceed simultaneously, meaning saving is planned for with a clear objective from the beginning. This planned saving is called “active saving.” As to the current saving conditions in China’s rural areas, the peasants’ objectives for saving are crucial to defining their saving behavior as passive or active. As the peasant households are responsible for survival, security protection and development functions, those that satisfy the needs for survival and protection belong to the category of passive saving, while those that meet the goal of development are considered active saving. It is hardly surprising that for a long time, the peasants have always had a preference for saving. Traditional rural culture shows that saving-inclined peasant households usually get more respect in the villages. Being seen as decent families observing a duty, they usually have a good reputation in villages. Saving is, as such, beyond rational conception, completely different from the attributes of Western investors. Focusing our investigation on the general contents of saving motives, we observe a developing process from low to high levels, categorized into six stages: First Stage: the saving motive is saving itself, without any particular objective. It is a sort of unintentional saving. Second Stage: assurance motive. The saving intends to provide life guarantee to cope with unexpected troubles and old age. Before old age, or in the absence of contingencies, the savings for this purpose will usually not be used. However, as the aim is not specific and certain, this kind of saving motive is relatively weaker and more arbitrary. The amount can vary. Third Stage: to provide for children and the elderly. The motive is clearer than in the previous stage, but it generally will not happen within the near future. Since the saving will not be used in the near future, saving time can thus be delayed; it in turn weakens the saving motive. Fourth Stage: wedding and funeral motive. There is generally a clear deadline here for saving with urgent needs. The saving of this kind therefore has a stronger motive, being the central issue to be solved within a family. Usually the whole family will be mobilized to save as much as possible (it is especially evident in average families in towns and rural areas). Fifth Stage: motive to improve life. Only can the saving motive of a family reach this stage after satisfying all the needs of previous stages. Generally money is used in the purchase of durable appliances, and improving housing conditions. 63

Once this stage is attained, the saving motive is perceivably intensified. Sixth Stage: profit motive. If there is still surplus after a person’s income surplus is used to satisfy various needs of previous stages, the saving motive is no longer limited to consumption only. Income will be capitalized to gain profit, such as investment in bonds, stocks, or saving in banks with higher profitability. In China, quite a number of people have developed their saving motive to this stage. This of course is an outcome of development and prosperity of China’s financial market, enabling people to have more investment options. Focusing our investigation on individual families, we see that in China, considerable families are still in the first or second stage, mainly those in the Western region and rural areas. The few families reaching the fifth or sixth stage are mostly in coastal and economically developed areas. According to Economic Research Data, 31.1% of urban residents save money to provide for children and the elderly; 31.0% save money for family members’ weddings and funerals; 22.1% save money to purchase high-end, durable consumption items. The three account for a total of 84.2% of all samples. In rural families in the vast Central and Western regions, the first two family consumption needs are far higher than urban residents. Saving just to survive is the main objective for peasant household saving. 3.3.3  Savings Establishment Options Rural savings deposit is a form of credit activity in which peasant households place temporarily idle currencies into savings establishments. The rural financial system in China includes policy-supported financial establishments, commercial financial establishments, cooperative financial establishments and [informal] folk finance. Many sub-county-level branches of commercial financial establishments are retreating from rural areas where the effects for economies of scale cannot be achieved, and rural credit unions become the major establishment dealing with the saving issues. The design of a new financial system in rural areas is, to a certain extent, meant to absorb some saving pressure, such as the setting up of establishments like village-township banks and Postal Savings Bank. Surveys on households saving conducted in Fengyang County of Anhui Province show that deposit convenience remains the main factor affecting peasants’ choice of savings institutions: the closer the establishment is from home, the more preferable. In rural areas, establishments currently providing better savings facilities are the following: postal savings branches are ranked as top choice, followed by rural credit unions, 64

with commercial banks located in the streets of towns and cities in the third place. 3.4  Analysis of Peasant Household Loan Behavior under the Household Contract System 3.4.1  Consumer Credit Consumer credit offered to peasant households is mainly based upon their consumption needs. We analyzed earlier the consumption behavior of peasant households—survival, security, ‘face’-related, development—and drew the conclusion that such consumption hardly accrued any expected returns. Therefore, as far as formal financial institutions are concerned, these forms of consumption do not meet credit requirements. If no credit security is given to these types of consumption, particularly the previous two, peasant households might see themselves ruined. The reason why informal finance can prosper at all times— even usury cannot be eliminated despite all effort—is that it provides a financial product that regulated finance cannot: unsecured consumer credit. We need to give further thought to why unsecured finance can exist. If risk control is a tricky issue with collateral loans, then how much less are we able to control risk without the security of collateral? This sort of fund flow is quite a revelation for financial institutional innovation, and its credit mechanism is what we will be putting emphasis on and analyzing in the later parts of the book. We often hear remarks from governmental financial supervisory authorities condemning the evil of usury, but it is often usurious loans that serve as the only means for peasant household’s to fulfill their inelastic consumption. Just imagine, while formal finance does not provide such loans and the government attempts to strike down informal financial channels making such offers, the peasant households would no doubt have few options, given that these measures are taken to meet legal formalities but not their practical realities. Now, consumer credit for development has caught the attention of the formal financial sector, and through programs of advanced studies student loans are offered to aid those from poor families——but this is only for college and university students, and millions of peasant households still see their needs for financing development consumption unfulfilled. When the State does not provide for sufficient rural social insurance, we can hardly count on the peasant households to deal with issues of clothing and food, housing and transportation, birth and old age, illness and death without financial support. Strictly speaking, 65

this kind of social program should be sponsored by the state, otherwise it would be hard for peasant households to move towards a market economy since their family functions are restrained, according to James Scott’s “morality” proposition. Ever since the practice of the household contract system in China began, rural economic development has never made the leap out of traditional agriculture. We see what “a thrilling leap” it is for the rural economy, and the gap cannot be crossed without a sound social insurance system or credit support from the formal finance sector. 3.4.2  Production Credit Production credit is the credit behavior of peasant households for investment in economic development and production, including credit demand and supply of simple reproduction and expanded reproduction we mentioned earlier. Generally peasant households are seldom afforded with credit in the process of simple reproduction. Ever since the Reform, peasant households have, through contracted land operations, solved the erstwhile problem of food and clothing shortages. After fulfilling the annual obligation for the State and the collective (from the levies and fees to the agricultural tax), and after providing for themselves, the peasant households still have some surplus, which can be used in simple reproduction of the next cycle. In agricultural production, for example, the need for a new cycle of simple reproduction involves mainly buying seed, chemical fertilizer, pesticide, etc. These can be arranged after selling their grains, if no sudden outbreak of natural disaster gets in the way. Expanded reproduction is a goal that most peasant households find hard to accomplish on their own, nevertheless. To invest in production of scale, they have to borrow money to obtain the means of production such as machines, diesel, small irrigation devices, etc., and even hire a certain number of workers. By the peasants’ economic level, we can divide them into four groups: traditional peasants, households of modern agriculture, households involved in concurrent occupations, and industrial and commercial farmers. Nowadays more and more peasant households have started running sideline businesses, and some traditional peasant households have gradually been transformed into households operating modern agriculture of scale. Meanwhile, some others who had previously worked as migrant workers and accumulated some savings as well as skills have started to develop secondary and tertiary industries. These peasant households have stronger needs for credit loans. 66

3.4.3  Need for Agricultural Insurance Agricultural insurance has the social benefit of diversifying agricultural risks, stabilizing peasant income, balancing income redistribution, etc., and is an important means to improve socio-economic well-being. Due to the specificity of agricultural production, peasant households are constantly confronted by two kinds of risks. The first is natural disaster. It is a factor beyond human control, and the result is often destructive for agricultural production. The second risk is the overfluctuation of market prices. Big fluctuations will result in agricultural production loss, particularly losses in expanded reproduction with larger investment. “Poor harvest precedes a year of poverty.” Whatever has caused the loss, it is equally devastating for peasant households. From ancient times, agriculture and rural economy could only thrive on following the natural order of saving in good years for bad years. How do we solve the problem through a regular institutional supply of insurance, and advance the peasant households within the same year what is going to be “saved in future good years for bad years?” This is a bottleneck to break through, as the issue has been restraining the peasants from the development of modern agriculture and the practice of expanded reproduction. 3.5  Analysis of Conditions Constraining Peasant Household’s Financial Need under the Household Contract System 3.5.1  Credit Constraint In regard to credit arrangement, formal financial institutions have exerted a rigid contract constraint as the presupposition—commercial credit. This constraint is fatal for the peasant households, for what satisfies the demand of commercial credit is hard to achieve for common peasants. The reason for this arrangement is not attributed to the peasants themselves, but to the fact that the State does not endow the peasants with core commercial property rights—real estate and land property rights. Studies from Justin Lin Yifu and others (1998) have shown that, compared with other less developed countries, commercialized informal credit transactions occur less in rural areas of China. One of the reasons is that the status of private lenders has never been recognised by law; as mentioned earlier, in most cases they are considered illegal. Another reason is that most peasants do not have property as collateral, as land contract transfers are still not permitted by the government. As we have been repeatedly emphasizing, the characteristics of the 67

Chinese rural economy make it impossible for private financial arrangements to become a common phenomenon in rural areas, or, to put it another way, the Chinese family economy cannot afford what it takes for commercial agricultural credit arrangement. Theoretically speaking, the agricultural operation modes compatible with private rural credit arrangements should be those of business operations, not household operations for survival and security. Hence, the credit demand of Chinese peasants in the long run will still follow this order mentioned earlier: First, they increase available household liquid fund through non-agricultural revenue. Second, they borrow from friends and relatives or get financial loan aid from the State. Lastly, they have to resort to usurious loan as the final recourse. Standardized commercial agricultural loan remains for most Chinese farmers an institutional arrangement that they aspire to but cannot reach. Under such circumstances, the author agrees somewhat with Li Jiange (2003), who observes that in some poor regions in China, cash flow and economic benefits generated through economic activities cannot support the operation of any commercial financial institutions. He concludes that the capital needs of the peasants in these areas can only be met through policy-supported financial institutions. Here, he rightly points out half of the problem but his conclusion is not totally correct: apart from the commercial system, there is not only the policy-supported financial system, but also cooperative finance. The latter is an endogenous institution that is even more compatible with the rural economic institution. I will elaborate on this later. As to conditions unfavorable for the peasants in regard to land systems (propriety rights) and secured agricultural loans, they have not been recognized by commercial banks. But if we look back at historical evolutions in China over the centuries and examine the multiple connotations the land possesses, we see that it is not very often that peasant households would use their land as collateral even if they could. Actually, once peasant income increases, usurious activities would decrease accordingly. And old-fashioned (non-interest-bearing) loans between friends and relatives are becoming more and more interest-bearing. With the growth of their income, the so-called “costs to save face” (Zhang Jie, 2001) will increase, and the peasant households tend to seek financial aid from some other agricultural credit institutional arrangement with the advantage of anonymity. Under such conditions, the higher interest rate paid can be considered as redeeming with currency the “costs to save face.” We can therefore expect to see the appearance of a certain endogenous financial institutional arrangement with characteristics specific to 68

the Chinese rural society, creating a win-win situation between the game of cash transaction costs and costs to save face. This could be a cooperative institution mediating a cooperative relationship between peasant households in terms of circulating resources and mutual funding to meet the needs of production and financing. The core value of the system is to recognize an informal form of credit— rural cultural ethics, which will replace the formal credit form recognized by regulated commercial banks—collateral of liquid property. However, governmental preferences have it that formal financial institutions tend to exclude informal finance, impeding endogenous financial institutional arrangement and supply. Thus the potential credit of peasant households still cannot function at this stage. 3.5.2  Institutional Constraint Institutional constraints refer to legal issues affecting the peasant households’ access to finance. Rural financial institutions are usually divided into formal finance and informal finance, also called “official” finance and “folk” finance in China. The former is legal and protected by law, while the latter is neither based on nor protected by law. (1) Formal Financial Institutional Supply: ever since the implementation of the household contract system in 1978, rural finance in China has been through numerous reforms. The current formal financial supply system includes mainly rural credit unions, the Agricultural Bank, the Agricultural Development Bank and rural savings service offered by postal savings branches. ① Rural Credit Union: the nature of rural credit unions is to act as a peasant cooperative financial institution, according to its founding and reform missions. It is responsible for servicing the “tripartite agrarian sectors” (san nong) and meeting the diverse financial needs of peasant households and rural areas in a direct fashion, and places itself on the forefront of the rural financial market. When it comes to the nature of its founding, the rural credit union is a financial institution recognized by the government, with the peasants as the subjects, operating in a cooperative way. As to its function, the rural credit union serves mainly the san nong and the main clients would be millions of rural households. Nevertheless, during the process of its founding and operation, the rural credit union actually follows a path of multiple-objective games. Since the Reform, credit unions have been going through the following paths Under the guidance of the central government: recovering the “three natures” (populous nature in 69

organization, democratic nature in governance, flexible nature in operation) and de-linking itself from the Agricultural Bank; enhancing operation autonomy and expanding management authority; boosting economic survival capabilities; reformalizing in accordance with principles of the cooperative system; strengthening the function to serve the tripartite agrarian sectors. In the evolution, the rural credit union system is aimed to better serve rural finance. But in terms of ownership, it does not follow the actual cooperative system, and despite numerous reforms it still fails to service the san nong as the government has commissioned. Rural credit union therefore finds itself stranded between the dilemma of being inclined towards marketized operations and persisting with the cooperative system (He Guangwen, 2005). ② The Agricultural Bank: Being the biggest agriculture-related commercial bank as well as the biggest bank at county level, the Agricultural Bank has great influence on rural economic development, and its development can be divided into three stages. Before the commercialization reform in 1994, the Agricultural Bank served as the major force of rural finance: it took charge of the management of credit unions, as well as the functioning of rural marketization and policy-supported finance. The peasants could deal directly with the Bank, whose savings branches were everywhere in rural areas—not only the major financial establishments for peasant savings, but also the major channel for peasant households to get loans. During this stage, the Agricultural Bank exercised positive influence on rural economic development. However, these functions and effects, nevertheless, were based on the support of State policies, and did not involve any performance assessment, competition, or market mechanism. After the commercialization reform in 1994, the Agricultural Bank has adopted the strategy to retreat from rural areas. Thus the peasant households, formerly its most important clients, have been abandoned as a result. Currently, the Agricultural Bank is oriented itself to serve the san nong while retaining their commercial operations. The double criteria under the new market strategic positioning require the Bank to timely adjust and improve the allocation of county-level establishments and human resources, for better functioning of the Bank as the chief financial channel and the san nong service provider. ③ The Agricultural Development Bank: ever since its founding in 1994, the Agricultural Development Bank has been China’s only policy-oriented bank in the rural financial domain. According to the central government’s positioning 70

of its functions and competencies, the Bank’s main missions are to take as its basis the state’s credit to raise funds for policy-supported agricultural financing, undertake operations of state-designated agricultural policy finance, take charge of allocating revenue-related fund supporting the rural sectors on behalf of the governments, and serve agriculture and rural economy, pursuant to the state laws, regulations, guidelines and policies. From its past roles of giving support to poor rural areas, undertaking comprehensive agricultural development and providing loans to food and cotton processing enterprises, the Bank has now turned to enclosed management operation of allocating special funds for food, oil and cotton purchases. There is no direct financing possibility for the peasants. With the exception of a few agriculture-related enterprises, most peasants are excluded from getting loans. ④ Agricultural Insurance: in 1982, People’s Insurance Company of China started agricultural insurance in China, mainly on crop farming and breeding. With the marketization of insurance companies, as well as the shrinking of governmental subsidies, agricultural insurance is declining; with the exception of measures taken by some local governments to allocate such subsidies, the failure to balance supply and demand is apparently an issue for agricultural insurance. This has resulted in the lack of production insurance for many peasants in the rural areas. (2) Informal Financial Institutional Supply: informal finance is used as opposed to formal finance to provide various capital loans and financing services for rural production, operation and consumption needs (Wang Shuguang, 2006). Informal finance designates non-standardized financial tools adopted by unregulated channels and is opposed to formal financial establishments regulated by the government. In fact, informal finance can be simply defined as any fundlending activity or behavior not regulated by the government. ① Non-Interest-Bearing Supply: this mainly happens within friends and family circles. It is very common among peasant households, embodying the traditional ethics that all should come to help those in need. This lending is often used for the purpose of consumption need, showing mutual help and mutual support between friends and families. There is no binding contract, nor legal protection, but such loans are bound by inter-personal relations and human sentiments, and their pay-back credit is usually very high. This type of lending is common financial practice in rural credit relations. ② Interest-Bearing Supply: there are two kinds according to interest rates. 71

High-interest loan is often called usury, while low-interest loan is usually lower than or equal to the interest rates of credit unions. High-interest loans have much higher interest rates than financial services in rural credit unions. Currently these loans are controlled by the government, and they generally go underground; as a result, their transaction scale is often underestimated. In fact, usurious loans are quite common in rural areas. In highly developed rural areas such as Wenzhou and other districts, loan interest rates are decided by market demands, and capital is invested mainly in expanded reproduction activities including non-agricultural industry entrepreneurship, etc. In less developed rural areas, high-interest loans are mainly reinvested in domains of peasant household consumption activities. As such lending activities are controlled, a sense of insecurity arises among lenders and borrowers, which might cause further troubles. Although high-interest loans are controlled by the government, they still occupy a dominant place in rural informal finance in terms of scale and impact. Li Jianjun (2005) has measured and estimated the scale of China’s underground finance, and observed that in 2003, the underground financial net investment has reached a record-breaking 650-800 billion RMB, which accounts for 5.6%-7.9% of GDP, and 12.9-15.9% of national saving. Wen Tiejun’s investigation, conducted in 41 villages in 24 counties and towns of 15 provinces in Eastern, Central and Western regions, shows 57 borrowing cases and 27 lending cases. After processing the data, statistics show that non-interest-bearing loans only existed in two places. In all other regions there were high-interest loans. In places where the investigation was made, occurrences of informal financing were up to 95%, and high-interest loans constituted 85% of it. 3.5.3  Information Constraint Information asymmetry refers to the fact that different parties possess different amounts of information when entering into a contractual relationship. For the two parties involved in borrowing and lending in the rural financial market, the asymmetry is as follows: economic subjects in rural areas are numerous, often of small scale, spreading out in large terrains, operating in informal manner. Branches of big banking corporations operating through standardized riskmanaging procedures tend to find it difficult to conduct vigorous investigations before transactions to assess the risks of granting such loans, neither can they ensure successful loan collection through strict monitoring processes after the transaction. Moreover, the peasants find it difficult to provide sufficient collateral. 72

Under such circumstances, the rational response from banks is usually to reduce or refuse loans. At the same time, the peasants do not have sufficient understanding of financial establishments. So there is indeed a problem of information asymmetry between the two parties. This information asymmetry can also present itself in the perception of information carrier. Formal financial establishments demand formalized information, which generates higher costs and cannot effectively reflect the dynamic information of peasant households. The peasants have little information about financial policies and financial product supplies; they pay little attention to the requirements and changes of rigid constraints in finance, and great attention to acquaintanceship or interpersonal ties in financial establishments. These again cause asymmetry in effective information. 3.5.4  Cost Constraint For rural financial establishments, information asymmetry results in cost increase when they conduct investigation and assess peasant clients to whom they might grant loans. Since conditions of households vary so much, information costs would further increase when the quantity of households increases. Besides, the existence of bad debts further increases undesirable costs for rural financial establishments. Furthermore, the operational costs of rural financial establishments have been increasing: as the system tends towards “public ownership,” the costs of “keeping employment” and “maintaining the operations of the establishment” has been increasing. For the peasants, certain costs are involved as they familiarize themselves with financial establishments—a considerable part of the costs is due to information asymmetry, which results in “psychological costs.” “High threshold, complicated procedures, and difficulty in obtaining loans” are common impressions of regulated finance. In summary, the costs of formal financial establishments include information gathering and processing, hardware operation, organizational operation and management, and exterior transactions. These costs have to be paid by profits earned through operations; otherwise the establishments either have to take the loss or even close down—a common issue faced by rural credit unions since the Reform, and shared by the Agricultural Bank before its commercialization. On the other hand, because of the “high threshold” of formal finance, those who can obtain loans are mostly local “wealthy households” (usually those who undertake farming and breeding in larger scale, with higher revenue, or those which can include the salary of a public functionary in the family revenue). 73

Lower-income common peasants often have to find an acquaintance to be a mediator to facilitate the process (the fact that credit unions ask the peasants to engage civil servants as guarantors when they apply for credit makes it even more necessary). Imploring people to have loans granted and offering thank-you gifts for loans have thus become unspoken rules. These mental and material costs become constraints restricting borrowing and lending activities in rural areas. 3.6  Brief Summary This chapter starts with the factors for founding the household contract system, analyzes the nature of the system, observes that the system is actually an institutional arrangement centered on incentive compatible mechanism, an institutional innovation established on the principal-agent agreement to manage the collective land, and an induced institutional change originating from the grass-root level, recognized and promoted by governments of all levels. We also give in-depth analyses concerning peasant household economic behavior, saving behavior, and loan behavior. Through the analysis of factors constraining the peasant household’s financial needs, we reveal the existing problems in rural financial demands.


Chapter 4  Paradox of the Reform: Exogenous Institutional Arrangement in Rural Finance 4. 1  Analysis of the Causes for and Objectives of Creating an Exogenous Institution in Rural Finance Generally speaking, the financial system in rural China has developed in two completely different fields and along two completely different paths. On the one hand, an informal finance has come into being naturally in civil society, with the intermediation of unregulated financial entities or with direct transactions between the two sides of capital supply and demand. On the other hand, a formal, regulated financial system has been formed in the process of economic and financial reform, and engages in financial activities organized or promoted by formal financial establishments. 4.1.1  Objective Reasons for the Creation of the Exogenous Financial Institution (1) Considerations for the economic effectiveness and social legitimacy of resource allocation: In general, resource allocation is carried out by economic subjects on two levels, i.e. the microscopic level (enterprises and individuals) and the macroscopic level (governments and policy-making authorities). Microeconomic subjects are equal in terms of social status and engage in equitable exchange, fair competition, free decision-making and free choice in accordance with market principles, allocating resources in view of optimizing benefits for themselves. This manner of allocating resources is oriented towards high profit margins, thereby achieving economic effectiveness for resource allocation. For instance, under spontaneous regulation by market mechanisms, capital flows from low-profit to high-profit projects, from agricultural to commercial activities, and from poorer to richer regions, and it can be said that such capital flows contribute to effective use of rare resources. From the viewpoint of microeconomics, profit or effect, this practice has a certain level of legitimacy. However, judging from the viewpoint of social legitimacy, it can undermine the equality of opportunity, neglect the need for capital of projects or 75

regions from which capital flows out, bring about unfair situations by supporting the strong and abandoning the weak, and result in imbalances or crises in social structure. Furthermore, from macroeconomic and long-term considerations, it does not contribute to the development of the projects or regions receiving capital flow, and thus lacks social legitimacy. Consequently, the government resorts to non-commercial principles and, while basically employing economic means, complements them with administrative means it deems necessary, in order to intervene in the allocation of social resources, thereby achieving and realizing objectives in keeping with social legitimacy. Therefore we can see that, under the conditions of market economy, it is necessary for the government to engage in macroeconomic regulation and control to achieve uniformity in terms of economic effectiveness and social legitimacy. Such necessity is concrete even in the financial sector, which plays a major role in the national economy; the government needs to intervene in the overall planning of the way the finance functions so as to enhance harmonious development. This rationale not only provides the basic theoretical foundation for the development of policy-based finance, but constitutes an important objective premise for national credit capital to enter rural financial markets. (2) Considerations for the fundamental status and industrial characteristics of agriculture: As a sector of production, agriculture provides basic goods and a living environment to mankind, and is the mother of all economic activities. But with the continuous advance of industrialization, the sector has gradually become weakened. In comparison with secondary and tertiary industries, agriculture is in an obviously disadvantageous position, as shown in the following analyses. (a) Agriculture produces food; but according to Engel’s law, as income increases, the percentage of food-related expenses in overall expenditure will decrease, which means that the increase of the need for food falls behind that of the need for other industries and services. (b) Due to long production cycles and intrinsic biological characteristics, it is much more difficult for agricultural production technology to progress as compared to industry; as a result, increase in the productivity of agricultural labor is subject to more limitations. (c) The effect of the law of “diminishing returns of land” is obvious; in particular, at a constant relative level of technology, a higher degree of intensification will mean the need for a bigger 76

investment to achieve an equivalent increase in production. (d) The items involved in agriculture are endowed with life; not only are production periods greatly influenced by the climate, but the products are hard to conserve, resulting in higher natural and market risks. (e) The dispersed and widespread nature of land results in a relatively low degree of intensification in agricultural production. (f) Agricultural production is dependent on land capability, and as the development of infrastructure in farming lands is subject to long investment pay-back periods, the ones who reap are often not those who sowed. Agriculture’s disadvantageous situation in economic terms directly results in the specific nature of agricultural credit. First of all, agricultural credit is seasonal. As agricultural production is aimed at plant cultivation and animal breeding, it is subject to weather and climate to a considerable degree. Seasonality is thus evident: Before the harvest season, capital is more needed than usual, and demand for loans increases; but after the harvest, large amounts of capital flow back and loans are paid back. Secondly, agricultural credit functions on a long-term basis. Plants and animals need a long period of time for their growth, and the length of the time cannot be totally controlled by man, which results in the fact that the turnover time for capital is longer in agriculture than in industry and commerce, the accumulation of agricultural capital is slower, and longer loan periods are needed. Thirdly, agricultural credit is more subject to risk. Under current technological conditions, natural disasters remain an important threat to agricultural production, causing serious losses in agriculture and breeding around the world. As a result, the accumulation of capital in agriculture is less stable than in industry and mining, and agricultural loans are often exposed to risks related to delay and insolvency. In view of the risk-prone nature of agricultural loans, most countries resort to pledges in kind with the exception of certain credit loans. This approach not only places limitations on the channels for peasants to obtain loans, but also increases the economic burden for the borrowers. Furthermore, in the actual circumstances where natural disasters cannot be completely overcome in the domain of agricultural production, neither pledges in kind nor credit guarantees are sufficient for wiping out the risks in terms of the losses caused by bad debts. Fourthly, agricultural credit is scattered and fragmented. As agricultural production is restricted by numerous factors related to land, the natural environment, the level of productivity, etc., the production scale is often relatively small. Currently, many developing countries are still characterized by peasant economy, and even in advanced capitalist countries, 77

family-run farms are still the majority. This one-farm-per-household operating method is limited by the scale of operation and the speed of capital accumulation, the result being that solvency is generally lower than in industry and commerce. Consequently, the amounts of agricultural loans are relatively small and “scattered”. These characteristics (high risk, low profit, high cost, and slow capital turnover) result in agricultural credit being in contradiction with the principle for loaning as practiced by financial establishments whose aim is to gain profit. When investing in industry and commerce allows for higher returns, capital generally flows from agriculture to industry and commerce. As a result, financial establishments, which are supposed to “provide water” to agriculture, turn out to pump water out of it. Agricultural capital flows out in great amounts towards industrial and commercial sectors with high profits and short payback periods. In China, this phenomenon has become really significant in recent years. But in agriculture, the use of advanced technology, variety improvement, the purchase of agricultural machinery, the improvement of soil conditions, the use of chemical pesticides, fertilizers and film, and the development of infrastructure all necessitate huge investments. In other words, without sufficient capital input, there will be no stable long-term development for agriculture. As to where agricultural capital comes from, there are two channels: internal accumulation and external input. Since agriculture is characterized by the combination of natural reproduction and economic re-production, the slowness of capital turnover, the lack of capacity to ward off natural disasters, and the existence of high market risks, internal accumulation of capital is slow and far from meeting the needs. Therefore, whether it be the development of agriculture, the vitalization of rural economy, or the enhancement of peasants’ quality of life, the input of external capital is very much needed. And when commercial capital is reluctant to enter rural financial markets, national credit plans turn out to be indispensable. 4.1.2  The objective function of the financial institution under the national strategy Justin Lin Yifu (2003) states that the objective of China’s financial since the founding of the People’s Republic of China in 1949 has been to meet the nation’s strategic needs for a national economic plan centered on serving heavy industry, and his research confirms this viewpoint. From the perspective of the formation and evolution of China’s financial institution since 1949, national strategy has 78

always been a constraint condition for the development of the financial system, and following this line of thinking, we can divide the history of this transformation into three distinct periods. From 1949 to 1977, China’s rural finance went through a period of nationalization. During this time, the nation’s main strategy was to create a socialist fundamental economic system, implement a planned economy, and establish people’s communes. From the angle of the state’s objectives in developing the economy, the focus of national economic planning was industrialization based on heavy industry. Thus, in order to serve this strategic objective, the state had to satisfy the capital needs of heavy industrialization, and inevitably, attempts to monopolize and allocate financial resources became part of the national will. In accordance with such strategic requirements, the financial institution was organized as a typical planned system based on national monopoly and state centralization. Its most important characteristic was the existence of a single national banking system, with the People’s Bank of China as the sole national center for credits and loans, settlement, and currency issuance. A whole set of concrete institutional arrangements was implemented on the basis of this fundamental system. A capital supply system was at the center of this planned financial institution whose objective was to serve national plans and to keep watch over them (Zhang Qiuyun et al., 2006). From 1978 to 1996, China’s rural finance underwent a process of marketization. During this period, the national strategy consisted in setting up a system of socialist market economy, and as a result, household contract responsibility system was implemented in farming villages. Industries and businesses in urban areas transformed from a single nationalized system to a more diverse one, and the nation’s mission for economic development shifted its focus toward the creation of a society of well-being. Adapting to this transformation from planned to market economy, China’s financial institution embarked on an evolution from a system of nationalization characterized by monopoly and centralized planning to one centered on the market. One of the landmarks of this period was the shifting of the financial establishments from uniformity to diversity, with the setting up of specialized banks. Another landmark was the promulgation of the Commercial Bank Law, which started off reforms of commercialized within stateowned specialized banks, with the Agricultural Bank of China (ABC) leading the trend by implementing a commercialized operational system in 1995. An 79

institutional framework integrating commercial finance, policy-based finance and cooperative finance was gradually formed, and the means of financial regulation, developing on the basis of uniform administrative means, made a transition towards market-oriented mechanisms. From 1997 up to the present, rural finance has been evolving toward diversification. As China geared up its market-oriented development, and after the central government proposed its strategies for creating a harmonious society, and in particular, strategies for new rural development, the financial institution adapted itself to the needs of the nation’s new strategic objectives by broadening the scale of its reform in view of marketization and by promoting the creation of a diversified institution. In the revamping of rural finance, a gradually commercialized system unexpectedly increased the flow of capital out of rural communities, resulting in more and more serious credit problems in rural areas. In order to address the issue, a series of rural financial reforms has been undertaken, with, among other measures, a property rights reform in rural credit unions starting 2003, and the creation of village- township-based banks and micro-credit companies starting 2005. These attempts are aimed at a diversified allocation of government-controlled rural financial resources, but the reform measures emerged from uniform government preferences associated with an exogenous institution, and did not take into account problems like the dissymmetry between supply and demand in the original rural finance or the costs that remained high in the financial institution. The above overview of the evolution of China’s financial institution has allowed us to reach the fundamental conclusion that the institution has always had to conform to the nation’s strategic arrangements, whether the objective is planned economy or market economy. 4.1.3  The Ideal Positioning of the Exogenous Financial Institution In low-income developing countries, the government is also entrusted with the important duty of supporting agricultural credit. For instance, M. Hasody held the typical view that since the majority of the farming population consists of peasants, the level of the economy can only be elevated via the development and organization of a credit system targeting these peasants. Renowned developmental economists W. A. Lewis, B. H. Higgins and B. H. Leibenstein also made similar conclusions, stating, respectively, that the capital that peasants need far exceeds the savings they could make; that credit is indispensable for certain sectors, especially in the 80

development of small farming activities and small industries; and that the increase of capital, labor, company equipment, know-how and credit convenience will result in an increase of per capita income. The actual situation is that the governments of most low-income countries firmly follow such viewpoints or similar ideas, but the credit plans they offer their peasants have very little effect on stimulating agricultural development, despite the fact that interest rates for such loans have become lower. With respect to rural credit, what role does the government need to play? Should it monopolize financial resources to allow for a uniform exogenous institutional arrangement, or should it make it possible for an endogenous financial institution and an exogenous one to coexist in harmony? Or, ought it to play a bigger role in coordinating and supervising the collaboration between the two? Doubtless to say, the last thing the government should do is to do nothing and let rural finance develop randomly. J.K. GaIbraith points out in A Theory of Price Control (1952) that the credit system can be a tool for economic progress as well as a factor of economic stagnancy and recession. He also contends that credit can become a tool for stimulating economic progress only when the economy has achieved a certain degree of development. C. M. Lee is convinced that, before the government’s credit plan starts functioning, peasants should follow the path of commercial agriculture. J. W. Mellor states on his part that cooperative credit plans should closely match technological reform plans and should never advance ahead of them. While the viewpoint of Galbraith and his followers has met with serious criticism by a great number of scholars and politicians, it is unfortunately true in the actual context of rural finance. Unless the government gains a sufficient understanding of the role credit plays in the development of rural economy, and of peasants’ attitude with regard to savings, investment and debt, its rural credit plans are doomed to be ineffective. Many low-income countries have started to improve their agricultural credit planning. For them, the reason development is hampered in this respect lies in the fact that peasants are too poor, too lacking in capital, and furthermore, subject to high interest rates when they contract loans. The aim of the government is to offer peasants a larger array of more advantageous loans, but, compared with the profits obtained from investments in agricultural research and promotion and from social capital investments, resources used in credit plans rarely bring about satisfactory results as far as profit is concerned. 81

It is actually not difficult to judge whether peasants need to obtain additional capital (by means of loans) to engage in lucrative investments; we need only to be sure whether they are able to purchase fertilizers, new tools, etc., and whether they have already purchased these factors. More often than not, the government does not need to provide loans, since many peasants can use their own resources to make investments. Once peasants have the will to proceed in this way, and have the ability to invest intelligently, then even small loans can benefit them. But if the government does not want to wait, then its imposed credit plans will run the risk of abusing capital resources that are already lacking. Government credit plans have a few points in common: the cost exceeds the revenue and subsidy is necessary; the interest rate is lower than the rates practiced on the market; and the actual interest rates are usually negative, partially due to inflation, and partially because the government always plays the role of the most tolerant creditor. Consequently, payback for loans is not sufficiently guaranteed, and such credit plans end up further increasing inflationary pressure. While the experience of many countries clearly shows that using credit plans to encourage agricultural development is costly and a waste of resources, why has this approach gained so much approval and so many frantic followers? First of all, and this is the most important point, it is the result of the government’s and many economists’ lack of understanding as to peasants’ attitude towards debts and loans, and in particular, the actual fact that many peasants are reluctant to resort to loans. Secondly, the government considers credit plans as an easy way to increase the volume of capital in rural areas, but it forgets that loans do not mean capital. The mere increase of money supply does not necessarily create capital; if peasants use the loans for consumption purposes, the part of the capital thus used will no longer be available for use in production and investment. Thirdly, the governments of many low-income countries believe --- wrongly --- that it is very easy to create modern financial establishments that provide service to peasants; they do not see that any real growth of financial establishments can only come into being as a result of economic development. Fourthly, the government is not conscious of the strong economic rationale behind the high nominal interest rates practiced in informal money markets. In low-income countries, the supply of loanable capital is insufficient, and at first sight, market interest rates are higher than the rates practiced in high-income countries. However, people rarely realize that the income of those who control such insufficient capital is not as high as nominal interest 82

income. Data from a study on rural credit shows that the interest rates of usurious loans are only 11% on average. The high interest rates of short-term loans do not mean high annual revenue rate for the capital, for it is possible that much of the loan sharks’ capital is idle most of the time. If there exists a proper additional output market, the majority of peasants would not need to use low interest-rate loans to stimulate production or investment. A forced implementation would often result in peasants using their own resources to purchase new input factors or tools, and only a few years later, when it can be proved that the lack of capital is indeed the main obstacle in the use of modern input factors, can the government approach of creating special credit convenience be confirmed in a true sense (Wang Fang et el. 2003). The above analysis only considers the issue from the perspective of the revenue of national credit plans. Due to differences between rural and urban economies, it is obvious that urban credit revenue is higher than rural credit revenue. Therefore, it is not hard to see that the state finds itself in a dilemma when it comes to solving problems linked to rural credit supply and the revenue of government-run credit establishments. The current situation of China’s rural credit is that the state has discovered that rural credit plans cannot meet the demands for rural credit, that rural savings flow massively out of rural areas, that there is a rather serious problem of rural households resorting to usurious loans in the informal market to meet their needs for credit, and that the government is facing challenges with regard to rural financial allocation. In particular, as new objectives for rural development are proposed, how rural financial resources can be properly allocated through institutional innovations in order to meet the nation’s new strategic requirements has become the core issue to be addressed in the new round of institutional supply. Is it possible to organize an exogenous financial institution that can not only solve the problem of current insufficiencies in rural financial supply, but at the same time solve the problem of revenue in national credit plans? If we consider this question from the perspective of the design of the institutional framework per se, we can see that three constraint conditions have to be satisfied: information symmetry, low transaction cost, and controllability of moral hazard. These three constraint conditions can be summed up in a single credit function. For a long time, credit as arranged by the exogenous financial institution has been evaluated on the basis of standards developed for urban commercial credit, resulting in low rating for 83

rural credit and high costs for the collection of credit-related information. On the other hand, the cost for collecting unregulated financial credit in rural areas is low, and the institution’s operating cost is also low, which is indicative of the vitality of the endogenous institution. Would it be possible to use as a basis for the granting of loans the rural credit as adopted by unregulated finance? Or to integrate existent unregulated rural finance into a framework of cooperation with exogenous finance? This is what the author is attempting to emphasize as an ideal positioning for a new round of institutional innovations in China’s exogenous financial institution. 4.2  Performance Analysis of the Institutional Arrangements in the Rural Commercial Finance 4.2.1  Relative Deficiencies: Fundamental Judgments with Regard to China’s Institutional Arrangement of Rural Commercial Finance The judgments and conclusions made by China’s academia regarding the performance of the arrangements in China’s rural commercial finance institution can be summarized into two viewpoints. The first considers that China’s rural finance institution has already been organized into a complete system, with reasonable functionality and a complete array of offers in terms of its organization and structure. The second viewpoint points out that, while after the reform of China’s rural finance it has basically acquired a service system combining policybased functions, commercial functions and cooperative functions, its overall functionality has yet to be complemented. These two sets of judgments have their respective legitimacy and practical significance, but both seem to be insufficient in terms of knowledge and guiding value. The former appears to be overly confident in the reform of the rural finance per se; the latter, although critical to a certain degree, has not pushed the analysis to more concrete insight. On the surface, China’s formal rural financial system has successfully evolved into a “three-horse carriage”, but due to uniformity in institutional arrangements, misplacement in organizational functions, and a lack of sophistication, its reputation falls short of reality. It is very difficult for the normal deficiencies of legitimacy in informal finance to become institutionally complementary to formal finance. Consequently, the problem facing China’s rural finance institution is not how to make it simple and complete, but how to construct it anew. When we look at the arrangements made in China’s rural commercial finance 84

institution, we realize that, in a strict sense, before the publication in 2006 of the document “A Few Opinions About the Adjustment And Loosening of Banking Activities in Rural Areas to Allow for the Admittance of Financial Establishments with a View to Better Supporting New Socialist Rural Development” by the China Banking Regulatory Commission (CBRC), the institutional arrangement of the rural commercial finance was carried out in a non market-oriented way under state control and thus was not an institutional choice made in the framework of a liberalized market. Therefore, the creation of any rural commercial financial establishments was restricted or forbidden, and the commercialization of the Agricultural Bank, a model for commercial finance developed under the state’s will, became the only option for China’s rural commercial finance institution. As the commercialization of the Agricultural Bank was a reform carried out “under state orders”, there were no competing entities with equivalent competence on the market, so the reform lacked endogenous dynamics from the very beginning. We can only say that, with respect to institutional functions, this reform did serve to modify an integrated institution combining policy-based and commercial characteristics and push it towards the objective of becoming a more specifically commercialized one, which has come to form a rural finance system with policy-oriented Agricultural Development Bank and cooperation-oriented rural credit unions in a three-way model of institutional complementation. Under such an institutional framework, financial establishments operate in a division of labor as defined by national policy, with the Agricultural Bank taking charge of the functions of commercialization. However, attributes of market competition, which are defining properties for commercial banks, have not been effectively developed. In other words, rural financial markets have not been opened, neither have rural commercial finance establishments, so the arrangements made in the rural commercial finance institution are flawed in themselves. In such an imposed arrangement, the Agricultural Bank, as the only commercial banking entity in the system, has re-oriented its operational values, with an increasing preference for non-agricultural activities. As a result, the role of the bank in sustaining the tripartite agrarian sector (san nong) has continued to dwindle, instead of strengthening, as it should have.


Table 4-2-1: Overview of China’s Rural Commercial Finance Establishments in 2004 Subject No. of Type of Establishments Establishments

Deposits (million RMB)

Percentage of Deposits(%)

Percentage of Loans(%)

Postal Savings





Rural Credit Unions





Agricultural Bank










Source: China Postal Savings & Remittances Bureau

As shown in Table 4-2-1, in 2004, deposits in China’s agricultural banks, rural credit unions and postal savings establishments occupy, respectively, 32.29%, 49.43%, and 18.28% in the total savings of the country’s rural finance sector, while loans granted by agricultural banks and rural credit unions represent 1.09% and 98.91% of the total, respectively. At the same time as the strategic objectives of the operation of the Agricultural Bank lose their agrarian character, rural credit unions have practically become the only financial establishments that develop credit activities in base-level rural townships, with a near total monopoly of the micro-credit market in the three-dimensional agrarian sector. According to other statistical data for the year 2004, in the increase of agricultural loans nationwide, totaling RMB 120.3 billion, commercial banks provided only RMB 4.5 billion (the rest being provided by rural credit unions), the equivalent of a mere 8% of the total loans they granted over the year. For the year 2005, up to the end of October, the nation’s rural credit unions granted agricultural loans for a total of over RMB 1,000 billion, or 85% of total agricultural loans granted by all financial establishments. 4.2.2  Performance Analysis of the Agricultural Bank under Commercial Institutional Arrangements Based on the State Council’s “Resolutions Regarding the Reform of the Financial Institution” in 1993, a “Guideline for Development in 1995-1997” was instituted in 1994 in the Agricultural Bank, assuring the objective of reorientation towards commercial banking. The main measures taken in this move towards commercialization were: (1) changing the “four-level management and onelevel operation” model to a “four-level operation” model, thus increasing the role of operation and making a transition from a multi-management positioning to 86

an operational one; (2) in the area of credit capital management, strengthening credit asset risk management, and, with the development of asset-liability ratio management, creating a risk management system to help control operational risks; and (3) developing new financial service activities, increasing the offer of new financial products, and enhancing international business activities. The Agricultural Bank entered a new era with a reform positioning based on the ideas of “full orientation towards the san nong, complete institutional revamping, businessoriented operation, and entrance into the market at auspicious moments’’. Since the Agricultural Bank started the process of commercialization-oriented reform, how has it performed? We will make a concrete analysis in two respects. Our first analysis concerns the strategic motivation of the withdrawal of rural establishments under considerations of commercial performance. Why did the Agricultural Bank decide to withdraw its rural branches after starting their largescale institutional reform toward commercialization in 1995? From the perspective of new institutional economics, we can see that the reason was to reduce transaction costs and increase revenues from the operation of the system. On the one hand, as rural establishments were numerous and spread out across large territories, a lot of money was needed to operate them, including the maintaining of both the facilities and the staff. While rural branches provided convenient conditions by dealing directly with local communities and offering service to the san nong, revenues from such credit operations were generally lower than management costs, resulting in deficit for the majority of these establishments. Internal data show that branch offices in most counties in central and western China were maintained at the cost of deficit for the banks; at the end of 2005, the Agricultural Bank’s countylevel branches in the 592 counties designated by the state as priority recipients of development support presented an average deficit of 34%. In other words, even county-level branches can be in deficit because they are located in the less welldeveloped regions of China. And obviously, this situation is incompatible with the reform toward commercialization. After years of contraction, the part of the Agricultural Bank’s operations that are still carried out at county level represents only 60% of the total number of branches, 51% of total employees, 42% of the savings and 35% of the loans. On the other hand, from the perspective of opportunity costs associated with credits, at the core of the Agricultural Bank’s reform toward commercialization is a requirement to make the banks function like corporations, and an essential 87

distinction between corporations and government-run establishments concerns their objective function –- optimization of public service for the latter, and maximization of corporate profit for the former. After the Agricultural Bank withdrew from rural areas, its credit/loan customers changed significantly in nature, and the bank shifted from serving rural targets or the san nong to serving urban, non-agrarian targets. Consequently, the credit/loan structure has been greatly transformed. Evaluating from the angle of transaction costs, we can see that the target parties have changed from small, scattered rural customers to large and relatively concentrated urban customers, the costs for information collection have been greatly reduced, and as a result, the Agricultural Bank has been able to successfully meet the objectives of their reform toward commercialization. Our second analysis concerns the paradox that rises between the performance requirements of commercialization and the objectives of supporting the threedimensional agrarian sector. Dealing in banking services for the nation’s agrarian sector, the Agricultural Bank is by definition an institution whose functions consist in serving the san nong, but the reform has also turned it into a commercial bank that needs to realize corporate operation objectives, with the optimization of shareholder revenues becoming a major pursuit after the Agricultural Bank entered the stock market as part of its development in the new era. Therefore, the Agricultural Bank took on a dual nature vacillating between state objectives and corporate objectives, and this duality is a decisive factor in defining the game that the bank plays in the deployment of its operational strategies. This game involves several strategic options; the state has the right to decide whether to provide subsidies or not, and the bank can choose whether or not to serve the san nong. The corresponding payoff matrix can be expressed as follows: Bank at the service of the San nong

Bank not serving the San nong

With state subsidies V

( - V, uncertainty of profit/loss (depending on the size of V) )

( - V, high profit )

No state subsidies

( 0, loss )

( 0, low profit )

We can see that, if we only consider the situation of a one-shot game, then when the state’s subsidy takes place before the game, the above game will correspond to a single Nash equilibrium, that is, when an agricultural bank makes its choice between serving policy-based agrarian objectives or corporate objectives, it will certainly choose the strategy of “receiving state subsidies and not serving the 88

san nong, thereby achieving high-profit performance objectives. In other words, at the same time as the bank receives state subsidies, it will pursue its objectives of commercialization and strives to optimize corporate benefits. But the problem is, if the banks give up their objectives of serving the san nong, the state will cancel various subsidies in the next round of the game, and the banks will not be able maintain their high-profit objectives. More importantly, China’s Agricultural bank is a state-owned establishment, and its operational strategies must adhere to political objectives. Therefore, if we consider the situation of a repeated game, when the state adopts a policy of subsidy, and the bank is required to serve the san nong, then in the given proposition of the dualobjective reform, the Agricultural Bank will certainly choose to make institutional arrangements for commercialization in such a way as to be able to stay on the critical point of achieving marginal benefits in providing service to the san nong, i.e. the breakeven point between service to it and commercialization, thus the need to compare the data in the upper left corner (uncertainty of profit/loss) with the value in the lower right corner (low profit). Empirical data shows that the critical point in question is the administrative level of county. The county is the main vehicle of the “de-agriculturalization” of rural communities, and can also function as an important link between the san nong. As the level where rural small- and mediumsize enterprises (SME) are concentrated, the county assumes the role of service provider for both corporations and peasants. The central government has entrusted the main missions of new rural development to the county government. Therefore, the Agricultural Bank withdrew itself from the two lowest rural administrative levels of village and township, which used to be the main recipients of its services, and restricted the scope of agriculture-related services to county-level cities; meanwhile, secondary and tertiary industries and SMEs in rural communities have become the main providers of service for the san nong, thereby satisfying the utility function. Here, we will take transaction cost as the unit of measurement and make a simple comparison between the two types of transactions: Commercialization Model 1 / Serving rural communities: Commercialization Model 2 / Serving the county level: Where C is total cost, P is bank’s gains, V is state subsidy,   is information cost, and   is cost of transaction scale. Since       , and   , when state subsidy remains constant, i.e.   , 89


If other conditions remain constant, the two principal operational costs, i.e. information cost and cost of transaction scale, are much lower in Model 2 than in Model 1, which shows that the reform brings about evident benefits. In the above reasoning, if Agricultural Bank branches exist in rural regions, there is an implicit necessary assumption:     But can the condition of    also be satisfied? In fact, when agricultural banks extend the scope of their san nong-related services to rural communities, it is often the case that operating costs cannot be reduced effectively and that operational benefits plus state subsidies are not sufficient for offsetting operating costs, resulting in negative total revenues. In this case, central government subsidies   becomes the sensitive value in the Bank’s reform toward commercialization. This leads us to the conclusion that the dual objectives of the Agricultural Bank’s reform toward commercialization are achieved through the restriction of the scope of agriculture-related service to the level of county under the premise of obtaining state subsidies. This is why the Agricultural Bank stepped out of the two rural levels of village and township extensively while still insisting on its adherence to objectives of serving the san nong. In order to further illustrate the changes in deposits and loans in rural areas after the Agricultural Bank’s reform toward commercialization, we will make a comparative study of related data from 1993 to 2006 as shown in Table 4-2-2. Table 4-2-2: Deposits and Loans in Rural Areas (Unit: RMB billion) Year 1993











Net deposits 464.98











Net loans 483.91











Source: China Financial Yearbook (publications of related years)


Loans/Deposits 1.04











Difference (deposits minus loans)












The above table allows us to see that since 1994, when the state required the four main state-owned banks to go commercial, and particularly since the Agricultural Bank’s reform toward commercialization, the absolute value of the difference between deposits and loans has been increasing year by year, which indicates a massive outflow of capital from rural areas. This not only worsens the problem of capital shortage in rural areas, but as the Central Bank encourages “upward depositing” of capital, large amounts of capital flow back to cities, widening bipolar structural differences between rural and urban areas. Meanwhile, we have also come to see that the contribution of agriculture credit to national economy is not proportional to that of agriculture, the percentage of agriculture loans in the net total of loans granted by the financial sector is far lower than the percentage agriculture occupies in the nation’s GDP. Table 4-2-3: Contribution of Agriculture to National Economy and Support Provided by Financial Sector to Agriculture in Recent Years (Unit: RMB billion) Year

Gross Domestic Product (GDP)

GDP increase Added Value Part of AVA Net Total of over previous of Agriculture in GDP (%) Various Loans year (%) (AVA) by Financial Establishments

Net Total of Part of Agr. Agriculture Loans in Net Loans Total of Loans by Financial Establishm ents (%)

























































































Source: China Financial Yearbook and China Statistics Yearbook (publications of related years)

As Table 4-2-2 shows, the total volume of agriculture loans is not proportional to the total volume of the agrarian economy, and the agricultural credit sector’s overall capital supply capacity has lessened. At the end of 2005, the net value of the nation’s agriculture loans amounts to RMB 1152.993 billion, or 5.92% of the 91

net value of all loans granted by financial establishments; the ratio of the value of agriculture loans to agricultural output is 0.5075 : 1, much lower than the ratio of the net value of all loans to total GDP (1.0678 : 1). The statistics of the last ten years show that the proportion of agriculture loans in total loans hover at 5% t0 6% in value, while the weight of agricultural added value in total GDP is still around 12%, despite a constant decreasing trend since the mid-1990s. These observations indicate that, as the degree of commercialization increases in the rural finance sector, the agrarian sector, which has a lower rate of marginal benefit for the capital invested, is becoming less and less attractive in the eyes of credit-granting financial establishments. Compared with the contribution of agriculture to GDP, the contribution of credit capital to agricultural GDP (agricultural output) is less obvious, and the correlation between rural finance resources and rural economy is comparatively weak; this is another illustration of the relative deficiency of the institutional arrangements made in the rural finance institution. The various manifestations of the relative deficiency in the commercialized rural finance institution can be explained by the existence in related institutional arrangements of a kind of supply-type financial control that embodies the political objective functions of the central government’s idealized exogenous financial institution, and by the fact that endogenous dynamic mechanisms have not yet formed. Attention has been paid to this problem in the new round of reforms for the further commercialization of the Agricultural Bank, and the plan is to attract new strategic investors by means of reforming the shareholding system, so as to establish a modern corporate system in the true sense of the term. However, the objectives of such a system can only represent shareholders’ benefits, and will certainly be incompatible with the objectives, defined by the state, of serving the san nong. Therefore, in the uncertain game that the Agricultural Bank is playing in a reform characterized by two contradictory sets of objectives, more instability is sure to come about in the functioning of the institution, in the operational strategies, in the credit products, etc. Those who play such a game will inevitably try to find a balance between state subsidy and market profit, thus restricting the release of energy that commercialization of the system ought to induce. The author believes that, in the effort to consolidate the reform of China’s rural finance, while the government has chosen a “supply-led” model of institutional transition, it should not count solely on the control of the financial institution and the monopoly of financial resources to achieve its objectives, but should also resort 92

to institutional openness and harness the market dynamics in resource allocation to establish, under the guidance of national policy and the moderation of interests, a commercialized financial institution that is adjusted to market needs and endowed with the properties of an endogenous mechanism, thereby boosting the spontaneous adjustment of the main structure of rural financial supply, and bringing about an optimized financial service system adapted to the economic development of rural communities. In view of this, the crucial approach by means of which the system of rural financial supply can be expanded today seems to be an institutional revamping of the mechanisms of the financial system to provide innovative services to the san nong, the result of which will be a mutually beneficial symbiosis of the commercial institution based on government-provided supply and the one based on the spontaneous supply of the market. 4.3  Performance Analysis of the Institutional Arrangement of the Policy-based Rural Finance 4.3.1  History of the Policy-based Rural Finance Institutional Arrangements After the founding of the People’s Republic of China in 1949, the nation’s policy-based rural finance was taken charge of by various financial establishments including the People’s Bank, the Agricultural Bank, and rural credit unions, all of which have executed to various degrees the policy-based financial function, as defined by the state, to serve rural communities. However, it was not until the creation of the Agricultural Development Bank of China, a policy-oriented bank specialized in agrarian activities, that the organization of China’s policy-based rural finance institution was officialized. Policy-based rural finance is an effective policy instrument that helps the government regulate economy and support agriculture under the financial conditions of the market, and is composed of several main types of activity: banking, insurance, guarantee, investment, etc. Policy-oriented banks constitute the core of the system, and have played an irreplaceable role in the development of China’s policy-based finance in the field of agriculture. Between 1949 and 1978, China went through a period of planned economy, and, in accordance with the highly centralized nature of this economic model, the financial system was highly uniform. During this time, the so-called policy-based finance and non policy-based finance were both inexistent, and financial activity 93

in rural areas actually took place under the sole orders of the People’s Bank. Or, put in another way, the system could be understood as functioning completely under government moderation. The main mission of rural finance at the time was to support agricultural production, with a focus on the development of food production. Such was “Stage One”. Stage Two took place between 1979 and 1994, with state-owned specialized banks taking charge off financial activities in a dispersed way. As China’s socialist market economy entered a period of rapid development and the reform of the financial system accelerated, commercial banks and people’s banks started to develop separately, and policy-based financial functions were attributed to specialized banks. For example, during this period, the Agricultural Bank of China (ABC) took charge of most loans related to food, cotton, and edible oil, support loans, seed engineering activities, etc. The China Construction Bank (CCB) was responsible for loans in the area of agricultural infrastructure development and in other fundamental fields; the Industrial and Commercial Bank of China (ICBC) was in charge of a large part of loans for acquisition of food and edible oil and the preparatory loans for the nation’s main produce; and the Bank of China (BOC) assumed the granting of loans in relation with the import and export of agricultural products. In 1982, agriculture insurance was restored, with the People’s Insurance Company of China offering policy-supported insurance schemes with low coverage and low premiums in the agrarian insurance sector. In short, during this stage, the different specialized financial establishments were respectively in charge of a part of the policy-based financial activities. Stage Three began in 1994 when measures of diversification mainly targeting the policy-based Agricultural Bank got under way. On April 19, 1994, the State Council decided to create the Agricultural Development Bank of China (ADBC), and by June 30 of the same year, the policy-based agriculture-related activities taken care of by the Industrial & Commercial Bank, the Agricultural Bank, the Construction Bank and the Bank of China were turned over to the new ADBC. The establishment of the ADBC symbolized a new era of development for China’s policy-based rural finance. During this stage, rural financial activities developed rapidly and in a diversified way. In 1999, four financial asset management companies were created, contributing to the stripping of a part of the policysupported bad loans. In 2004, the China Insurance Regulatory Commission (SIRC) started its agricultural insurance activity, and created three specialized 94

agricultural insurance companies one after another: Anxin, AnHua and Sunshine, each having a different operational model, either working in collaboration with the government, acting as an agent for the government, or dealing directly with clients. In 2005, these companies expanded considerably, with total revenues from premiums reaching RMB 72 billion. Since 2005, under the guidance of the government, policy-supported agriculture surety companies were established. Financially supported by the government and receiving corresponding subsidies, these companies have grown into leaders in the industrialization of agriculture, and offer surety for loans contracted by rural households. After over twenty years of development, a policy-based agricultural finance system has formed in China, covering various types of activity including banking, insurance, surety, and asset management. The system has contributed greatly to the nation’s macroeconomic regulation, effectively ensuring food security, income increase for peasants, etc. However, since the organization of the policy-based financial institution was done solely via the ADBC, the scope of operation of this bank is a determining factor in the performance of the policy-based financial institution. In the following section, we will try to analyze the performance in question in concrete terms. 4.3.2  Performance Evaluation of the Institutional Arrangements of the Policy-Oriented Rural Finance First of all, the ADBC’s scope of operations is relatively narrow. Since 1998, in support of the reform of the food circulation system, the State Council decided to take out from the ADBC the activity of special-purpose loans like comprehensive agricultural development loans and poverty alleviation development loans, and turn it over to a single banking unit for food and cotton purchase. As the food circulation system intensifies its reform toward commercialization, the market for food and cotton is completely opened up, which greatly affected the ADBC’s business activities, reducing the scale of its loans, and causing its operations to tip to one single area. In 2003 and 2004, loans for staple food, cotton and edible oil amounted to RMB 680.977 billion and 710.426 billion respectively, representing 99% of the total amount of loans granted by the ADBC for the year concerned. This monotony in its business operations made it difficult for the ADBC to develop and expand, and restrict its policy-based capital support for other agriculture-related activities and projects such as technology R&D for produce or agricultural infrastructure 95

development. Secondly, currently existing policy-based financial establishments are lacking in capital and the sources of capital tend to be uniform. The ADBC’s sources of capital include its capital base, the issuance of financial bonds, capital of financial support for agriculture, re-loans granted by the central bank, off-shore financing, deposits of corporations which have opened accounts within the scope of the concerned activity, etc. The ADBC has a registered capital of REM 20 billion, of which only a small part, REM 1 billion, was appropriated by the People’s Bank of China, the rest having been allocated by the ABC and the ICBC, including assets transferred in the form of loans and donations of fiscal refunds. While capital is insufficient, the sources of capital are limited; other than capital base and the partial absorption of corporate deposits, the Bank mainly depends on re-loans from the central bank and the issuance of financial bonds. Thus, there is a major gap between the sources of capital and the tasks the ADBC is entrusted with. Thirdly, the ADBC is met with numerous difficulties in its business operations. The sustainable development of the Bank’s activities necessitates capital support and is dependent on capital backflow. But, owing to the market risks linked to agricultural products, local companies’ abuse and misappropriation of capital, and the backwardness of risk management, among other reasons, the ADBC has a hard time collecting payments for the loans it has granted, and as a result there is a serious loss of credit capital. In addition, the Bank’s administrative expenses increase rapidly, and its organizational structure is gradually becoming fat, which result in high operating costs. The combination of high costs and low operational profit has certainly created a contradiction that seriously hampers the development of the ADBC. Lastly, the agriculture-supporting functions of the rural insurance sector are inadequate, and cannot meet the needs for risk diversification. Currently, China’s rural insurance sector is basically stagnant or even in recession; the kind of agricultural insurance system that we see in some foreign countries --a system dominated by the government and in which various kinds of financial establishments participate --- has not been created in China yet. Agricultural insurance has not yet achieved its effects in the management of the risks related to agricultural production, and such risks have been difficult to diversify.


4.4  Performance Analysis of the Institutional Change of Formal Cooperative Finance in Rural Regions 4.4.1  History of the Reform of Rural Credit Unions The development of China’s credit unions can be divided into five periods: Period one: Trial run, promotion and adaptation (1949 - 1958). After the PRC was founded, in an effort to curb usury, the People’s Bank of China promulgated a “Guideline for the Statutes of Rural Credit Unions” and a “Pact for Rural Credit Mutual Support Groups”, and established rural credit unions on the basis of these guidelines. By the first half of 1955, over 80% of the nation’s townships had set up credit unions, the number of offices had exceeded 150,000 nationwide, with a total of more than 95 million members. Period two: Tortuous development (1959 - 1978). People’s communes were instituted in 1956, and the banks’ operational offices and credit unions were combined into “credit departments” and placed under the management of the communes. In April 1959, new regulation separated the “offices” and the cooperatives, the latter being transferred downward to production brigades. During the Cultural Revolution, the management system of credit unions went through a number of changes, directly resulting in the abolition of the democratic organizational form of the credit system. Period three: Reform and adjustment (1977 - 1995). In 1977 and 1979, the State Council made a decision with regard to the nature of credit unions and the issue of their affiliation, whereby credit unions were defined as collective financial establishments and the Agricultural Bank’s grass-roots branches in rural regions. With this new decision, previously private-run credit cooperatives acquired a new status as government-run financial establishments. In August 1984, the State Council ratified the Agricultural Bank’s “Report on the Reform of the Management System of Credit Cooperatives”, the core content of which consisted in a proposal to really turn credit unions into cooperative financial organizations functioning on the basis of collective ownership. Following this change, the Agricultural Bank became a “leader” for credit unions with regard to policy and a supervisor/advisor with regard to their business activities, but leaving the unions execute the concrete tasks themselves. The traditional method of control via administrative orders was changed in favor of management by law and via the application of economic means, in a new structure of indirect management with county-level associations of 97

credit unions as intermediaries. Period four: Independent development (1996 - 2002). In August 1996, the State Council promulgated the “Resolution Regarding the Reform of Rural Financial System”, whereby rural credit unions were delinked from the Agricultural Bank, the former being subject to a new normative framework based on a cooperative system. This allowed the rural cooperative unions to get back onto the track of independent development. During this period, rural credit unions adhered to the principles of the cooperative system and initiated an institutional reform focused on the clarity of property rights, thereby establishing an initial operating mechanism emphasizing self-induced development, self-restraint and autonomous decision-making, and basically smoothing out the relationships between the credit unions, the People’s Bank, and the local governments. Period five: Consolidation of the reform (2003 – present). In 2003, the State Council promulgated the “Project for the Trial Run of the Consolidated Reform of Rural Credit Unions”, and decided to carry out, on the basis of previous trial runs in Jiangsu Province, new trial runs in eight provinces and urban areas to institute reform measures focused on the property rights reform. The new reform is aimed at solving two issues: the reform of the property rights system of the credit unions, with the legal person as the unit of reform; and the reform of the management system of credit unions, transferring management to the local government, and establishing province-level associations of credit unions. Meanwhile, in order to support the trial runs, the state instituted four support policies, including subsidy with maintenance of value, tax reduction, capital support provided by the central bank, and preferential interest rates. In August 2004, the office of the State Council published and distributed the document “Remarks with Regard to the Further Consolidation of the Reform of Rural Credit Unions”, and generalized trial runs to the whole country, with the exception of Tibet and Hainan (29 provinces in all). The institutional change of the rural credit cooperative system is a result of both the transmission of the central government’s rural financial policy to rural financial establishments, and the cooperatives’ autogenous institutional evolution sparked by constant adaptation to the rural environment they are exposed to. What is the performance of the transformation of the rural cooperative finance institution? Has it achieved the objectives fixed at the beginning of the institutional transformation? We can look at these issues from the following perspective.


4.4.2  The Difference of Deposits and Loans as an Indicator of the Performance of the Institutional Change A look at the situation of deposits and loans in rural credit unions allows us to see how capital is used by the unions in their approach for the allocation of rural financial resources. Table 4-4-1: Overview of deposits and loans in rural credit unions (1994 - 2002) Unit: RMB billion 1994







































Source: China Financial Statistics Yearbook (for the years concerned)

Table 4-4-1 shows that from 1994 to 2002 the difference between deposits and loans in rural credit unions increased constantly, up from RMB 150 billion in 1994 to nearly 600 billion in 2002. This suggests that there was a serious outflow of rural capital to cities via rural credit unions, and this trend had not significantly changed after the reform of the rural finance system. Diagram 4-1-1 presents the evolution of the deposit/loan ratio of rural credit unions, further revealing the impact of the unions’ institutional change on rural economy. The diagram shows that from 1984 to the mid-1990s, the deposit/loan ratio grew constantly, and the scale of the increase was nearly 0.2. In a lateral manner, this reflects the fact that during that period, the implementation of the household contract system boosted agricultural development and corporate activities in rural communities and townships, contributing to an increase of loans granted by rural credit unions in rural regions and some lessening of the “dualeconomy” character of the these establishments. However, after 1996, as rural credit unions became more and more characterized by commercialization, their deposit/loan ratio decreased to a certain extent, and a new trend arose where more deposits absorbed in rural areas were granted as loans in urban areas.


Diagram 4-4-1: Deposit/loan Difference in Rural Credit Unions (1984-2002) Source: Wang Shuguang, China Agricultural Development Report. Beijing: China Yearbook Press, 44, 2008. 4.4.3  The Performance of the Institutional Change of the Credit Unions as Indicated by Non-agricultural Capital Flow Table 4-4-2: Ratio of Peasant Households’ Deposits and Loans in Rural Credit Unions Unit: RMB billion 1984























Loan/Deposit Ratio 0.41







Source: China Financial Statistics Yearbook (for the years concerned)

Table 4-4-2 shows that since 1984 the ratio of peasant households’ loans to their deposits in rural credit unions had been steadily decreasing, down to 0.19 in 1996. That is to say, the loans peasants obtained from rural credit unions were less than 20% of their total deposits in those establishments. This also indicates that, through rural credit unions, massive amounts of capital flew from rural households to non-agrarian sectors, and during this period, rural credit unions looked like government-run commercial banks in rural areas, and could hardly be considered as cooperative financial organizations. In 1996, after the promulgation by the State Council of the “Regulations Regarding the Reform of the Rural Financial Institution”, the above situation was reversed to a certain extent, and the loan/deposit ratio started to increase in 1997, reaching 36% in 2002. However, in the meantime, rural credit unions saw their profit deteriorate, their capital was not sufficient to offset their debts, and the situation continued to worsen.


4.4.4  Performance of the Institutional Change of Rural Credit Unions as Indicated by the Evolution of Their Assets and Liabilities[1] Table 4-4-3: Evolution of Assets and Liabilities of Rural Credit Unions Unit: RMB billion 1996































Source: Li Shimei, Research on the Reform and Development of the Property Rights System of China’s Rural Cooperative Financial Organizations. 2005.

Table 4-4-3 shows that rural credit unions’ net capital dramatically decreased over the years, from RMB -7.7 billion in 1996 down to -168 billion in 2001. Except for the year 2002, when the situation was considerably relieved, the negative balance steadily worsened. From this perspective, the performance of credit union institutional change is not satisfactory. In fact, rural credit unions had become insolvent. The reason their balance got into this situation mainly has to do with a flaw in the design of the institution per se: as government-run credit unions, they had to conform to national interests and take charge of policy-based loans, but meanwhile, they also had to confront the market and sustain market risks. This duality of objectives brought about a kind of “soft constraint” in the internal operation and management of the credit unions, in particular, it provided the management team with the opportunity to rationalize debts. 4.4.5  The Institutional Change of the Credit Union System from the Perspective of the Original Intention of the Reform The Agricultural Bank’s 1984 project for reforming rural credit unions proposed an objective of restoring the “three characters” of rural credit unions: the mass character of their organization, the democratic character of their management, and flexible character of their operations. However, after nearly twenty years of evolution, the actual development of the rural credit unions veered further and

[1]  Xie Ping, Xu Zhong & Shen Minggao, “Performance Evaluation of the Reform of Rural Credit Unions” [J]. In Financial Research, 2006, (1).


further away from those “three characters. First of all, peasants did not join the credit unions on any voluntary basis, and instances of disaffiliation were practically inexistent, which means that whether in joining or withdrawing from the unions, the principles of “voluntariness” and “freedom” were not applied. Secondly, the credit unions were supposed to adhere to the principle of cooperation and mutual assistance, but the loaning procedures (between the credit unions and their members) turned out to be basically the same as in commercial banks, and it was the union director who decided whom to grant the loan to, what the amount of the loan was, and what the procedure should be for the collateral; as the result, loans to non-members represented up to 50% of all loans granted. Therefore, peasants never really considered the credit unions as a cooperative financial organization providing mutual assistance to peasants, but as some affiliates of official or government-run banks. Furthermore, rural credit unions did not conform to the principle of democratic management, and never really practice democratic management; since the cooperative system that we see on the surface was the result of the top-to-bottom application of administrative decisions, the unions’ internal personnel allocation and operational decision-making were naturally characterized by administrative control. Lastly, the credit unions were supposed to “mainly serve their members”, and not consider profit as a main objective, but the reality was that credit unions were obviously commercialized and fundamentally profit-oriented, becoming share-holding financial establishments pursuing the objective of profit (Xie Ping 2001). 4.5  The Causes of the New Rural Financial Institution and Its Performance Analysis China’s current formal rural financial institution is composed of three systems: the marketized financial system as represented by the Agricultural Bank, the government-subsidized financial system as represented by the Agricultural Development Bank, and the cooperative financial system as represented by rural credit unions. From the perspective of the practice of rural finance, this institutional framework has not efficiently solved the problem of financial supply and demand in rural areas, and in some places and in certain fields, serious malfunctions of the financial system can even occur. In view of this, the reform of rural finance and the innovation of the financial institution in the rural regions have become 102

important issues in the development of China’s rural finance. In particular, after the central government proposed in 2005 a new series of missions and objectives for the development of new rural communities, institutional innovations were rapidly introduced in the field of rural finance, marking the dawn of a new era. In the following discussions, we shall make empirical analyses of these innovations in the rural financial institution and the performance of such institutional changes. 4.5.1  The Cause of New Institutional Supply of Rural Finance and the New Institutional Framework The reform of rural finance has always been a hot topic in China’s financial sector. “The biggest problem of finance in China concerns the rural regions, and it is mainly reflected in the insufficiency of input (rural financial resources represent less than 30% of all the financial resources of the nation, while the urban areas dispose of over 70% of them; these percentages are inversely proportional to rural/ urban population distribution), the lack of establishments (the number of financial service points per 10,000 inhabitants in urban areas are four times higher than in rural areas), and the existence of a significant risk factor (the percentage of bad loans is 15% higher in rural areas than in urban areas). The most difficult point in Chinese finance lies in the rural areas, where it is difficult not only for peasants to obtain loans, but due to the high risk factor, it is also difficult for banks to grant loans. If China’s financial structure is to be adjusted, the focus should be on rural areas; when the financial problem is solved in these areas, the whole problem of unbalanced financial development in China will be solved.”[2] Since the beginning of the Chinese economic reform and open-up, three major reforms have been undertaken in the field of the rural financial institution. The newest round of reforms started in 2003 with the innovation of the property rights system in rural credit unions, and the motivation behind this reform drive came, as usual, from the fact that rural finance was lagging behind the development of rural economy. Most scholars in China were convinced that for a very long time, restrictions in rural finance had resulted in a situation where the rural finance service system was inadequate, the rural financial market lacked in openness, financial supply of

[2] E  xcerpt of Tang Shuangning’s speech at the 2008 Grand Financial Forum China, cf. China Finance Information network( 中财网 ), Nov. 5, 2008.


commercial character was insufficient in rural areas, and cooperative finance had been alienated, so that whether in terms of institutional framework, functioning mechanisms or operational methods, rural finance was not adapted to the needs of rural economy, and in particular to the requirements of new rural reconstruction. How to open new gates for the reform of rural finance? At the 2007 National Financial Conference, ex-Premier Wen Jiabao proposed the main idea to follow: speed up the development of rural financial reform, so as to optimize the rural financial system. In more concrete terms, effective measures are to be taken in various domains to strengthen financial services in rural communities, providing powerful financial support to the construction of Socialist New Villages. We shall accelerate an adequate rural financial system that is multi-layered, extensive and sustainable, and totally adapted to the characteristics of the san nong. We shall create a healthy organizational structure for the rural financial system so that it can effectively exert functions of commercial finance, policy-base finance, cooperative finance and other financial arrangements. We shall boost institutional innovations in rural finance, adjust and loosen the policy in an appropriate way to allow for the admittance of more financial establishments into rural areas, lower the threshold for such admittance, encourage and support the development of financial organizations of various types of ownership that are adapted to the specific needs of rural communities, and actively nurture various types of microcredit organizations. Meanwhile, we shall also enhance and improve supervision, so as to prevent potential risks. We shall spare no efforts in promoting rural financial products and service innovations, and in the development of agriculture insurance. Overall, we shall greatly upgrade policy support for rural finance. At the 17th Third Plenum in 2008, the Chinese Communist Party released a “Resolution on Several Major Issues Concerning the Development of Rural Reform”, in which a proposal was made to create a modern rural financial institution. According to this decision, rural finance is the core of modern rural economy, and therefore the following points are of critical importance: “Innovate the institution of rural finance, loosen the policy for admittance into rural finance, speed up the establishment of a rural financial system in which commercial finance, cooperative finance, and policy-based finance are integrated, capital is sufficient, services are adequate, functions are wholesome, and operating is safe. Upgrade the degree of policy support for rural finance, broaden channels for financing, make an effective integrated use of financial and fiscal levers and monetary policy tools, 104

implement fiscal reduction and expense subsidy for specific targets, and direct more credit capital and social capital into rural areas. All categories of financial establishments are to actively support the development of rural reform. Persist in the idea of an Agricultural Bank at the service of peasants and agriculture, strengthen its functions, clarify its responsibilities, and develop and consolidate its network of service for rural areas. Expand the support for agriculture in the activities of the Agricultural Development Bank, and enhance mid- and longterm credit support by policy-based finance for the development of agriculture and the construction of rural infrastructure. Extend the scope of agriculture-related activities in the Postal Savings Bank. Newly absorbed deposits in county-level banking and financial establishments are to be used mainly for the granting of loans to local applicants. Improve the legal governance structures of rural credit unions, maintain the stability of the level- and city-level unions’ status as legal persons, and make them effectively function as the main force serving the needs of peasants. Develop and regulate various new types of rural financial establishments and small and medium regional banks mainly destined to serving rural communities. Strengthen supervision, actively develop micro-credits, encourage the development of all kinds of micro-services adapted to the characteristics and financial needs of rural areas. Allow small rural financial organizations to absorb capital from larger financial establishments. Allow farmers’ professional cooperatives meeting certain conditions to implement credit cooperation. Regulate and boost the healthy development of informal (or folk) loaning activities. Accelerate the development of the rural credit system. Establish a rural credit surety mechanism based on government support, multi-party participation, and market operation. Expand the scope of effective collaterals in rural areas. Develop the rural insurance business, create a wholesome policy-based agricultural insurance system, speed up the establishment of mechanisms for agricultural re-insurance and catastrophe risk diversification. Strengthen the development of a futures market for agricultural products.’’ Seen from the level of the nation, a re-invented rural financial institution has become an important institutional base for the economic and social development of rural communities, and has given a boost to the creation of a rural financial system with multiple layers and multiple forms. However, as the institutional reform of rural finance is still controlled by the China Banking Regulatory Commission, the creation of a folk-based financial system has a hard time getting authorization, 105

and sometimes such efforts are even suspected of “illegal capital raising”. A look at the institutional innovations and arrangements that formal finance has provided to the rural financial system allows us to see that, in addition to the Agricultural Bank stating its objectives targeting “services to the san nong”, and the Agricultural Development Bank’s expansion toward new business activities, the new institutional framework mainly consists of (a) a reform of the property rights institution in cooperative finance, (b) the setting up of village-township-level banks, (c) the establishment of loan companies, (d) the creation of savings banks. In the following section, we shall make a concrete study and analysis of these new institutional arrangements and issues related to their performance. 4.5.2  Performance Analysis of New Institutional Supply in the New Rural Credit Unions The new round of reforms for rural credit unions started in 2003. In June of that year, the State Council promulgated the “Project for the Trial Run of the Consolidated Reform of Rural Credit Unions”, whereby it was decided to list eight provinces and urban areas including the Province of Shandong as the first group of administrative regions to implement trial runs, marking the start of the new round of reforms for rural credit unions. The project clearly stated, “in accordance with the general requirements of ‘clarifying property rights relationships, strengthening the constraint mechanisms, enhancing service functions, providing appropriate government assistance, and broadening the responsibilities of local governments’, we are to accelerate the reform of the management system and the property rights system of credit unions, in view of gradually transforming credit unions into community-based local financial establishments with peasants, rural companies and other economic organizations as shareholders, and providing services to the peasants, agriculture, and rural communities.” This round of reforms are focused on solving two issues: one, reforming the property rights institution of credit unions, clarifying property rights relationships, and improving governance structures of legal person; two, reforming the management system of credit unions, transferring the responsibility of managing the unions to local governments, and creating associations of credit unions at province- and municipality-levels. (1) The Choices Regarding the Model of Property Rights Reform and the Model of Management (a) The choice for the shareholding system and considerations in terms of 106

objectives. For Zhou Xiaochuan, head of the People’s Bank of China, the reform of rural finance consists in “paying for the purchase of a mechanism.’’ The mechanism in question is a concrete approach to revamp the existing property rights of credit unions, a reform that is to be carried out in different ways based on the principle of market and in accordance with the specificities of different regions. Property rights are organized according to three different regimes: the shareholding system, the shareholding cooperative system, and the cooperative system. The two former systems are implemented in economically more developed regions, while the last one is maintained and continuously improved in less developed regions. The general reform consists mainly in the promotion of the shareholding system in view of advancing toward commercialization. We can therefore see that the new round of reforms for credit unions expects to create a modern corporate system with clear property rights, with the objective of enhancing operational performance through the introduction of a commercialized model. In institutional terms, such a reform preaches a withdrawal from the current cooperative financial institution. For Jiang Dingzhi, Vice-Director of the Banking Regulatory Commission, “Reforming the rural credit unions and directing them toward the shareholding system is not only the choice of the market per se, but the result of years of exploration and reform efforts. Actual practice has proved that cooperation promoted via administrative power is lacking in vitality, and the rural credit unions that have been run by the government for a long time and have deviated from the original purposes of cooperation will never be able to return to the track of the cooperative system. Therefore, the shareholding system should be the leading direction toward which the reform of rural credit unions should move in order for it to be effectively consolidated’’ (Jiang Dingzhi 2008). Currently, China’s rural credit unions are strongly engaged in the promotion of a reform based on the shareholding principle, while persistence in the cooperative model has come to indicate an obstinate adhesion to an outdated economic institution. At this point, we have to pay attention to this question: Whether in the cooperative system or the shareholding system, is the institutional organization concerned with the credit unions’ own benefits, or the objective of serving the san nong, or both? From the perspective of the cooperative system, the institution itself has been instituted to serve the benefits of the cooperators, so the cooperative organizations are not looking for the maximization of profit for themselves. By contrast, the shareholding system is a modern commercial system, and has fixed as 107

its main objective the optimization of corporate profit. Therefore, these two systems have very different objectives. If we admit that the present cooperative financial institution has deviated from the concept of cooperation in its real sense, or that due to the alienation of the cooperative system, it is no longer possible for existent rural credit unions to get back on the track of cooperation, then we cannot but accept the fact that the current reform of rural credit unions has no other choice but to give up the cooperative system and to consider commercialization as the main objective of operation. On this basis, the reform is nevertheless given a quintessentially incompatible political objective: supporting the san nong. With regard to this, we shall proceed to an empirical analysis with the use of concrete data. (b) The model of management by province-level associations of credit unions. In the new round of reforms targeting rural credit unions, although the state has not defined any uniform regulatory framework with regard to how to establish the exact management model, in actual practice, the model of province-level associations of credit unions has basically been adopted nation-wide, with the notable exception of the cities of Beijing, Shanghai and Tianjin, which have created municipality-level rural commercial banks and cooperative banks. For a long time, the management model of rural credit unions has been based on rules set up for the financial sector. The major flaw of such a model is clearly visible, i.e. the state’s special policy for rural credit unions is abusively used to compensate the deficit within the system. The implementation of a sectorial management model led by province-level associations of credit unions is useful for mobilizing the dynamics of local governments and centralizing responsibilities, rights and benefits at the level of the provincial government, and therefore, to a certain extent, it is beneficial for enhancing the local governments’ efficiency in the allocation of financial resources. However, the risks associated with this management model are not to be neglected. Theoretically speaking, the management of province-level associations of credit unions is supposed to be some form of sectorial management, not a sort of direct administrative control over people, properties and objects, and the relationship with grass-roots rural credit unions is supposed to be one of activity-related advice and service. The management and decision-making of rural credit unions should be dominated by peasants who have the status of members, and not by province-level associations of credit unions. From the actual practice in various regions, we can see that the directors of province-level associations are appointed by province-level party 108

committees, the directors of local or county-level associations are appointed by province-level associations, and the model of reform for the property rights of local credit unions is to be ratified by province-level associations. In other terms, province-level associations of credit unions have come to manage the people, properties and objects of local credit unions. Under the model of management by province-level associations, local credit unions have converged toward a uniform orientation in terms of operation and performance evaluation, that is, conforming to the model of commercial banks: following the model of shareholding-type banks in the reform of property rights, and pursuing the maximization of current profit in business operations. In order to achieve the objective of reorientation toward becoming commercial banks, local credit unions have engaged in joint planning with local governments, and, benefitting from the same conditions as for the examination and authorization of commercial banks and from the various policies the state has adopted with regard to local credit unions, they have been able to advance rapidly toward the objective of commercialization. (2) Performance Analysis of the Property Rights Reform Based on “Paying for the Purchase of a Mechanism”. At the core of the new round of reforms for rural credit unions is the property rights system, that is, paying money for the purchase of a mechanism: rural credit unions acquire project-specific central bank bills issued by the People’s Bank to replace the bad loans accumulated through the years in a bid to transform their operating mechanism, so that the reformed credit unions can really become market entities that operate independently, are self-constrained, develop autonomously, and assume risks by themselves. The purpose of this institutional design is evident: introduce market mechanisms, solve historical problems, achieve the objective of profit associated with commercialization, and serving the san nong in a better way. (a) Comparison of the operating results before and after the property rights reform of credit unions. Table 4-5-1 shows that since the new round of reforms targeting rural credit unions got underway in 2003, the percentage of bad loans decreased significantly, while the rate of capital sufficiency increased remarkably; in other words, as commercial business establishments, their performance improved. But we should also pay attention to the fact that behind these improvements, there was the state’s commitment to capital input in the form of specific bills issued by the central bank. In this round of reforms characterized by such capital input, 109

the condition for the central government to issue central bank bills was that rural credit unions themselves should compensate for half of the debt/capital deficit, and in the actual practice, the “payment condition” is for the credit unions’ capital sufficiency rate to attain 2% within two years, and for the percentage of bad loans to be reduced by at least 50% compared to the end of 2002, plus, of course, qualitative objectives like clarity of property rights, adequateness of governance structure, etc. As things go, the actual payment to be made for the purchase of the central bank bills are the two “hard indicators” that are the percentage of bad loans and the rate of capital sufficiency. For the rural credit unions under local government management, in order to seize this precious opportunity, they must increase their capital and expand their shares as quickly as possible. In so doing, they let short-term opportunist behavior take over the requirements of revamping the operating mechanism and improving the governance structure, resulting in the “mechanism purchase” approach going against the original intentions. According to an investigation by questionnaire carried out by Xie Ping, Xu Zhong and Shen Minggao (2006) with regard to the first and the second series of trial runs, for the credit unions investigated, profitability rate in 2004 increased by 100% over 2003, but when such factors as preferential policies and the state’s raising of benchmark interest rates are taken into account, the credit unions’ own profit-making ability in 2004 had actually not increased over the previous year. Table 4-5-1: Operating Performances Before and After the Property Rights Reform of Rural Credit Unions 2002
















Source: Related reports on People’s Daily and other media[3]

(b) Comparison of the operating results of the branch offices before and after the property rights reform. In order to further analyze the concrete situation of the increase of loans granted by rural credit unions to rural households, Xie Ping et al. put the credit unions of first series of trial-run regions into three groups, High,

[3]  The data are mid-year figures for 2005, and year-end figures for the other years.


Medium and Low, according to the percentage of rural household loans in 2000. The evolution of the percentage of rural household loans for these three groups during the period 2000 – 2004 is shown in Diagram 4-5-1. From this diagram, we can see that the fastest growing percentage concerns the group with the lowest percentage in 2001, and the percentage of loans granted by the credit unions of this group shows a tendency of continuous increase over the previous four years. For the other two groups, this indicator is relatively stable during the same period; the group with the highest percentage shows a slight increase in 2004, while the medium group shows a slight decrease. These results indicate that the trial runs of the reform of credit unions were of limited effect in increasing the loans granted to rural households. The regions with a high percentage of rural household loans (namely the relatively poor areas) already show percentages as high as 90% and over, which can hardly be increased further. In the regions with medium percentages (i.e. regions with a medium level of development), the cultivating and breeding activities made it possible for rural household loans to increase, but despite this potential, no real increase was observed. The regions with the lowest percentage of loans are the more highly developed ones, and the increase of rural household loans resulted mainly from non-agricultural activities and consumer loans; while the percentage increased more rapidly, it had nothing to do with the purpose of supporting the san nong.

◆ —Group with low percentage of loans  

▲ —Group with high percentage of loans

— ■ —Group with medium percentage of loans  

Diagram 4-5-1: Evolution of the Percentage of Rural Household Loans for the High, Medium, and Low Groups


However, in contrast with unregulated folk-based lending, which are concerned with credit, future cash flow, and unlimited responsibilities, credit unions’ loaning practices are more focused on the quantity and quality of collaterals. Diagram 4-5-2 shows that even if the credit unions’ microcredits are taken into account, the average rate of credit loans are about 25% for credit unions. For the credit unions of the first series of trial runs, the trial reform had not resulted in significant effect on credit loans, and for the second series of trial runs, the rate of credit loans had even decreased over the previous period. In their selection of loan clients, the credit unions relied too much on collaterals and not on their advantage in terms of information, and this is one of the main reasons why it was difficult for rural households to obtain loans and why unregulated borrowing/ lending activities developed actively. The reform of credit unions over-emphasized the safety of loans, and not the consistency between loan-related risks and profit, which may have made it more difficult for rural households to obtain loans, and not the other way around.

Diagram 4-5-2: Percentage of Credit Loans for the Credit Unions in Trial-run Regions Source: Xie Ping, Xu Xhong & Shen Minggao, “Performance Evaluation of the Reform of Rural Credit Unions,” Financial Research, 2006, (1).

(c) Analysis of the reasons behind the paradox concerning the performance of the reform of rural credit unions. First of all, under the conditions of market economy, the allocation of capital resources depends on the rate of return on investment; however, factors like the weak nature of rural economy, the 112

backwardness of the investment environment, the dispersed character caused by the smallness of the average scale, the limitedness of a unit of loans, and regional differences in resource availability and the level of development result in multilayered and highly diversified need for capital, and this situation in turn brings about high costs for information acquisition and for transactions on the one hand and low rates of return on investment. The double constraints of natural risks and market-related risks, and the lack of collateral objects also increase the risk level for investment. Commercialized rural credit unions lack the endogenous dynamics for supporting the san nong. Secondly, as Professor Wen Tiejun points out, China’s current reform scheme was designed on the basis of sectorial benefit, and its purpose is to establish a financial system in which transaction costs can be reduced and financing efficiency enhanced. Since property rights determine the behavior of the subject of benefits, the collective character of property rights also determine the fact that the main agent for the institutional change can only be the government, with the purpose of achieving the government’s re-allocation and macroeconomic management of rural financial resources; the consequence of this is that the multilayered and diversified needs of rural economy and the overall functioning of the rural financial system are neglected. After the primitive accumulation of industry has been achieved, the stability and development of agriculture and rural communities has become one of the main objectives pursued by the state, but comparatively speaking, the prevention of risks and the maintenance of financial stability seem to be even more important objectives. Furthermore, the specificities of rural credit ---small scale, long periodicity, information distortion, lack of collaterals, etc. --- certainly bring about higher transaction costs and credit risks. Under the circumstance where interest rates do not reflect the risks incurred, requirements related to risk-benefit symmetry make it impossible in reality for the financial needs of weak economic entities like rural households to be satisfied via the services provided by formal financial establishments, and after the reform, rural credit unions are certainly operated in a commercialized way, and as long as policybased compensations do not exist, it will be difficult for them to take the risk of supporting the san nong.


4.5.3  Performance Analysis of the Institutional Arrangement for VillageTownship Banks (1) Analysis of the motivation behind the institutional arrangement. Along with the development of rural economy, the rural financial market has become more and more seriously “anemic”. Since the four major national commercial banks withdrew from the rural credit market in 1998, rural credit unions have become the only formal financial establishments that can still offer normal financial support to the vast number of rural households. However, as indicated by many studies, the existence of problems in property rights and the organizational model, in the management system, in the risk sharing mechanism, etc. caused the rural credit unions to become a mere “decoration” in the landscape of rural financial supply, unable to assume the responsibility of offering effective credit-related services to the san nong. On the other hand, rural credit unions, together with commercial banks and postal savings establishments, formed a huge “capital funnel” through which deposits of rural households flow into cities, resulting in serious “deruralization” of rural capital. Under such circumstances, the needs for capital in rural communities are in part satisfied by the “mutual assistance” provided by relatives and friends, and various unregulated, “underground” loaning organizations prosper. However, the amount of the loans provided by relatives or friends is often small, and such loans are badly regulated, giving easily rise to disputes, or, in Wen Tiejun’s words (Wen, 2001), “the cost of ‘face’ becomes higher and higher.” As to the underground loaning organizations, as they practice extremely high interest rates and the conditions of repayment are extremely harsh, they cannot satisfy the financial needs of the vast majority of ordinary rural households. In October 2006, Professor Muhammad Yunus, internationally renowned as the “father of microcredits” or “banker of poor people” won the Nobel Peace Prize for the world’s first rural bank, the Grameen Bank, that he created in Bangladesh. Thirty years ago, he lent 37 US dollars to 42 extremely poor Bangladeshi women, and soon afterwards, he established the Grameen Bank. Today, Grameen Bank has become a banking system with 1,200 branches and serving more than 46,000 villages, bringing more than four million poor rural residents in Bangladesh to rise from poverty to prosperity. In order to learn from the success model of the Grameen Bank, fill the 114

vacuum in rural financial supply and introduce competition, China’s Banking Regulatory Commission release in 2006 the document “Various Opinions Concerning the Adjustment and Loosening the Admittance of Banking and Financial Establishments in Rural Regions with a view to Provide Better Support to the Building of New Socialist Villages” (shortened as “Opinions” hereafter), and the government greatly loosened its admittance policies for rural financial establishments in such respects as category of establishments or capital restriction, and the new policies were implemented in trial runs in six provinces and regions including Sichuan, Inner Mongolia and Jilin. In March 2007, the first village-township banks (hereafter rural banks) were born in these six trial-run provinces/regions. In October 2007, the Banking Regulatory Commission extended implementation to 31 provinces/regions. In December of 2007, the first foreign-capital rural bank, Cengdu HSBC Rural Bank opened its doors for business. In the same month, the rural bank created at the initiative of the National Development Bank also started operation. In August 2008, the Agricultural Bank set up rural banks simultaneously in Hubei Province and Inner Mongolia. By October 2008, the number of rural banks established nationwide had exceeded twenty. (2) The clash between the dual objectives of setting up village and township banks. According to the “Interim Provisions for the Management of Village and Township Banks”, rural banks are banking/financial establishments in rural regions with the capital of domestic and offshore financial establishments, domestic nonfinancial corporate legal entities, and domestic natural persons, and their main purpose is to offer financial services to local peasants, villages and agricultural activities and support local economic development as a whole. In a nutshell, serving the san nong is the fundamental purpose of village-township banks. Meanwhile, since these rural banks are independent corporate entities which “operate autonomously, sustain risks by themselves, are responsible for their own profit or deficit, and are bound by obligations of self-restraint”, it is only natural that their promoters or investors consider profit maximization as their most important objective; on the other hand, peasants are a disadvantaged group, and agriculture and rural economic operations are high-risk and low-benefit economic activities heavily influenced by natural and market conditions. As there is a serious lack of policy-based agricultural insurance, village and township banks are driven by benefit, and can hardly adhere to the ideal of “single-mindedly” serving the san 115

nong and supporting new rural reconstruction, so they will gradually deviate from their original purpose and try to look for new market-oriented positioning. Under such circumstances, the phenomenon of “agriculture shifting to non-agriculture” that took place in the credit capital state-owned commercial banks in rural areas will inevitably repeat itself in village-township banks. The way Fengyang Limin Rural Bank is operated since its opening in May 2008 constitutes a typical example in this respect. (3) Performance analysis of the institutional functioning. Considering the trial run of the Sichuan Yilong Huimin Village Bank, the ability of rural banks to solve the problem of “service vacuum and insufficiency of competition” in rural areas is still weak, and this is mainly reflected by the fact that the bank has a high deposit/loan ratio and is unable to curb the outward flow of rural capital. A short while after its founding, the bank’s deposit/loan ration attained 2.74, higher than the county average of 2.1, showing a higher degree of capital outflow. Peasants have not become the absolute majority of those who have been granted loans at the Huimin Village Bank, and the loans they have obtained represent only 43% of the total amount of loans granted, showing that the proportion of loans granted to rural households is relatively low at this bank. The rural banks lack in competitive advantage and the space for their existence is rather narrow. In Yilong County, the rural credit unions are in an absolutely advantageous position in terms of service point distribution, integrated inter-union settlement, capital scale, social relationships, etc., and it is very difficult for the Huimin Village-Township Bank to compete with them. It is much easier for credit unions to attract “quality customers” among rural households. As to the majority of medium and small rural households, the microcredit model of Yilong County’s Rural Development Association is more popular. The Huimin Bank, with only one service point and very few intermediate activities, draws its profit mainly from its loans. But as the scale of the loans is small, there is doubt about the bank’s fiscal sustainability. More importantly, the agriculture-supporting credit model of rural banks lacks in fundamental innovations compared to credit unions, and are still subject to higher systemic risks. Investigation data from Jiangxi Province’s first trial-run rural bank, the Nankang City Ganshang Village-Township Bank (shortened as Ganshang Bank hereafter), shows similar problems. The bank was established in February 2008, and due to the fact that local people do not fully understand and trust rural banks, 116

currently 80% of the deposits in this bank come from government departments and agencies, of which 76% are provided by the local fiscal bureau. This shows that rural banks have very limited capital resources. As to Fengyang Limin VillageTownship Bank, since it was created in May 2008, the local fiscal authorities arranged for an amount of specific-purpose deposits of RMB 20 million to support its development, and regarding these fiscal deposits, the county’s accounting and audit bureau even felt obliged to provide opinions in regard of risk auditing. Because of the conflict between business-oriented operation and the objective of supporting peasants and agriculture, as our analysis above shows, it is very hard for rural banks to remain “single-minded” in their purpose. The bank director we interviewed stated that if rural banks were to serve only the san nong, they would not be able to continue to operate and would soon go bankrupt. Investigation data also shows that in July 2008, among the largest ten loan clients of Ganshang Bank, only two were fully involved in the sector of agriculture. One of them was Nankang Luchuan Forestry Company, which obtained a RMB 2 million loan for post-disaster reconstruction and reforestation; the other was a private company that obtained a RMB 950,000 loan to develop a forest plantation. The rest of the loans, totaling RMB 16.45 million, were used for man-made panels, the auto trade, glass fibers, mining activities, renovation and decoration of shops, etc. In terms of the purpose of use, the ratio of agriculture to non-agriculture was 1 : 5.6. Ganshang Bank has the same operational strategies as market-oriented commercial banks, and has not developed any concrete new policies regarding the support of the san nong. As to the bank’s accounting settlement, up to now, it is still taken charge of by the Nankang Branch of the Ganzhou City Commercial Bank. In the credit activity, although it has instituted an independent loan management system, the fundamental rationale still follows the commercial bank’s loan management system, without any new and effective credit operation rules and procedures. With regard to financial products, there are basically only a few typical, conventional services like collateral, pledge, guarantee, and discount, and although the bank launched a series of loans tailored for Nankang City’s specific needs in economic development, like “Xingkang Huinong loans” (designed for peasants), “Xinkang Guoye loans” (designed for fruit production), “Xingkang Bianmin loans” (designed for citizens), these products did not break away from the old ways of conventional loaning and could hardly find recognition and acceptance among rural households. 117

Since rural banks are still in the stage of trial runs in various regions across China, it is still difficult to obtain systematic statistic data to analyze their performance. But from the above two examples, we can see that rural banks are still faced to a considerable degree with the problem of “maladaptation”. Lack of capital and monotony of activities are just a few of the obstacles for the successful development of commercial operations, and above all, the banks have fallen far behind with regard to their original objective of serving the san nong. 4.5.4  Performance Analysis of the Institutional Arrangement for Loan Companies Also in the intention of filling the financial “vacuum” that has appeared in China’s rural regions, and direct the massive “underground finance” into the san nong which is in dire need of “blood transfusion”, the People’s Bank of China took the success lesson of the development of micro-credits in foreign countries and ratified trial runs in the field of informal commercial microcredit sector with deployment in five provinces and autonomous regions. Consequently, Rishenglong and Jinyuantai, two commercial microcredit companies created with the capital of natural persons, went into operation on December 27, 2005 in Pingyao County, Shanxi Province. They only provide loan services and do not take savings. An investigation carried out in 2007 showed that the two microcredit companies were functioning well, and they not only attained financial independence and high profit levels, but achieved the stunning performance of 100% loan recovery rate and 100% interest collection rate, demonstrating remarkable risk control ability. But meanwhile, such good operational performance was achieved on the basis of a strong desire to pursue profit and a very precautious approach in terms of risk aversion. Due to these two factors, these microcredit companies set up higher “thresholds” for selecting their loan clients, resulting in a certain degree of inequality in the allocation of credit resources. Table 4-5-2 is taken from the investigation of Zhang Jie et al. (2007) about the financial needs of rural households in surrounding areas and how these needs were satisfied by the two companies. The data clearly shows that the microcredit companies, pursuing the objectives of profitability and risk control, were more inclined to satisfying the needs of highincome non-farming customers. Among the 100 rural households investigated, ten had needs for requesting a loan for investing in plant cultivation, among which four were from the low-income group, three from the medium-income group, and 118

three from the high-income group, but only one household from the high-income group was satisfied in their need for capital. 44 households had needs for capital to invest in breeding, 8 of which were satisfied, among which one was from the lowincome group (seven applicants in all), two were from the medium-income group (20 applicants), and five from the high-income group (17 applicants). Needs for consumption-type loans existed only in the medium- and low-income groups of rural households, among which only medium-income households saw their needs satisfied. Requests for loans for industrial and commercial purposes were satisfied to a greater degree, and high-income households were satisfied the most easily. Table 4-5-2: Need for Microloans of Rural Households in Different Income Groups and Degree of Satisfaction Purpose of loan

Number of households with need for commercial microloans

Number of households obtaining microloans

Input for plant cultivation



Input for breeding

44(7/11,20/36, 17/53)


Input for agricultural infrastructure



Input for commercial/industrial

58(4/11,17/36, 37/53)




purposes Consumption expenses

N.B.: The figures in parentheses present the ratios of households whose needs are satisfied to the total number of households in respective income groups. The income groups are defined as follows: Low = under RMB 10,000, Medium = REM 1 – 20,000, HIGH = above REM 20,000. Agricultural infrastructure includes the purchase of agricultural machinery and tools, well drilling, purchase of water pumps, etc. Commercial/industrial input includes working capital for transport, product processing, small business, etc., and investment for expansion of production. Expenses for consumption purposes include marriages/funerals, construction of houses, hospital fees, education, purchase of large home appliances, etc. Source: Zhang Jie, Performance of the Institutional Adjustments in China’s Rural Financial Institution from the Perspective of Financial Needs. Beijing: China Renmin University Press, 2007: 285.


4.5.5  Performance Analysis of the Institutional Arrangement for Postal Savings Banks (1) Analysis of the institutional arrangement and the motivation. Postal savings bureaus and rural credit unions have always been the main establishments in China for the absorption of deposits from rural households. However, for a long time postal savings bureaus have adopted a policy of only taking deposits and not granting loans in rural regions, resulting in massive outflow of rural capital, and totally falling short of the objective of using that capital to feed the san nong. On December 31, 2006, China’s Banking Regulatory Commission, as part of the institutional reform of the postal services, formally ratified the establishment of the China Postal Savings Bank, for which China Postal Group provided the full capital. This move amounted to a historical leap in the regulation of the management and operation of the postal savings sector in China. The re-structured Postal Savings Bank has deposits totaling REM 1,700 billion and over 36,000 branches and stations, of which two thirds are located in counties and rural regions below the level of county. As such, it is the largest financial network linking rural and urban areas, and constitutes an integral part of China’s rural financial service system. In accordance with the requirements of the Banking Regulatory Commission, the market positioning of the newly established Postal Savings Bank is to provide residents in both urban areas and the vast rural areas with fundamental financial services, in order to support the building of New Socialist Villages and harmonize the social and economic development in the cities and the countryside, and the main targets of the bank are retail and intermediary activities. The bank is also encouraged to expand its scope of operations under the condition of risk controllability, bring into full play its advantageous edge in network-wide postal savings resources, and boost the flow of postal savings capital back into rural regions. With this new market positioning, China Postal Savings Bank’s branches across the nation have been launching various microloan projects designed for residents in villages and cities alike. In December 2005, the Banking Regulatory Commission ratified the first round of trial runs of pledge loans with postal savings time deposit certificates as collaterals and selected the provinces of Fujian, Hubei and Shaanxi as for the tryout. In March 2007, the operation is extended to the whole nation. This was the first time China Post launched operations in the area of assets, and in consideration 120

of the ability of the Postal Savings Bank to sustain risks, the Banking Regulatory Commission ruled that Postal Savings could only develop trial runs in the domain of microloans by pledge with time deposit certificates as collateral. Lenders must use postal savings time deposit certificates contracted in the province of residence as collateral for loans starting from REM 1000, the amount of each loan must not exceed 80% of the face value of the collateralized deposit certificate, and the period of the loan must not exceed 12 months. By March 26, 2007, Postal Savings Bank had started granting microloans by pledge at 1901 branches in 903 counties and cities nationwide, with loans totaling RMB 1.71 billion, of which 66.96% were granted in rural regions. These operations relieved to a certain degree the difficulty for peasants to obtain loans, and established the base for the future deployment of the Postal Savings Bank’s business activities. In June 22, 2007, the Postal Savings Bank officially launched in Weizhuang Township in Changyuan County, Henan Province a trial run for its microcredit activity. The target clients of this operation was the township’s micro- or small business-owners, self-employed entities or rural households, and the loans were granted mainly in the two forms of “joint guarantee by commercial tenants” and “joint guarantee by rural households”. For both categories, the period of the loan was 1 to 12 months, no other collateral was necessary during the application procedure, and the loans could be repaid via various means. After the Postal Savings Bank launched its service of granting microloans by pledge with time deposit certificates as collateral, the microcredit service opened a new channel of financing for innumerous business owners and rural households nationwide. (2) Performance analysis of the cost of operating the system. According to the study of Li Ya (2007) regarding the Postal Savings’ activity of microloans by pledge in Hebei Province, the actual operation in branch offices presented the following problems. Firstly, there were much more non-agricultural loans than agricultural ones. As the first branch offices to launch the activity were located in larger cities and county capitals which are more economically developed and densely populated, the operation did not cover households in smaller towns and rural areas. As a result, most of the clients who applied for such loans intended to use them in businessrelated capital turnover or individual consumption, and only a small number of them were to use the loans for agricultural production. On the other hand, due to reasons related to ideology or mindset, when peasants have extra money, they tend 121

to deposit it, and if they need money, they prefer to borrow from people instead of asking for a loan and pay for the interest afterwards. In the 68 microloans by pledge granted in some city, 90% were of non-agricultural nature, and only seven, or 10% of the total, were used for agricultural production. In the 61 loans for non-agriculture purposes, 30 were used for business turnover, 21 for real estate purchase, 8 for private consumption, and 2 for other purposes. In some county, amongst the microloans by pledge of a total amount of RMB 826,000, more than 80% were used for non-agriculture purposes, and only RMB 138,000, or 16.7% of the total, was used in agriculture. Secondly, there were much more collaterals in the form of the lender’s own deposit certificate than in the form of a third party’s deposit certificate. Microloans by pledge are intended for individual applicants using deposit certificate as collateral and with one-time recovery of the total amount of principal and interest at the end of the loan period, and there are two forms of pledges, with the ender’s own assets as collateral or with a third party’s assets as collateral. The actual operations after this activity was launched indicated that most of the applicants were in urgent need of capital, but since their time deposits had not reached the end of the term, they decided to apply for loans by pledge in order to minimize the loss of interest on their savings. According to statistics, in the RMB 275.5223 million granted in the form of loans in the whole province, 215.4685 million were obtained with lenders’ deposit certificates as collateral, which amounted to 78.2% of the total, while loans obtained with third-party collateral amounted to only 21.8% or 60.0538 million. The study also found that in one city, the 15 loans granted during one month, totaling RMB 804,000, were all collateralized with the lenders’ own deposit certificates. Also, the number of loans with a term of less than six months was higher than that of loans of over six months. In one city for example, the vast majority of the 280 microloans by pledge granted were for terms of under six months; in another city, of the 68 loans granted by nine Postal Savings branches, totaling RMB 3.4044 million, 67, or RMB 3.3954 --- that is, almost 100% --- were for a 6-month term, and only one loan of RMB 9000 was for a one-year term. This clearly shows that medium- and low-income rural households with insufficient personal savings were practically excluded from this business activity. Thirdly, the period was short and did not match the needs of agricultural production. Currently, the microloans by pledge granted by postal savings establishments have a maximum term of one year, and this is obviously not adapted 122

to agriculture, which is characterized by long production cycles and slow return on investment. During the period studied, in the time deposits of RMB 60.755 billion saved in banks in Hebei Province, 86%, or REM 52.246 billion, were for terms of one year or less. Since most lenders used one-year time deposits as collateral, the number of deposits for 6 months or under that had not been collateralized was 3511, with a total amount of RMB 120.4274 million, occupying 84.38% of the total amount of non-collateralized time deposits; as for non-collateralized deposits for terms of 6 to 12 months, the number was only 716, totaling RMB 22.2926 million, or 15.62% of all non-collateralized deposits. The study showed that most clients applied for loans because they were short of capital, and needed to obtain loans before the end of the terms of their deposits in order to proceed to short-term capital turnover, so the purpose of such loans was mainly for satisfying urgent financial needs. Furthermore, the trial runs in various regions indicated that the service level of Postal Savings personnel was not very high, and the development of the activity was restricted as a result. The staff involved in the launching of microloans by pledge had worked in postal deposits and savings or money exchange, and had not acquired any experience in the loan/credit activity; therefore, their knowledge of assets-related operations of Postal Savings was very limited, and most of them even only worked on a part-time basis. This phenomenon constitutes a disadvantage for the control of risks in the loan/credit activity, and can hamper its long-term development. 4.6  Analysis of the Exogenous Institutional Change in regard of Transaction Cost and the Game under the State’s Preference From the discussions in the preceding sections, it is not difficult for us to realize that China’s agrarian question is very special, and while current mainstream theories can be used to explain parts and fragments of the issue, they cannot expound the question as a whole and clarify the logic contained in it. From the founding of the PRC to the era of economic reform, the transformation of the exogenous financial institution in rural China had been an imposed institutional change dominated by the state, and the state’s preferences became the dynamic mechanisms for institutional change. If such preferences adhered to a consistent objective function, institutional arrangements ought to be relatively stable, but why 123

were they constantly modified in reality? If the preferred objective function had changed, then what should be the core variables for realizing it? With regard to this, the author will make a concrete analysis of the institutional change based on the parameter of transaction cost. 4.6.1  Exogenous Institutional Arrangement in Rural Finance with Externalization of Transaction Costs The “externalization of transaction costs” means that the costs involved in the organization and functioning of the financial institution are not assumed by organizations inside the institution, but are taken charge of by promoters outside the institution. On the eve of the economic reform, the sole promoter of the exogenous financial institution in rural China was the state, so all the costs related to the institution’s functioning was “cleared” by the state, and the duty of all categories of financial establishments and organizations was to grant loans according to the state’s plans and orders. With regard to rural credit unions, since their trial launch in 1957, they were quickly integrated into the management system of the Agricultural Bank and People’s Bank, and accordingly the nature of the institution changed to government-run finance, the credit/loan mission completely falling in line with the managing bank. The result of this was that the original mechanism of the cooperative financial institution became ineffective, and transaction costs stayed at a high level. Commercial banks, the most important of which being the Agricultural Bank, were also faced with the objective of executing missions according to the state’s credit/loan-related plans and orders; as far as the Agricultural Bank is concerned, between its founding in 1951 to 1979, it went through three rounds of dissolution/merger and rehabilitation. So changes were frequent, and the costs of all those changes were entirely paid by the state. Why did changes occur so often during those thirty years? The author is convinced that the main reason originated from the objective of financial monopoly under the national strategy. After the PRC was founded, in order to consolidate the regime and create a socialist system, financial resources became extremely important for the guarantee of pecuniary power. Therefore, the state was focused on monopolizing financial resources, so that they could be used to serve the state’s socialist objectives, and as a result, the allocation of financial resources did not take into account the calculation of transaction costs, and was done solely in accordance with the requirements of a planned economy, becoming the state’s “second fiscal regime”. Any institutional 124

arrangements based on such externalization of transaction costs certainly result in the institution lacking in incentive mechanisms, financial establishments will not be bound by any objectives of performance. And the non-separation between politics and enterprise necessarily brings about low performance levels which, of course, are hard to evaluate by any quantitative means. Therefore, because of the state’s strategic objectives and its preference for the monopoly of financial resources, this round of exogenous institutional arrangements of the financial system was carried out at the expense of externalized transaction costs and with the objective of monopolizing financial resources. 4.6.2  Exogenous Institutional Arrangement in Rural Finance with Internalization of Transaction Costs The internalization of transaction costs means that the costs involved in the organization and functioning of the financial institution are taken charge of by the organizations internally, and the state does not assume the duty of paying for those costs. This institutional arrangement requires that the organizations within the institution operate autonomously, assume the profit and deficit by themselves, and become independent market entities. In August 1996, in accordance with the “State Council Decisions Concerning the Institutional Reform of the Rural Financial System”, China’s rural finance was required to establish a rural financial system based on cooperative model and functioning by the principles of commercial finance and policy-based operation. In order to achieve this, the Agricultural Bank started its reform toward commercialization in 1996, and in 2003, rural credit unions started a reform around the core issue of the property rights institution. Such reforms indicate that the state’s financial system was no longer only concerned with the problem of financial resource monopoly, and that it had moved out of the original system in which transactions costs were cleared by the state, the result of which was that financial organizations and establishments were obliged to undertake an institutional revamping and follow the path of marketization by focusing on transaction costs. For this precise reason, the Agricultural Bank, in order to allow its establishments to achieve the objective of marketization and profit, decided to undertake a massive operation of dissolution and merger targeting its rural financial establishments which necessitated relatively high transaction costs. County-level cities, positioned at the critical point between profit and deficit, became the baseline for maintaining, and county-level establishments directed 125

their service objective mainly at urban commercial and industrial clients above county level who necessitated lower transaction costs. The result of all this was an internalization of transaction costs, and the objective of marketization --- the state’s preference for this new round of institutional arrangements --- was achieved. The same thing happened with rural credit unions. As large numbers of rural credit unions actively sought to transform themselves into rural commercial banks and commercial cooperative banks, they turned the target of service from peasant households to urban industrial and commercial clients. It can be said that this round of the reform game, focused on the reduction of transaction costs, was played at the expense of the savings of rural households and by cutting down on credits and loans granted to them. 4.6.3  Exogenous Institutional Arrangement in Rural Finance with Diversification of Transaction Costs The pluralization of transaction costs means that the costs involved in the organization and functioning of the financial institution are not only taken charge of by the organizations and establishments inside the system, but also assumed by the promoters of the institution, namely public organizations like the state or the governments at different levels. This kind of institutional arrangement complicates the issue of payment for transaction costs, since it is hard to decide which systems should enjoy such special preferential treatments. If we look at China’s current exogenous financial institution, we can see that the arrangement is focused on the Agricultural Development Bank, including the institutional reform of rural credit unions which is currently under way. Since its founding in 1994, the Agricultural Development Bank is mainly charged with the purchase, sales and storing of agricultural products, the integrated development of agriculture, the construction of rural infrastructure, the protection of rural ecology and environment, etc. It is also stipulated that the banking system function according to the principles of independent accounting and auditing, autonomy, capital-preservation operation, and corporate management and governance. Although the state originally made this institutional arrangement with a view to internalizing the transaction costs involved in the functioning of the institution, in the actual operations, because the bank is lacking in capital of its own, it is faced with the problems of low capital sufficiency rate, bad autonomous financing ability, and increasing asset/liability deficit. Meanwhile, as there is a lack of diversity in business activities, credit-, 126

loan- and capital-related products are of relatively low quality, and therefore operational risks are increased, resulting in the deficit caused by overly high transaction costs and in need of large amounts of subsidy by the state to cover the loss. Furthermore, in order to obtain benefit from the state’s policy of replacement of specific-purpose bills, rural credit unions strived to obtain cash via capital increase and share expansion, the result of which was that the transactions that were supposed to be paid by the credit unions themselves were turned over to the state. This newest round of exogenous institutional arrangements of the financial system is characterized by the fact that the state’s preference contains both a political objective function --- serving the san nong --- and an objective function of marketization --- assuming profit and deficit autonomously. In this situation, when the two objective functions are in clash, the preference of the financial establishments comes into a conflict of interests with the state’s preference, so that the game around the issue of who should pay for transaction costs develops in the end into a diversified payment strategy.


Chapter 5  Supply Repression: Endogenous Rural Financial Institutional Arrangement 5.1  The Formation and Evolution of the Endogenous Institution of Rural Finance 5.1.1  Historical Factors Regarding the Formation of the Endogenous Institution of Rural Finance and Its Necessity Endogenous finance is evolved and formed spontaneously in the rural areas to address the needs of everyday life. It plays a very significant role in the rural financial sector. Since ancient times, endogenous finance has been developing continuously alongside the national rural credit institutions, which could be dated back to around the Spring and Autumn and the Warring States Periods. It keeps its vitality even after thousands of years. A study of its evolution thus will help better understand its mechanism and effectiveness when put in practice. First: continuation and development of a rural economy based on peasant economy. The rural financial market is first developed from a relatively underdeveloped economy. This is a determinant for the inevitability of primary folk financial activities self-initiated by the people. China’s feudal society was formed thousands of years ago, having gone through different dynasties and regimes. But peasant economy as the dominant economic mode and feudal system the social framework fundamentally sustained rural China. In the rural areas, the capitalist mode of production has yet to germinate or is still in its infancy. Whichever case it maybe, the financial institutional development remains in its early stage. Under this economic condition in which the social order is stable, the family values are strong, and relationships among friends, relatives and neighbors are extremely close and intimate, the social system undergoes very little changes. Under the bondage of blood-ties and socio-geographical proximity, mutual support and acts of justice etc. are adopted as natural social ethics and codes of social behavior. The essential feature of peasant economy is low productivity. The household economy has to meet the basic needs for survival and tends to evade risks. Under these circumstances, a large variety of folk financial organizations and loan activities, the majority of which are trust-based, emerge. They have been operating for hundreds and thousands of years, and are likely to further propagate. With the introduction of the reform and opening up policy, different kinds of private and individual 129

economic activities emerge as demands for capital from the private sector soar. But commercial and state-owned banks stay away from the vast rural areas. They are particularly strict with credits for individuals in rural areas. The rural credit unions were essentially rural cooperative organizations. As was mentioned above, after the decade-long turmoil of the Cultural Revolution, they are no longer rural entities but the grassroots organizations of the Agricultural Bank and therefore unable to play the role of financing for peasants. Traditional unregulated financial activities of the civil society are formed and developed as a result. Second: meeting the needs of the new individual economic development in the private-sector. Various economic systems have greatly transformed and evolved during the past three decades of economic reforms in China. The restructuring of state-run collective ownership economy in particular has resulted in the shaping of a diversified economy. But running in parallel is a financial system that oftentimes lags behind economic reforms. Meanwhile, people in China are more open and there is a consensus about developing the private-sector economy by individual agents today. Contrary to the general expectation that financial organizations serving the economic development of individuals should be in place in response to the new situation, state-owned banks and credit unions fall short of meeting the emerging needs and services. The formation of private-sector financial organizations thus becomes necessary. Third: the issue of complementarity in the absence of formal financial services. The "adverse selection" of the retreating of state-owned agriculture–related banks from rural to urban areas, on the one hand, creates a space for the development of an endogenous finance. Informal finance meeting the needs of the rural market therefore emerges. On the other hand, the endogenous financial institution enjoys an advantage at transaction costs. In general, state-owned banks are reluctant to provide loans to rural enterprises and individual rural households because the loans are usually small in scale and the rural population is spread out over a large area. Furthermore financial establishments offering rural credit have to face the double risk of economic reproduction and natural reproduction confronting peasants. On the contrary, informal rural financial organizations are formed spontaneously within the rural areas. They are sensitive to micro information. As the lenders and the borrowers know each other well, transaction cost is hence less. Moreover, the endogenous finance enjoys an advantage over formal finance by being simpler in formalities with higher efficiency in terms of service provision. 130

Historically speaking, there are various forms for the institution of the endogenous finance. In terms of the degree of organization, there are two types of endogenous finance. They are: 1. Informal individual or groups offering credits, and 2. Cooperatives or other community-based financial establishments. 5.1.2  Formation and Development of Informal Credits by Individuals or Organizations Informal financing prevails in China's vast rural and agricultural areas, especially in places where the income level is low, the location is remote and the scale of agriculture is small. Its transaction size has far exceeded the formal financing sector. Informal lending is more accessible than and has an advantage over formal financial establishments. Informal loans generally refer to low-interest or interestfree loans rural households get from friends and relatives, and commercial credits provided by relatively better-off farmers and professional money-lenders. Informal financial establishments include traditional savings and credits mechanisms beyond formal finance. Informal commercial lenders, also known as brokers, are the subject of informal rural finance. Having no government subsidy, their financing capacity and adaptability to rural conditions contribute to their strong vitality in all aspects. Money lenders have no luxury permanent office, no staff nor registered accounts. But they provide the rural households with the much-needed financial services. Being close to the borrowers, these money-lenders could respond promptly to the related information and needs of rural households. They are able to provide more flexible and lenient repayment terms, and conclude the transactions face-to-face in the form of verbal contracts with a low cost. Facts show that massive low-income rural households have access to credits of this kind. Due to the income gap among villagers, some rural households have turned into money-lenders. In general, informal money-lenders have a good grasp on the credibility of their neighbors and therefore have little difficulty in getting the money back, a situation difficult to attain by formal financing. Money-lenders do not require collaterals as requested in formal commercial lending and informal lending is usually confined by village boundaries. Some are able to secure cross-boundary loans through esteemed local people as intermediaries. Where formal financing is absent, it is not the stock of local saving but credibility of households and individuals in the village that counts for getting loans in rural areas. A virtuous rural household with good reputation 131

apparently has no problem in getting a loan. Despite the merits of money-lenders, policy-makers and the public in general have not given them enough attention. The main reason is the high interest rate they charge, which is considered to be exploitative and has deviated from the tradition of mutual support. It is believed that most of these loans fail to boost borrowers´ repayment ability and eventually turn in debts as the loans are for consumption rather than for agricultural production. They do not serve the goal of “national economic development” at both local and national levels, while the government’s credit projects are formulated for this goal. Furthermore, informal loans, having been sidelined by the institution of formal finance, carry considerable risks and induce negative competitions according to advocates of commercialized finance. Not only do informal loans fail to support the rural economic development and agro-technological advancement, they also interfere with formal financial activities and keep large amount of savings at bay. The study of informal credit activities in Fengyang County of Anhui Province shows that there is a correlation between the interest rate of rural loans and formal financial activities. In the 1990s when rural fund unions still met the needs of rural households and enterprises, monthly interest rates for individual loan stayed at a level of 8% to 10%, slightly higher than that of the formal rural financial establishments. After the rural fund unions went defunct in 1995, a huge amount of rural funds have been absorbed by formal savings establishments. Rural areas face the difficulty of funding shortage. Loans for individual rural households and enterprises became a problem, resulting in the boom of money-lending activities. Private money-lenders pooled money by borrowing from individuals at a monthly interest rate of 5% to 8%, higher than that offered by the state-owned banks. Even a number of government officials invest their money with these money-lenders. Individual rural households and enterprises on the other hand borrow from these money-lenders at a monthly interest rate not less than 10%. Some even stood as high as 20%. According to the survey, one government official in the township in Huangnipu alone had been able to draw a funding of nearly 10 million RMB. The high interest rate led to a rush on loan investment, which was nothing but impulsive. Repayment became a problem. Some were only settled after three years in default. In 1997, local governments vehemently pushed the restructuring of state-owned collectivized enterprises and developed individual private enterprises. A number of state-owned collectivized enterprises went bankrupt leaving a lot of 132

bad debts. In the face of credit crunch, money-lenders in rural areas thrived again motivated by the bountiful return as demands for capital in rural areas soared despite painful experience only a few years back. Cement, lime and quartz sand processing industries in Liufu, Xiquan and Wudian, the three townships to the west of the county, had been able to pool capitals from the private financing via high interest rate by different means. Some had been able to draw as much as one billion RMB. The case illustrates that the survival and activities of money-lenders are closely related to the social and economic development in rural areas. Moneylenders have enjoyed a competitive advantage in many rural financial markets, as they are able to provide services not available from formal creditors. They operated with a relatively higher interest rate for small loans to cover the costs. Where there are better communications systems and facilities, capitals will readily flow to areas with promising prospects of high profits. That will drive down the marginal profitability. In turn, interest rate drops as competitions among money-lenders intensify. However, if the government intervenes by getting rid of money-lenders who are considered the root of evils, or by controlling their activities through capping interest rate, capital shortage will be worsen and the interest rate cap would automatically fail. While the raison d’être of these money-lending activities is acknowledged, the value orientation of the government and the socio-cultural ethics oftentimes has it dismissed as immoral. Even if the stigma is removed and the government puts in place constructive measures to facilitate these activities, there are still constraints on the survival of informal financial establishments in rural areas. Rural money-lenders have difficulties in modernizing themselves, as well as planning for competition and economic growth in view of their private relationships with rural households and their adaptability to the rural financial market. Nor are they apt for conditional loans targeted to agricultural production investments. Even though the effort to keep a tight grip on how the loans are used is mostly of no avail, the government does not want to be seen as a supporter of consumer credits. That said, the government does allocate some resources to consumer credits. Taking an objective historical view, we believe that informal money-lenders will still have a foothold in the rural financial market in the future. They will continue to provide financial services many people are in need of and are willing to secure even with higher interests. Informal commercial lending is a legitimate 133

and useful integral of the rural financial market. The government should not aim at outlawing it. Instead, efforts should be made to enhance competitions so that quality and pricing of their services would be improved and adjusted. 5.1.3  Formation and Evolution of Cooperatives and Other CommunityBased Financial Establishments International experiences show that borrowers´ groups run in regular as well as irregular forms. Governments in many countries set up credit provision as a function of cooperatives. It is often done in the name of forming and supporting cooperatives. A credit union is a credit alliance dedicated to solicit saving from and give out loan to members. A bank can give loans to provisional and semi-permanent borrowers´ groups to share responsibility. Some have been successful. They have proven to be the best experience for rural financial markets in developing economies. Not only do they provide credits, they also provide savings services. Tapping enthusiastically into new technologies and market services, they have been able to enhance and have adapted to agricultural modernization. As actors of rural financial markets, farmers' organizations or cooperatives run a diversity of businesses, having no distinctive business portfolio from other forms of financial cooperative body. Cooperatives are intermediaries of individual rural households. Through shared responsibilities in repayment and mutual supervision, cooperatives reduce the costs for both lenders and borrowers, as well as risks of default. They also help to disseminate information such that they could sell products jointly, and improve debt collection. Moreover, they also provide consultation services in technology, investment and marketing. Very few people know about their capacity in this regard. In general, borrowers´ groups do reduce lenders´ administrative costs. But in developing countries and regions, repayment of loans by cooperatives is still very unstable. Unfortunately, it is very rare for cooperatives to accumulate members´ saving to a significant scale. Managing credits in combination with other services has proven to be rather difficult. Of course, this does not mean that certain cooperatives are not effective. Similar to informal money-lenders and organizations, we believe there is room for the survival and development of cooperative finance, potential of which has yet to be tapped. Positioned somewhere between formal and informal financial establishments, community-based financial establishments facilitate savings and loans for people in the community. Due to their loose structures, some community banks are 134

associations and mutual help groups in nature. They are not legal entities and are considered private financial establishments. Because of institutional access restrictions, there is no community-based bank until 2009 when Document No. 1 of the Central Government openly ratified community bank as an acceptable entity the state’s institution. This is a significant leap in the history of financial institution in China illustrating the importance the state puts on informal finance. But, its genuine and free access in the practical level depends on the recognition and enforcement of the regulatory authorities. 5.2  Performance Analysis of Institutional Changes of the Informal Cooperative Finance in the Informal sector This section examines the institutional evolution of cooperative finance from a historical perspective and analyzes the incentives and efficacy of the induced institutional changes, so as to study the role and impact of rural cooperative finance in the rural economic development. 5.2.1  Organization Modes, Function and Performance of Traditional Informal Cooperative Finance (1) Modes of organization of traditional cooperative finance ① Mutual-aid credit association(he hui): a comprehensive concept also known as rotating savings and credit association (ROSCA), he hui is a generic term for various kinds of traditional, spontaneous and mutual help folk financial organizations with a broad membership. Located mainly in rural areas, these mutual-aid cooperative financial establishments are usually built on the basis of kinship. There are six major forms of he hui: rotating credit association (Lun hui), bid credit association (Biao hui), dice-throwing credit association (Yao hui), fundraising association (Tai hui), lot-drawing credit association (Bo hui), and goodfortune credit association (Shouyuan hui). They differ in details but are more or less identical in operational mechanisms. The associations are mainly initiated and convened by the association heads or chiefs who are in urgent need of money. By virtue of their personal integrity, together with relatively well-off and trust-worthy guarantors, they invite up to a few dozen of relatives, neighbors and colleagues to be members, referred to as feet of the association. They will agree on a payable 135

membership fee and a schedule for payment and harvesting (the accumulated amount of membership fees). The first round of membership fee goes to the association head. The order of harvesting is decided by various means. For lun hui, members “harvest” according to a pre-arranged order. For yao hui, the order is determined by throwing dice. For biao hui, members bid to “harvest.” Members have only one “harvest” either by bidding or dice throwing. They will continue to pay their membership fee until everyone has “harvested” once. After that, the association will close down or will be reorganized. In all situations, there is a steady flow of fund. And it is the trusting relationship built upon daily interactions between heads and members of associations that works and eventually shapes credit relations in a closed environment. ② Mutual-Aid Savings Associations: mutual-aid savings associations mainly operate in less economically developed areas. Dubbed “Poverty Relief Mutual-Aid Fund Union” in some places, these mutual-aid associations are initiated, governed, and shared by the people with the missions on disaster relief, poverty relief, and production development. In general, these associations are village and membershipbased, democratically managed, and supervised by the people. Members join and quit the associations of their free will. (2) Functions of traditional cooperative finance: as a grassroots financial organization, he hui complements and substitutes formal finance. In times of institutional repression when formal financial establishments turn stalemate, credit agencies in rural areas proliferate rapidly with the growth in credit demands. A large number of he hui thus appears, filling the gap of credit crunch due to institutional repression by their efficient, simple and convenient services. In the process of rural development, he hui has proven its economic significance in three major aspects. Firstly, these organizations channel idle private capitals into the market through loans, thus enhance social capital flow and societal development as a whole. Secondly, he hui, in filling the gap of credit supply by directly providing loans to borrowers who have difficulties in obtaining credits from formal financial establishments, manifests the principle of fairness in the access of loans. These organizations substitute and complement formal financial establishments particularly in micro finance. Thirdly, he hui satisfies the credit demand of marginalized groups who have been denied access to such loans for a long time. Many of the small and short-term creditors have been able to improve their consumption on daily life as well as agricultural production, thanks to he hui. 136

On the other hand, the simple, efficient and convenient operation of he hui has also tendered major support to individual industrial and commercial entrepreneurs and small rural enterprises. Many of them thus got credits from the grassroots financial association he hui for obtaining their “first bucket of gold.” Rural mutual-aid savings associations address the basic credit needs of victims of disaster and adversity. The credits they provide are small in amount, low in interest rate, and short in credit period. Compared to he hui, non-profit mutual-aid savings associations display more features for poverty relief. 5.2.2  Incentive of Institutional Changes in Traditional Informal Cooperative Finance In China, traditional folk cooperative financial organizations have a history of more than a thousand years. Before 1949, there are already records of such organizations in Northern, Eastern and Southern China. The scale of these mutualaid associations are generally quite small, ranging from about ten to a few dozen members with a lifespan of one to ten years. But since the 1980s, biao hui with the membership of hundreds of people and operating capital of some 10 million RMB are found in Zhejiang and Fujian Provinces. Its small-scale membership is a result of the government´s long-term suppression of “folk finance”, whereas these organizations persist despite this is due to the fact that formal financial credits fail to satisfy people's needs. While traditional informal cooperative financial organizations have undergone enormous changes, the basic form remains more or less the same. Three kinds of motivation have been identified over these years. Firstly, it is politics at the central government level. To serve the needs for some political goals at different times, the central government adopts different measures to regulate the financial sector. They include restrictions, crackdowns and tolerance etc. From 1949 to the late 70s shortly before China adopts the reform and open-up policy, the central government regulated and eventually nationalized rural cooperative finance to address the needs of heavy-industrialization and urban economic development. Secondly, it is about economic development. China has a long history of feudalism. Small-scale peasant economy has been the dominant feature. Because of its compatibility with such economy in the rural areas, cooperative finance develops considerably. Changes take place as these organizations adapt to the different economic situations where they operate. For instance, at China´s Southeast coastal areas where financing 137

demands boom with rapid economic development, the scale of cooperative financial organizations changes regularly from small to large. Different associations also grow in strength. Thirdly, it is about the cause of social institutional changes, which affect the traditional cooperative financial institution and organizations. The introduction of the household contract responsibility system after the collapse of the People´s Commune provides the soil for the survival and growth of the cooperative financial institution. New forms of rural mutual-aid credit cooperatives emerge, as it is quite difficult to the already nationalized cooperative organizations to their previous form. Without doubt, government suppression is another major reason leading to the changes in folk cooperative finance. For the government, unregulated mutual-aid credit associations and other informal financial organizations exhibit the following flaws: Firstly, they compete with formal financial establishments for savings. And their spontaneity disturbs the Central Bank´s role in managing and monitoring the total volume of social credits, increases the circulation of capital outside of the system, and affects the government´s financial readjustments and monetary policies. Secondly, poor operation and management systems of credit associations could easily result in financial crisis bringing chaos to regional financial order and jeopardizing social credits. Furthermore, illegal means might be deployed to ensure the smooth operation of credit associations and other informal financial organizations. Some are connected to triad organizations, not conducive to a stable social order. Thus, informal cooperative finance develops a mechanism in coping with governmental suppressions, making changes and taking on new forms to meet market needs under different political constraints. These changes can be considered survival principles of cooperative finance. 5.2.3  Performance of Institutional Changes in Traditional Informal Cooperative Finance Due to the lack of formal financial data, it is difficult to conduct a performance review of traditional informal cooperative finance in direct comparison with formal finance. Hereof, a study on how these cooperative financial organizations satisfy the needs of rural households is presented. It is a survey undertaken by Liu Minquan, Xu Zhong, and Yu Jiantuo ( 2006 ) on mutual-aid credit associations in Taizhou of Zhejiang Province. The following table shows the situation of borrowing among households in Taizhou. 138

Table 5-2-1 Comparison between member and non-member household in money borrowing Type of household

Total No. of household

No. of borrowing household

Total amount borrowed (RMB)

Average amount borrowed Average amount per household (RMB) borrowed per capita (RMB)













There is a 10.41% difference in the percentage of member to non- member households in terms of borrowing. The survey shows that 54.97% of member households borrow while only 44.83% of non-member households do similarly. The difference indicates that members have a propensity to loan. Moreover, the average amount of loan per capita/per household for members almost doubles that of non-members. The survey shows that participation in these mutual-aid credit associations boosts rural households´ daily consumption and expenses in large and durable goods. It should be noted that as the volume of financing grows with the development of these mutual-aid credit associations, the profits harvested from breach of contract will also increase for members. In Wenzhou, Ningbo, and Fuan of Fujian, as much as hundreds of thousands or even millions of funds could be pooled by these associations, significantly augmenting members´ gains if default. Cases in which members take the money and flee happen from time to time. It is evident that risks increase as folk financial organizations scale up. Informal cooperative finance evolves more slowly than its formal counterpart in terms of organizational form. As changes involved for various kinds of he hui and other mutual-aid credit associations aim to serve local people in the communities, their revenue should be relatively stable. But a closer look at the situation reveals that the attitude of formal finance, or the government´s political preference, plays a decisive role. When the government loosens its control over informal finance, at the same time that formal finance is adversely selected for rural credits, the revenue of informal finance will be high. In times of social institutional changes, informal cooperative finance will adopt appropriate measures to go with the changes. They could be further divided into proactive induced changes (such as the current rural credit cooperatives) and passive induced changes (like the rural fund union), depending on the different external driving momentum. Proactive changes are revenue-driven and thus show visible results in performance, whereas 139

passive changes, driven by external forces, show little or even negative results.   5.3  Performance Analysis of Institutional Changes of Rural Fund Unions 5.3.1  The Founding of Rural Fund Unions Rural cooperative fund unions were founded in the mid- 1980s when the household contract responsibility system is adopted bringing an end to the People´s Commune. At that time, people in different places “claimed owed money back and turned defaults into loans” in a process of clearing up assets of collective ownership. Its development can be divided into five different phases: (1) Germination (1984-1986): since the second half of 1983, some villages in the provinces of Heilongjiang, Liaoning and Jiangsu began to consolidate collectivized properties and adopted measures such as “team under village management” or “brigade under township management” to put collective funds in the hands of local authorities so that accumulated funds could be more effectively managed and better used. Meanwhile, internal financing also took place as collective funds were used as interest-bearing loans between collectivized economic organizations in rural areas. The results had been positive. The security and added value of collective assets were protected. A channel for investments in agriculture was therefore open. The central government voiced its firm support in the 1985 No. 5 Document, but recognition from the country's financial supervisory authorities had yet to be materialized. (2) Pilot experiment (1987-1991): rural cooperative fund unions in the country boomed with affirmation and support of the central government. Internal financing experienced the largest growth from 1986 to 1988. An increase of 4 billion RMB was recorded in these two years alone. In November 1991, the 8th Plenary Session of the 13th CPC Central Committee unveiled the document The Resolution and urged governments of all levels to keep up with their efforts in running rural cooperative fund unions. In December of the same year, the Ministry of Agriculture issued the Notice on Enhancing Institutionalization and Standardization of Rural Cooperative Fund Unions. Thereupon, the rural fund union entered a phase of universal development and supporting reforms. (3) Rapid expansion (1992-1995): in 1993, the CPC Central Committee issued Document No. 6 Viewpoints on Current Economic Situation and Strengthening Macroeconomic Adjustment and Control to consolidate financial order and maintain 140

financial regulation. The institutional environment was grim for informal rural finance. Yet rural fund unions still developed rapidly. According to statistics, there is a total of 19,700 and 134,000 rural cooperative fund unions at the township and village levels respectively, constituting 41.7 % and 18.3 % of the total number of townships and villages by the end of 1995. Total amount of membership fee in 1995 stands at 72.3 billion RMB, an increase by 8.1 times compared with 1990. Total investment is 82.8 billion RMB in the same year, a 10.2-time increase compared with that in 1990. (4) Consolidation (1996-1998): by the end of 1996, there were 21,000 township-level and 24,000 village-level cooperative fund unions. They were able to raise a total of some 150 billion RMB, the highest ever since their very first establishment. This period was marked by financial disorder. Supply and Marketing Cooperatives, Family Planning Commission, governmental authorities of civil affairs, labor and social security etc. jumped on the bandwagon to set up fund unions and share capital associations, eagerly participating in the vicious competition of high-interest money market. In view of the chaotic situation, the decision to overhaul rural fund unions was made in November 1997 to guard against financial risks and the monopoly of state finance. Related policies were tightened, causing the sudden revelation of conflicts in rural cooperative fund unions. In 1998, bank runs became rampant. Large-scale run incidents affecting social and political stability in rural areas were reported in Sichuan and Hebei Provinces. (5) Closing down (January 1999 onwards): in January 1999, the State Council issued Document No. 3, declaring an official ban on the rural fund unions. 5.3.2  Incentives for Institutional Changes of Rural Cooperative Fund Unions The rural cooperative fund union is a specific financial form in a particular time in history. In essence, what kind of financial institution is this? Some contend that it is an “alienated institution of cooperative finance” (He Guangwen, 2006). Some believe that they are county or township governmental banks: financial organizations overseen and directly managed by respective local governments (Liu Shiding, 2005). This special financial organization has existed for 15 years from its founding to the compulsory closure. Zhang Yuanhong et al. (2004) see it as a process of trial and error in rural areas in a bid to enable institutional innovations 141

in rural finance to address the different economic needs in different periods of time. Hereupon, three factors are believed to have contributed to the financial institutional changes: (1) Institutional innovation as the prime mover: rural cooperative fund union emerges in the 1980s. The need to clear up accumulated collectivized assets is the direct driving force for its formation. But the fundamental motivation lies in the accumulated saving of peasants and their desire to invest. Since the introduction of the household responsibility system, there is a significant increase in grain production. Accumulation of grain in turn results in cash saving. Peasants start to look for new ventures and investments other than food production. Rural enterprises, the first choice of peasants, not only open up a new path for investments, but also turn saving into capital. A batch of rural entrepreneurs appears. (Fan Dijun, 2007) Rural cooperative fund union is thus less a capital management structure to clear up assets in collective ownership. Rather, it is an endogenous innovation arising from peasants´ needs for investment in the wake of accumulation in saving. (2) Government as the driving force for institutional change: unlike cooperative finance in its generic sense, the rural cooperative fund union operated with local (mainly county and township-level) government participation. Whereas most fund unions operated under the management of the agricultural and economic authorities of local townships, some were directly managed by the township governments. The fund unions therefore stayed largely under the shadow of the government. From the onset, local governments were investors of the fund unions, which thus decided these financial organizations’ undertaking of governmental functions including giving out loans, making investments and supporting spending of the government etc. The larger the fund unions, the more the governments would tend to control. This could easily result in violations such as offering higher interest rates to attract saving, irregular operation, etc. (3) Institutional closure as a national strategy: as rural cooperative fund unions grew continuously in size, more and more problems were exposed. The situation became more acute during the Asian financial crisis in 1997 and 1998. In January 1999, the central government decided to close down the fund union for the sake of the country's financial security. Having been in rural areas for 15 years, the fund union´s abrupt closure would inevitably have huge impacts on rural economy. The cost was colossal. According to statistics, the country had to settle a debt 142

amounting to 59.923 billion RMB (8.4 billion solicited by local governments, and 51.523 billion RMB borrowed from the central government) due to the closure of Rural Cooperative Funds as of end of January 2001. This was a big blow to the development of rural economy and a heavy burden for local governments. (Wang Shuguang, 2006) 5.3.3  Efficacy of Changes in Rural Cooperative Fund Unions Impacts of the set-up and closure of rural cooperative fund unions on rural economy are revealed by the following empirical data:

Chart 5-3-1 Integrated Savings in Fengyang County over the Past 30 Years (unit: (10,000 RMB)

(1) Analysis of correlation between rural savings and rural cooperative fund unions. From Chart 5-3-1, integrated savings during the decade between 1975 and 1985 in Fengyang County amounts to almost zero, indicating that rural households did not have extra money to put away as savings. Between 1985 and 1995, households´ savings slowly but continuously increased due to economic development. In 1996 when the Reform was in full gear, there was a significant leap with a total amount exceeding 500 million RMB. The savings kept rising with a smaller growth rate until 2000, when a rapid increase is recorded thereafter. Household income rises speedily after the year 2000.



◆ -- Balance of Agricultural Savings Deposits in the Agricultural Bank

-- ■ -- Rural Credit Union Savings --

▲ -- Postal Savings

--x-- Total

Unit: 100 million RMB

Chart 5-3-2 Savings Deposits in Rural Financial Establishments

Chart 5-3-2 shows that rural postal savings, rural credit unions, agricultural savings in the Agriculture Bank were all relatively small between 1975 and 1985. From 1985 on, rural postal savings rose rather slowly compared to that of the credit unions and the Agriculture Bank. The latter two are about on a par. But the growth of total rural savings was still slow until 1995 with a more significant increase. The sharp increase was mainly due to savings in rural fund unions.

-- ■ -- Quantity of Fengyang County SMEs --

▲ -- Savings

Unit: 100 thousand RMB

Chart 5-3-3 Savings and Investment for Rural Capital


The above chart shows that the number of rural enterprises remained the same since 1978 when reform was first introduced. It was not until around 1992 when the open-up policy and market economic development reached the peak in China that the number of the rural township enterprises started to pick up. A large number of entrepreneurs and investors emerged from rural areas. Rural savings increased modestly because rural fund unions became the major channel of rural credits. After 1995, adjustments in the policy of rural fund unions disrupted enterprise financing. The result was a rapid drop in the number of rural enterprises. With the closure of the fund unions, savings flew to formal financial establishments and the amount kept rising. (2) Analysis of the correlation between the rise and fall of rural enterprises and the rural fund unions. There is a direct correlation between the rise and fall of rural enterprises and rural fund unions. The first peak of development for rural enterprises fell on the decade between 1978 and 1988. By the end of 1988, the number of rural enterprises in the country reached 18.88 million, with a total payroll of 95.46 million people. This is the period of development for rural fund unions that played a positive role on rural credits. The second peak occurred between 1992 and 1994. Rural enterprises account for 30% of GDP, 31% of the country's tax revenue, and 34% of the country´s export revenue. Peasant incomes accounted for 27% of the country´s gross income. This is the heyday of rural fund unions. Total invested capital in the rural areas via the fund unions amounted to 82.8 billion RMB in 1995. Between 1995 and 1998, the number of rural enterprises stood at 20.04 million, 9 % less compared to 1995, with a payroll of 125.37million, 2.5 % less than in 1995. This is the cleaning up period for rural fund unions. Promptly came the decision to eradicate the fund unions, causing the shutting down of rural enterprises’ capital pipeline and eventually leading to their closures. 5.4  Game Analysis of Institutional Changes of Endogenous Finance with the Preferences of Rural Households and the State Rural households are the core of rural credits in the institutional arrangements of both endogenous and exogenous finances. Thus the correlation between the preferences of rural households and the arrangements is obvious. The institution will work if the arrangement provides positive net profits for rural credits at the same time it satisfies the needs of rural households. Otherwise, it will fail. There are 145

many forms of endogenous financial organizations and here we use the institutional arrangement of cooperative finance as an example. For rural credit unions, the institutional changes are mainly induced by the government, the primary action group. Rural credit unions began as cooperative organizations, before they became one part of the People´s Commune. Later on, they turned into grassroots organizations of the state-owned Agriculture Bank. Afterward they “de-linked” from it and resumed operation with the cooperative nature. At present, they are undergoing a diversified ownership restructuring process. All of these are imposed institutional changes predominated by the government. Taking advantage of its natural status of monopoly in supply, the government effectively reduces delays and frictional costs in the institutional changes. Nonetheless, there is some discrepancy between the utility function of the state in the institutional changes of rural credit unions and the utility function of the rural economic subject. Besides, constrained by the “paradox of the state,” the institutional supply by the government falls far behind the needs of the rural economic agents, particularly in the aspects of meeting peasants’ financial institutional demand and improving institutional efficiency of rural finance (the presence of large quantities of informal finance could serve as an evidence). If we take a closer look at the evolutional history of rural credit unions, we find the axis of logic for the institutional changes of the credit unions, i.e., the government’s utility function, displays specific characteristics in different periods of time. During the reforms before 1998, rural credit unions fell victims to the situation in which their utility preference ranked the lowest in the government´s priority list, marked by institutional stabilization and other important institutional reforms (e.g., the reform of state-owned commercial banks). The governmental preference then shifts away from stability (i.e., maximization of rent) and gears towards a more positive direction, as the rural economic structure has changed. Other reasons include: the needs for rural finance take to another level; the tripartite agrarian issue becomes more acute, as well as knowledge and experience for the transformation have been accumulated (the expansion of the selections set of rural financial institution) (Jiang Shuxia, Luo Jie, et el, 2007). In the above, we have shown the incentives inducing institutional changes of cooperative finance, from the perspective of institutional preferences of the government. To better illustrate this point, we will apply game theory to give further analysis of the participants’ decision-making in the institution of cooperative finance. 146

The government and rural households are the two major players in the profit game of rural cooperative finance. As supply medium in the rural financial market, financial organizations satisfy rural financial needs at the same time they demand rural financial savings. As the subject of the supply medium changes, it is directly reflected in the allocation of financial resources. Inevitably, as the primary group in rural financial resource allocation, the government would choose a system that serves its purpose to control resources. Since the founding of the People’s Republic, the Chinese government has had two main strategic objectives: first, the heavy industry-oriented industrialization process; second, the new era’s new rural reconstruction of coordinated rural-urban development to solve the san nong issue. When the first goal is prioritized, two strategies--repression and support--are adopted. The former is to control and intervene in the financial market, and put a tight rein on the development of various kinds of unregulated cooperative finance. When the latter is preferred, it means that the government loosens its control on the rural financial market. As players of the game, rural households could employ two main counter measures, i.e. cooperation and non-cooperation. The payoff matrix for the game is shown in the following table. Table 5-4-1 Game Matrix of Payoffs between Rural Households and the Government Rural households





2, 1

-2, 2


0, 3

-3, -1

In the above game model, there are four strategic combinations, namely: (repression, cooperation), (repression, non-cooperation), (support, cooperation) and (support, non-cooperation). The strategic payoff for the players is presented in simple numerical order. If repression is adopted, the rural cooperative finance will be imposed institutional supply, whose resource allocation is governmentcontrolled. When rural households decide to cooperate, their chances of obtaining loans would be lower, with the payoff of 1. When rural households choose not to cooperate, the possibility of getting loans from informal sector is high, with a payoff of 2. That means it is more difficult for rural households to obtain loans from the credit unions than from private lenders. If the government employs the support 147

strategy, the institutional supply of rural cooperative finance will be an induced one. True cooperative finance can be set up between rural households when they adopt the cooperation strategy. Their financial needs will be better satisfied with a payoff of 3. If non-cooperation strategy is preferred, rural households can only get loans from other non-cooperative financial organizations, and the payoff is -1. The government´s objective function to control the allocation of financial resources is guaranteed when the repression strategy is met with cooperation on the side of rural households. The corresponding payoff is 2. When non-cooperation is chosen under the government’s repression strategy, the payoff becomes -2, and the government´s goal to control financial resources cannot be realized. In a situation in which rural households cooperate while the government is supportive, the latter´s objective of controlling financial resources to serve the state’s strategic goal cannot be met. The payoff is then zero. If rural households do not cooperate even when the government adopts a supportive policy, then the government can neither achieve the goal of controlling rural funds, nor promote the country´s agricultural development. The payoff falls to -3. Thus, “non-cooperation” is the optimal strategy for rural households when the government decides to exert a tighter grip on rural finance, and “cooperation” when the government is supportive. In order to meet the first objective of industrialization, the government has only one equilibrium strategy, i.e. repression. As such, the game repeats and the equilibrium falls on repression and non-cooperation. This result sheds light on the driving forces for numerous institutional changes in cooperative finance since the founding of the PRC. Likewise, when the government adjusts its objective function and shifts its strategy in the new era from industrialization to new rural reconstruction, the objective function aligns with that of rural households. Both the rural households and the government thus attain optimal utility. As such, changes take place in the game payoff matrix. The equilibrium is reached when the strategies of support and cooperation are implemented. And they are the incentives for institutional reforms of the cooperative finance in the new era. 5.5  Brief Summary Through a thorough analysis of the institutional formation and transformation of the rural endogenous finance, this chapter examines the incentives for its institutional changes and assesses the performance of these changes, combined with 148

a case study of Fengyang County to further prove the rationality of the institutional arrangement. Meanwhile, the institutional evolution of traditional informal (folk) finance is studied taking as an example the rural cooperative finance. We observe the transformation of rural fund unions and analyze the impact of the fund unions on rural township enterprises. Finally, through an analysis of game preferences between the rural households and the state, we notice an inevitable gap between the preferences of rural households and the state’s institutional arrangement of rural finance, when the state favors the exogenous institution. Meanwhile, when efforts are made in order to narrow the gap, some space is granted to the endogenous institution as its raison d’être.


Chapter 6  Model Selection: Peasant Household Cooperative Finance Institutional Model China’s rural finance problems have become increasingly serious with the malfunction of the exogenous institutional arrangement and the repression of the endogenous arrangement. New solutions must be found with a new institution in order to get out of this dilemma. In view of their present operations, the endogenous institution must be equipped with an incentive compatibility mechanism to solve its dysfunction while the endogenous mechanism should be energized by eliminating repressive policies. Is it possible to establish a new endogenous financial institution that is compatible to the household contract system and connected to the existing exogenous institution? This question is going to be the focus of this chapter. 6.1  The Goal and Principle for the Peasant Household Cooperative Finance System Currently, the financial reform in China is geared towards commercialization and marketization. In the rural financial market, rural credit unions have become the mainstay of rural financial institutional arrangements as a result of the withdrawal of state-owned commercial banks from rural areas. A great number of rural credit unions were founded with help from the government to promote the stable development of the rural economy in the early years of the People’s Republic of China. Nevertheless, the rural credit unions were turned into part of the state-owned financial system in the 1960s. Since the Reform, the state has made great effort to reestablish the cooperative nature of these rural credit unions with little success. But the government’s imposed institutional change has failed to achieve its expected result. These efforts only turned the control of these credit unions from the central government to the local governments. The goal of the recovery of cooperative finance has failed. The fundamental orientation of the present reform of rural financial system should be to establish a rural cooperative finance that adapts to rural financial demands. 6.1.1  Rural Cooperative Financial Institutional Arrangement According to the definition of the International Labour Organization (1994), the cooperative is a democratic organization formed voluntarily by a group of people with common goals. Cooperative finance is a special form of cooperative 151

economy specializing in financial activities on the principle of cooperation. The members participate by putting a share of financial assets into the cooperative. Cooperative finance has a history of over 140 years in the West. Rural cooperative finance is an important part of national finance in a country. Rural Credit Union has been the main form, perhaps even the only form of rural cooperative finance in China. The current rural credit unions have deviated from the principle of cooperation after 50 odd years of development. The experiences of various reforms have revealed that the attempt to reorient the rural credit unions to the principle of cooperation is hindered by “path dependence”. Firstly the management of present rural credit unions has fallen into the hands of local governments, which has fortified their control over financial resources. Thus rural credit unions have become the tools for allocating local financial resources to local governments, which betrays the cooperative principle. A rural credit union that builds on the cooperative principle should be owned by its members. That is, its members should be afforded the enjoyment of user right, transfer rights, disposition rights and benefit rights. Such a transformation has been resisted by the local governments because this will weaken their capacity to allocate local financial resources. They refuse to give up their power and vested interests. In addition, the rural credit unions need a long time to learn to run independently along cooperative principles after having been affiliated with state-owned banks and having a strong “affinity” with the state-owned financial establishments and the social environment adaptable with them. Lastly, at present, the staff of rural credit unions does not share the same interests with the peasants. They are of higher economic status than its peasant-clients. Resuming their cooperative nature will mean the current credit unions “downgrading” from being affiliates of state-owned banks into peasant organizations. It is naturally resisted by those with vested economic interests. As per the reasons mentioned above, a reform to change the organization principle of rural credit unions to a cooperative one will not be easy. In short, it is necessary to rebuild rural cooperative finance in China. No doubt, we should not deny the value and function of cooperative financial institutions just because of the alienation of the official institutional arrangement of cooperative finance. On the contrary, the absence of operative finance in a real sense has resulted in a defective rural financial system in China. The peasant households cannot enjoy their proper interests in cooperative finance. Accordingly, it is imperative to establish a cooperative finance, especially having the peasant 152

households as its agents, that is in accordance with the demand and supply of rural finance. 6.1.2  The Goal of Institutional Arrangement of Rural Cooperative Finance (1) Rural cooperative financial institutions can complement the current rural financial sector in its shortcomings. The rural reform in the late 1970s has given use rights and the benefit rights to individual peasant households even though the nominal collective ownership of the land has been reserved. The rural households have become the chief economic agents in rural China. The greatest institutional benefit of this arrangement is that it has helped to maintain social stability. As a result, each individual Chinese peasant household has been assigned a small piece of land out of which a living from farming can be made. Even despite the urban-rural income gap widening, most of the peasants, who compose the majority of the population, can secure their basic livelihood by the land they own. They are therefore not the proletariat in the classical sense. Many migrant peasant workers emerge during the process of industrialization and urbanization. However, they would not settle in the cities and become urban residents. Most of them eventually stay on in the rural areas. The arable land they own become their guarantee of subsistence. That is the reason why the experience of urbanization and industrialization in China is not characterized by a great number of urban slum dwellers. Neither is social unrest a common happening. It can be attributed to this land institutional arrangement. Nevertheless, this agrarian institution does not come without a cost. It has hindered the industrialization of agriculture in China. Agriculture cannot achieve economies of scale. A great number of rural labor forces do farming with limited land resources. The rural labor productivity in China is lower than the average social level, leading to a lower agricultural profit rate and thus rural income is lower than the average social level. Under the constraint of arable land resource, the dualistic urban-rural structure will persist for a long time to come. As the fundamental institutional contradiction in China is the dualistic urbanrural structure, we also need a dual structure in China’s financial institutional arrangement. It is impossible to apply the same commercial model to satisfy both the urban and rural financial demands. Commercial finance is oriented towards profit-making and therefore to economies of scale. The concentration of capital will lower the unit cost 153

of financing. The current rural institutional arrangement is characterized by decentralized and scattered operations of land. Economies of scale do not exist. The profitability of rural capital is necessarily lower than other industries. In accordance with this institution, scattered rural households are the agents of rural economy. They are generally in need of small loans. The unit cost of financing becomes relatively high. The current institutional arrangement has resulted in formal commercial finance retreating from the rural sector. Under this condition, it is necessary to establish cooperative finance in rural China. (2) Rural cooperative finance can help to lower the transaction costs. Theodore W. Shultz believes that rural households are comparable to the enterprise as the unit of the capitalist market economy and thus behave according to the logic of “rational economic man”. Coase asserts instead that the peasants’ behavior cannot be analyzed according to the market logic because the peasant economy is more concerned with economic survival rather than profit maximization. Chinese rural society is characterized by its clan social structure which emphasizes blood-ties and clan favoritism. The family is centered in this structure and surrounded by blood-ties. It is then further extended through ever expanding circles of relatives and acquaintances of different degrees of affinity. A social structure of multiple concentric circles is thus formed. In this social network structure, a rural household’s financial needs are often met in the forms of “do me a favor” loans by relatives and friends for agricultural production and daily living expenses. This type of loan is usually interest-free for the aim of mutual aid, adaptable to peasant economy. As the society and economy develop, these “favor loans” are typically unable to meet the financial needs of commerce. Rural household would usually also need loans from financial establishments. However, individual households often face difficulties when dealing with these establishments. It is because the financial needs of Chinese peasants have the following features: First, a large number of peasant families need non-productive loans to meet daily expenses and customary spending, e.g. housing spending, and marriage or funeral gift money, which do not entail an income stream and therefore cannot guarantee loan repayment. Secondly, there is the problem of information asymmetry between the rural households and financial establishments. In those “favor loans,” the lenders and borrowers are usually connected by extensive relationships. The lenders will have better information advantage over the formal sector. On the one hand, what the formal financial 154

establishments face are dispersed peasants and pre-event information asymmetry due to lack of private information about the household clients and their activities. Under the restriction of interest rate policies, formal establishments usually practice loan rationing. On the other hand, financial establishments are short of effective means to supervise loan usage. It is a situation of post-event information asymmetry which increases loan risks. Thirdly, the peasants generally do not have valid collateral for mortgage. Collateral with fixed value can facilitate a large loan which often is not accessible to peasants. The collaterals that peasants can usually provide are their houses, farming machines and produce which are not regarded as solid due to their limited cash convertibility. Formal financial establishments are distant from the peasants’ real daily life. The lack of valid collateral becomes an obvious disadvantage. Finally, the way to execute a loan contract is monotonous. What the peasant households produce are material products whereas formal financial organizations do not allow repayment in kind. The peasants have to liquidate their products to pay loan. In so doing they have to confront market uncertainties. That is why the scattered rural households tend to hold physical assets to avoid market risks and uncertainty. The case is different for the informal finance of folk lending. The ways of contract execution are more flexible. The lenders and borrowers usually have extensive connections. The lenders have more private information about the household borrowers. And they share similar production conditions and living environment. The lenders are more likely to accept the collaterals provided. The peasants can pay back the loan in a way acceptable by both parties when they obtain a loan from an informal lender. In this way, “folk finance” is advantageous being more adaptable to the credit needs of rural households. (3) Cooperative rural finance will promote interest-sharing among the peasant households. Rural cooperatives have been developing rapidly since the enactment of Rural Specialized Cooperative Bill in 2007. There are two benefits for taking part in rural cooperatives. First, the peasants can raise their profitability in market by productive cooperation and unified marketing. Some big cooperatives can even have their own branding. The market subjects are no longer individual households. The cooperative becomes an organized agent with higher efficiency and profitability. Second, peasants enjoy bigger bargaining power when they purchase productive materials, e.g. seed, fertilizers and other farming tools. In these two core interests, cooperatives can fortify the peasants’ negotiation power 155

in the market. The members enjoy more profit than as individual households, which has encouraged the peasants to join co-ops. Nevertheless, fund demand turns out to be the bottleneck in development for cooperative in order to meet the needs for further organization and expansion in scale. Under these circumstances, cooperative financial institution can help their development. Based on cooperation in production, the rural households can share the benefits of mutual funding. This can help solve the problem in developing large-scale production, and also provide less costly and more convenient financial services to the peasants. This makes it important for specialized production cooperatives to also engage in financial cooperation. 6.1.3  The Principles of Rural Cooperative Finance’s Institutional Arrangement Genuine cooperative credit institution grows out of the agrarian economic system. It is formed by the peasants spontaneously, instead of being an exogenous institutional arrangement. Endogenous rural cooperative finance should follow the principles of voluntary participation, mutual aid, democratic management and nonprofit making. The institutional arrangement of rural cooperative finance in China should take into consideration the reality of rural communities and be grounded upon it. What is to be established should be cooperative financial organizations in real sense. Rural cooperative finance should not simply seek economies of scale since the new cooperative organizations should mainly serve their members with middle or low-income. On one hand, if the organizations expand because of a larger stock of assets, the target clients they serve would be changed. If the target is no longer the middle and low-income group, the nature of the organizations would become different. On the other hand, if the number of middle and low-income members increases, the information cost and management costs may correspondingly also rise. Cooperative financial organizations are apparently not characterized by economies of scale. Pyramid structure is a commendable form of rural financial cooperative organizations taken into consideration of the reality of rural China. First, the peasants in a small region may establish a grass-roots financial cooperative to meet their need for small funding. It should have legal personality. Out of common interests, different cooperatives can unite voluntarily and form a higher level 156

federation to fortify their power in providing services. So above the village-level peasant credit cooperatives, there should be county (municipal) federation of credit cooperatives. The stockholders of an organization are composed of members at lower level, the lowest being the peasant households. A multi-level system of legal persons can be formed in such a fashion. Each level of credit association is an independent legal person capable of running independently and providing larger amount of funding for the rural households. The most important part of this system is to establish peasant credit cooperative at village level as the base of build federations of cooperatives at different higher levels. As to the management mechanism, the General Assembly is the highest authority for the credit cooperative and should truly represent the interests of its member peasants. The principle of “one person, one vote” should be adopted in grassroots credit cooperatives in making decisions about service types, personnel and important operation policies. Management staffs and a standing body should be elected from members by the General Assembly. Large loans should be approved by the General Assembly while small loans can be handled by the standing staff. Members have the right to supervise the general operation and the credit cooperative should release information periodically to ensure its members’ right for information. The credit cooperative engages in savings and loan business to serve its members, mainly composed of rural households of middle or lower income, whose financial demands are generally simple in form. The credit cooperative can make flexible credit contract with their members according to the particular situations of different households. Servicing its members rather than profit-making should be the primary goal of a credit cooperative. Credit cooperative should also provide market information, skill training and other public good services for its members in addition to its regular financial services. It is an orientation that should not be ignored. Support from the governments is indispensable to the development of rural cooperative finance. Rural cooperative finance is composed of mutual-aid organizations by the disadvantaged rural households. The governments should encourage and support their development by preferential policies, e.g. low-interest or interest-free loans, tax cuts or tax exemptions, and the use of credit and revenue. A strong support to rural cooperative finance can in turn bolster the development of agriculture. 157

6.2  Peasant Household Cooperative Finance Model 6.2.1  Basic Contents of the Model Lo

Diagram 6-2-1 Peasant Household Cooperative Financial Institution: “1+1 Model”

The Rural Household Cooperative Financial Institution “1+1 Model” refers to a model of “Production Plus Finance Cooperation”. It was proposed to make good use of the mutual help and cooperation in funding among the peasants to promote the development of agricultural industry, adjust the industrial structure and stabilize the order of competition. The model was carried out to strengthen and stabilize the pilot project of credit cooperatives. As a whole, it aims at pushing for a good and rapid development of rural economy and society in Fangyeng County. As demonstrated in Diagram 6-2-1, the production cooperation takes place when specialized co-ops purchase agricultural and subsidiary products from the peasant households and are in charge of unified marketing. Financial cooperation materializes when the peasants pay share capital to the co-ops and obtain loans in time of need. A “1+1” Model linking up rural households and combining production and finance cooperation here takes shape. 158

6.2.2  The Theoretical Implications and Practical Significance of the Model In analyzing the relationship between the rural household credit and incentive compatibility of financial institutions, we can come to a simple conclusion: exogenous financial institution is incentive incompatible with rural household whereas endogenous institution is compatible. To make the two systems function best, we can link up the exogenous with the endogenous institutions and inaugurate a new financial coupling system and lay a foundation for a new credit relationship. Nonetheless, this new relationship should be built upon rural household financial cooperative organizations in an endogenous financial institution, which is the core issue of this book. The validity of this statement depends on the hypothesis of the incentive compatibility of village cooperative financial institution. We will discuss the village cooperative financial institution and its functioning mechanism of governance structure in the following sections. (1)  Information Symmetry Mechanism First, we need to examine the relationship between villages and peasant households. There are few studies of the relationship between village and households in the literature of rural finance research except in rural informal finance. This book regards village as an important environment variable of rural finance. It is also an important perspective in the studies of rural finance. Only by including village in our analytical framework can we solve the problem of information parameter in rural finance. The concept of village for this research requires clarification. The concept of village has two definitions in China. The first is administrative village delineated according to the jurisdiction of local government, the name of which is official. The second is known as natural village consisting of rural households living in a relatively dense residential district for generations and where the conventional name of the village is passed down in history. In general, an administrative village is often made up of more than two natural villages. Up to the first half of 2007, China had 691,510 administrative villages and more than 710,000 natural villages. When we refer to villages in this book, we mean “natural” villages, the unit of rural finance we have adopted for this research. The reason for this is that the delineation of administrative villages in China has undergone frequent changes since the founding of the People’s Republic of China. Villages have decreased in number while increased in area. Such changes have taken place mainly for administrative 159

convenience with the result being the weakening of ties between peasants in their daily life. Some of the administrative villages in local government planning have in fact transformed into towns, deviating from the original meaning of village. We therefore choose natural villages (including some administrative villages with relatively fewer changes in history) formed naturally by the rural households themselves as the environment variable for this research. Secondly, we need to investigate the territorial relationship between households and villages. The households are related to their villages in three major ways. First, all villages have clear territorial boundaries, beyond which there is another village. Second, natural villages usually consist of households with blood ties. Many village households are derived from the same family clan. In most cases, villages are made up of peasants of blood relatives in that they are the posterity of common ancestry. The villagers are tied up by relationships based on father and son, siblings, and so on. Third, there are relative and geographic ties (proximity). The former refers to relationships among relatives (in some cases the relationships cover the whole village). The latter refers to the proximity of living in the same place. Accordingly, the social structure of villages is characterized by multiple concentric circles. The inner circle consists of blood ties, the middle circle is composed by relative relationships and the outer, the geographic (neighborhood). Furthermore, these multiple concentric circles of natural villages are encased within the big circle of administrative village as demonstrated in the following graph:

Graph 6-3-1: Diagram of Concentric Circular Social Structure of Village


Thirdly, we need to inspect the relationship between Household Concentric Network Circles and Information Symmetry Mechanism. We come to the conclusion of Concentric Circles Structure in analyzing the relationship between rural households and village. This structure offers us an important approach for investigating the information symmetry mechanism. That is, what is the path of information transmission? How large is the effective space for information symmetry? These are important questions concerning the information symmetry mechanism. All information is transmitted through a pathway. The information pathways in villages are expressed as the relationship networks between households. The peasants obtain information through their network with other households. This networking is different from the information networks in modern societies. It is a relationship structure between households, which is the above concentric circular structure between households and the village. In general, information is first circulated in the network of families with blood ties, and then in network of relatives, including family clans and relatives beyond five generations. Finally, information is passed among neighborhoods and fellow villagers. This information pathway can be illustrated by rural custom. For example, the peasants first inform their close clan members, then collateral relatives, and finally their neighbors on the occasion of weddings and funerals. Accusations will arise if the villagers do not follow this social custom of information pathway. At first, information is first conveyed through this pathway from point to point, then from points to lines, and finally from lines to lines. Information symmetry is valid only within certain spatial confines. Information distortion takes place out of its range. Information is transmitted by specific network structured by concentric circles. The outer circle is the border of information transmission. We emphasize information pathway and its information effectiveness here on the condition of universal knowing. It does not mean that beyond that boundary information is no longer transmissible. With advanced communication media, information can be transmitted anywhere without distortion. What we are referring to here is that information can be rapidly disseminated without distortion within a boundary, requiring no specific point to point conscious transmission. According to the above discussion, the village is the effective range of information symmetry among rural families, because of the path dependence of information transmission formed in the concentric circular structure. 161

(2)  Credibility Mechanism Credibility mechanism is the focus of our research of rural finance. The question of how to establish credibility between rural household and financial organization is a difficult problem that has yet to be resolved. Formal finance attributes the malfunction of rural finance simply to a lack of effective collateral. Nevertheless, in the domain of informal finance, we have never found a credit contract made by peasant household through collateral. How is the credibility mechanism formed in the credit relationship made in endogenous institutions? How does this mechanism function? First, let us analyze the value of credibility under village culture. ① Village culture and credibility culture. Village culture is an important factor directly related with the institutional arrangement of rural finance. Rural informal finance is usually dubbed as “grassroots” finance, which is closely related with rural culture. Without the particular village culture, there is no grassroots finance. Village culture is characterized by following features. A. Honesty. Whatever a rural household member does in a village, he or she should be proud of his or her trustworthiness. The neighbors should treat each other with honesty. B. Generosity. This is the most remarkable feature of village culture. Villagers are generous and hospitable and love to help others. It is the essence of village culture remaining unchanged for thousands of years, which distinguishes itself from the urban culture. Although it has been affected by the market economy, this particular cultural connotation basically persists. C. Righteousness. This concerns the morality of village culture. Villagers advocate righteousness and justice. They show a clear stance between what is right and wrong, what is praiseworthy and despicable. Because of these values, a man of high prestige will be elected as the patriarch of a clan, or the village cadre, etc. ② Analysis of Village Credit and the Value of Credibility. Village credit has always been an important feature in maintaining the relationship between rural households. In terms of economics, it is a particular financial product of the village. This product can be produced in a village continuously, without the problem of moral hazard in the absence of collateral. We believe the dominant factor facilitating the continuation of this system is a credit collateral particular to villages, the morality of village culture. This cultural morality has the same credit function as the physical collateral, which is the constraint mechanism of credit: whenever one fails to repay a loan, he or she has to suffer a loss, be it collateral or reputation. .


In formal finance, a debtor’s loss of reputation is not enough for compensating the creditor’s losses, therefore it refuses to accept this cultural morality as collateral. Nevertheless, in the case of informal finance, rural households have to face each other every day and possibly generate new relationships of interests on a daily basis, especially the mutual interests under the concentric structure. When a household breaches a credit contract, it has to suffer the collective punishment by the whole village. On the contrary, a household with good credit can continue to have credit in the future, and also enjoy a good reputation in the village. It is a positive mechanism correlating cultural morality and creditworthiness. Second, let us compare the cultures of credibility in villages and cities. In studying the problem of rural finance, we find that the two institutions (exogenous and endogenous) are in fact corresponding to two cultures, namely urban culture and village culture. Analysis of the values of village culture and urban culture. There are remarkable distinctions between them in terms of values. ① Diversity and homogeneity. Since the reform and opening up, urban culture in China has changed dramatically. More and more foreign cultures are flushing into China. Both the carriers and contents of culture have changed, especially the themes of culture, which under the impact of market values, are not confined monotonously to the political and have become increasingly diversified. Rural areas, especially villages, however have changed relatively less. The themes and contents of its culture remain unbroken, therefore no essential change in cultural values is observed in rural communities. ② Modernization and tradition. Urban culture accepts modern ideas both in form and content. The hustle and bustle of cities is the full expression of modern culture. Villages, far away from cities, have accepted relatively less modern information. Both the forms and contents of traditional culture are not lost. Even though modern culture is similarly enticing to villagers, it is not the mainstream in rural areas. Those who remain influential in villages are the elderly patriarchs. They identify themselves with traditional cultures. That conserves the traditional features of village cultures. ③ Market-oriented and non-utilitarianism. Urban culture is increasingly permeated by market-oriented utilitarianism. Cultural industrialization and commercialization is the trend and mammonism prevails. Traditional morality is losing ground while non-market-oriented traditional virtues are facing challenges. Village culture regards market-orientation as a deviation in ethics. Its core value still concerns the continuation of village ethics and morality, e.g. mutual help and 163

caring among neighbors, emphasizing affection and righteousness, etc. ④ Mainstream and side-stream. Urban culture is the main-stream while village culture is the side-stream. It is indisputable. The distinction between urban and rural cultures is expressed through the complexities of credibility, which is increasingly utilitarian. First, the culture of credibility has become diversified as the culture subjects have become more diverse, especially under the tide of market-economy. The convergence between urban and rural cultures as well as the domestic and foreign has brought about dramatic change in the value of credibility after the reform and opening up. Honesty and guarantees have to be secured by contract. Although village culture has also been under the impact of the market economy, the stability of the concentric-circular structure and the foundation of ethics have not fundamentally been shaken. Credibility in villages is still based upon honesty and honor. Second, as social mobility increases, organizations and individuals in market keep changing in space and time. These vagaries mainly take place in cities where the flows of people, goods and capital concentrate. It then becomes difficult to verify the veracity of information about each individual. On the contrary, in villages which are relatively small in space and stable with little mobility, it is easier to validate the information. The cultural difference between the urban and the rural due to variation in information is directly expressed in credibility. In cities, the adverse selection due to information uncertainty and the uncontrollability of moral hazard must be constrained rigidly by effective collaterals. Third, we come to the selection of financial institution under village culture and urban culture. We have seen the differences between village and urban cultures, which are also reflected in the difference in the concepts of credibility. Here we further analyze the influence on the selection of rural financial institution by the differences of two cultures. Firstly, the dominance of urban culture and the selection of exogenous institution of rural finance. Due to the inequality between two cultures, urban culture becomes dominant and is officially recognized, predominating over the rural. Under this precondition, the institutional arrangement of rural finance is determined by the value preference of the official culture. Exogenous financial institution accords with the requirements of urban culture and the value preference of urban culture of credibility, being the priority of official culture. Village culture is underprivileged and not officially recognized, not falling in with the official 164

value preference. That is the reason why endogenous institutional arrangement of rural finance is not selected. As the institutions of market economy continue to improve, exogenous financial institution becomes the symbol of market economy and is inserted into the rural economy. The endeavor to solve the problem of rural financial resource allocation by exogenous institutional supply has become the preference of official culture, especially in terms of the value of credibility. Meanwhile, the endogenous financial institution which fits well with the village culture is underprivileged and not recognized by the official culture. Its reasonable institutional arrangement has been repressed and distorted, leading to unbalance in the supply and demand of rural financial institution. Secondly, the moral hazard of urban culture and the selection of exogenous financial institution. In urban culture, the information asymmetry and uncertainty of moral hazard caused by diversity and mobility has made the government select the imposed financial institutional arrangement with risk management. It is an exogenous institution directly arranged by the government, which requires collateral as a rigid constraint and contract with fixed terms. To avoid adverse selection caused by information asymmetry and moral hazard, this arrangement requires a cost with little elasticity: collateral. The costs of this collateral and its range of acceptability by the contractors depend on the transaction cost of credit arrangement. When the transaction cost becomes too high to be acceptable by either side, or not enough to offset the opportunity cost, the deal to make a contract fails. Village culture and the nature of its value of credibility render the collateral as required by exogenous institutional arrangement ineffective. Village culture does not recognize the necessity of collateral. The information symmetry and the ethnics as well as morality in villages have naturally fulfilled the function of collateral. This is the reason why exogenous financial institution is incompatible with the rural culture. Lastly, the analysis of the compatibility of the credit mechanism of endogenous financial institutional arrangement with village culture. The urban and rural are two different cultural types. The differences between these two cultures require different institutional arrangements. If an institutional arrangement is incompatible with the cultural environment, it is necessarily be repelled. The particular moral norms of village culture have already taken the value of credibility as a specific constraint, which matches with the financial institution. It is therefore not necessary to duplicate the requirement of rigid collaterals in contracts based on the urban 165

value of credibility, which invalidates the credibility mechanism of village culture. Furthermore, we have to take a realistic economic condition into consideration: the existing state policy of rural property rights, namely, first, the confirmed rights of contracted land to the peasants, second, the confirmed rights of resident land to the peasants, and third, the confirmed rights of the housing of the peasants. Although these are forms of wealth owned by the peasants, they do not have certificate of property rights under the existing legal policy. As a result, the means of production of the peasants cannot work as liquid assets. Legally, they cannot function as credit assets. This requires us to reconsider the institutional supply in rural finance. Exogenous or endogenous institutional supply? That is the question. We can make a comparison in table 6-2-1: Credit Mode

Credit Contents

Cost of Breach




Transfer of property rights




Loss of living environment

Table 6-2-1: Comparison on Endogenous and Exogenous Institutional Supplies

The above table shows that under the existing developmental environment of rural economy and the village culture, a finance institution must be endogenous to be compatible. In other words, the constraint condition that satisfies that incentive compatibility of credit institution with rural families is the living environment of the village, rather than the transfer of property rights of assets. Its cost is the smallest institution operational cost. (3)  Constraint Mechanism of Moral Hazard Whether the cooperative finance in villages, as a particular endogenous financial institution, has a moral constraint mechanism is the key factor determining the operation cost of the financial institution. Here we analyze the financial institution that satisfies the constraint mechanism of moral hazard and its conditions of constraint. Concentric Circles Structure and Concentric Circles Credit Analysis In the investigation of the relationship between village and rural households, we discover the concentric circles network, which is congruent with some studies in the literature of rural credit. Zhang Jie (2005) believes that “the rural 166

consciousness of Chinese rural society and the family concentric circular structure make the peasants rely on traditional ways and modes of getting loans for a long time to come, instead of plunging into a modern credit system. For a large part of rural society in China, especially in the mid-western rural regions, the order of preference in selecting loans still follows the logical order we have emphasized. If agricultural income is not enough for subsistence, a rural household will seek the internal financing from non-agricultural income. If the household budget gap still persists, they will seek external financing, the order of which is, first, credit from the state, and then friendly lending within the family concentric circular structure.” However, in our research, we find that the order of preference is reversed. The order of financing for rural household is firstly to seek lending from relatives and friends, and then from state credit. According to the Survey of Ten Thousand Households in Fangyeng County in 2005, the order was as follows: siblings—relatives— neighbors—fellow villagers—government—usury. The reason for the concentric circles structure of credit to exist is that it reflects the social relationship between rural households and villages. This relationship embodies (1) the accounting of financing cost, i.e., the ascending order from interest-free loans to the smallest and, finally, highest cost; (2) the moral precepts of the village, which stipulates that when a rural household is not recognized by its relatives and fellow villagers, it can no longer seek further loans, lacking the necessary credibility; (3) the cost of “face”, i.e., the loans a rural household can get directly depend on its status in the village. If a family keeps borrowing without proper reasons, it would be denounced by the village culture as like “not living by honest labor,” or “black sheep”, etc. This credit culture makes it an imperative that unless it is absolutely necessary, a rural household will avoid enlarging its family loans. Hence, external modern finance is incompatible with the concentric structure of villages. Or to put it another way, modern financial institution becomes effective only when it manages to break through the concentric structure in villages. Under the precondition of this structure, endogenous cooperative finance in villages is incentive compatible, i.e. with the smallest institutional costs. Analysis of village informal finance in a repeated game How does an endogenous financial institution arrange the credit relationship between rural households? Here we analyze why a repeated game of strategy is formed. Do the motivation and goal of the game conflict? Is it possible to reduce 167

the number of game repetition to directly achieve a win-win cooperation? Suppose the participants of a credit game are rural households and financial cooperative organizations. The expenditure function is as follows: A represents the amount of loan to a rural household by the cooperative; R is the rate of return to the household’s investment; r is the interest rate of the organization; if a household fails to repay, it will suffer a penalty of P, which can be viewed as the loss of future yields if expelled from the organization, or the self-reproving out of conscience under village culture. If a household’s investment succeeds, its gain is (R-r) A while the organization’s return is (1+r) A. If the household chooses not to repay, its return is (1 + R) A − P. Generally, we assume a household will repay if its investment succeeds. Then (R−r)A>(1+R)A−P. That means P>(1+r)A.        Household Organization


Not Repay

Defer payment


− A, A − P

No Deferment

r' A,−r' A

− A, A − P

Table 6-2-2 Credit Game Matrix of Rural Household and Cooperative Financial Organization

Here, δ is the discount factor. r' A is the amount of repayment when the investment fails, which is smaller than the amount when successful. It can be seen that when δ is larger enough, the organization will select offering deferment and the household will choose to repay. It shows that cooperative financial organizations can overcome the defect of short term of payment in formal finance, and provide a genuine shelter against risk for rural households. Of course, here we assume the household’s investment will become successful in the second round after the deferment. In a stricter case, we can assume the probability of success of investment and reach a similar conclusion. (4)  Penalty Mechanism under Village Culture of Credibility In an endogenous financial institutional arrangement, the morality of village culture can serve as special collateral and fulfill the function of credibility even though there is no system of physical credit collateral. We can analyze how it works. The reason the morality of village culture can take the function of credibility is 168

that the village serves as a protection for rural households under a peasant economy. Rural households have the double function of production and consumption. Due to the underdevelopment of the social security system in rural areas, the consumption function makes the family unstable in securing its protection function. It therefore becomes a common demand for rural households to seek external help and form a social mutual aid network. That is the “shadow system” of social security in the village, based on the morality and sense of righteousness of village culture. It not only provides security to those households in need but also makes sure that those who oblige others will be safe. If a household violates this criterion, it will be condemned by the village collective and its social security will be endangered in the future. On the contrary, if a household abides by it, it will earn a reputation in the village and find it easier to fulfill its expectation of getting help in the future. We can represent this “shadow social security system” based on the value of credibility in village culture in table 6-2-3: Follow

Do Not Follow

Rural Household

Demand, Supply

Demand, Not Supply

Village (Community)

Demand, Supply

Demand, Not Supply

Table 6-2-3 Game Matrix of Rural Household and Village Based on Village Morality Culture

(5)  Incentive Compatible Mechanism Does the peasant household cooperative financial institution contain an incentive compatible mechanism? Compared with traditional rural financial institution, what are the new characteristics of this new institutional supply model? Or put another way: can this institutional model resolve the predicament of asymmetry between supply and demand in the existing rural institutions? We analyze these questions as follows. First, let us analyze the misplacement of financial function in traditional informal credit institution. The financial products of traditional rural informal credit institution emerge out of the demands of rural households. For a long time, under the conditions of peasant economy, rural household’s needs were categorized by two objectives: survival and development. The problem of survival is of particular importance as there is no social security system in rural areas. The peasants in need would turn to usury. The needs in extraordinary life situations like, births, weddings, providing for the elderly, medical care and funerals have long been the 169

main reasons for seeking financial products from rural informal finance, especially usury. This finance for social security is an alienation of the normal financial function. It is a reflection that the national social security system is defective, and also of the risk of the financial product supply in formal finance. Financial capital is in essence a form of capital seeking profits, be it formal or informal. However, with such a function misplacement it is difficult to achieve its goal of making profits. There are two kinds of loans for social security in informal finance ① Interest-free loans, i.e. gratuitous help from relatives and friends. That is the cultural product of village under the concentric circular structure. A rural household is the provider and also the demander of this product. It does not require a fixed deadline of repayment. However, whenever the benefactor is in need, the beneficiary has to pay back as much as he or she can. Moreover, the beneficiary has to pay more. Although no agreement is made on paying more, it is a convention formed in village culture; ② Extensible loans bearing interests. When a household has difficulty in making repayments, it can be extended. On some occasions, it can even be extended to the next generation. In either case, formal finance would find it inappropriate. If payments on loan are in arrears, it will be regarded as a bad loan. Mistrust then emerges between rural households and formal finance, leading to the interruption of supply of financial product, and malfunction of institutional supply in the exogenous financial institution. Second, let us analyze the constraint condition of institutional supply in rural cooperative finance. Although traditional informal credit products take up the function of social security supposed to be taken up by the state, this misplacement may result in a challenge to the sustainability of finance. When this occurs, formal finance’s product supply withers and even retreats from the rural market. The establishment of rural social security is therefore an imperative for the government. It is the essential precondition for transcending, or improving the peasant economy. At present, China is building in rural areas a new cooperative medical care system, the subsistence allowances system, the five guarantees household system (providing food, clothing, medical care, housing and burial expenses for the aged, the infirm, old widows and orphans), 9-year compulsory education and boarding subsidy, etc. To an extent, these systems solve the problem of survival for families. They partially correct the distortions in financial products. Under this precondition, rural households can escape the dilemma of functions between survival and development. The financial demand for production will rise, which provides a 170

favorable condition for the development of production in rural families. Based upon this, we propose the institutional supply of peasant cooperative finance, which must be built on the foundation of development and cooperation in agricultural industry among rural households. That is its major difference from traditional intrinsic institutions. The constraint condition mentioned above can rectify the distortions of traditional finance and re-orient its function from securing survival toward development in production. It is fair to say that the statement about the necessity of this precondition is correct. This conclusion is based on the external institutional environment of rural areas and the functions of family. It must be emphasized that the given condition is not simple rural household production, but production cooperation among peasant households, which is a stricter condition. This condition is based on two considerations: transaction costs and the compatibility of exogenous institutions. ① When rural households join together in production cooperation, economies of scale can lower the marginal cost of production while internal cooperation can cut the transaction costs. Cooperative finance at the village level can bring about higher profitability than traditional folk financial institutions. Through innovation, the existing endogenous institution can gain the momentum of sustainable development. ② Exogenous financial institution has always been separated from endogenous financial institution. Apart from ideology, the most important reason is the cost of institutional compatibility. Without production cooperation, no financial subject in the traditional rural informal sector can have advantage in terms of moral hazard cost or transaction costs. That is the reason for institutional innovation in rural household financial cooperation. Analysis of Institutional Supply of Rural Household Cooperative Finance Given the constraint condition of household cooperative finance, the mode of operation of the institutional supply is shown in diagram 6-2-2

Diagram 6-2-2 Mode of Operation of Rural Household Cooperative Finance


There are three levels in the above supply model. 1. The condition of supply: there must be cooperative relations in production among rural families. Household production cooperative organization is formed. 2. The target of supply: from individual households to the households of a cooperative and their collective. The financial demand of households becomes the capital shortage on the basis of cooperation, rather than previous capital demand of individual families. 3. The way of supply is changed from the supply to individual household to two levels: internal mutual funding among the households in cooperation, and capital loans among cooperatives. 6.3  Analysis of the Compatibility between Peasant Household Cooperative Financial Institution and Exogenous Financial Institution The key to whether the rural household cooperative financial institution can succeed rests with its compatibility with external financial institution. The compatibility is mainly determined by whether these two institutions can be joined up and the cost of joining up is less than the benefits it brings about. According to the principle of institutional compatibility, we analyze three aspects. First, the comparative information cost of institutional compatibility. In the operation of a financial institution, one of the core costs is information cost. Traditional rural financial institution has its particular geographic advantage in terms of information. Joining up exogenous and endogenous financial institutions will result in a complementarity of their respective advantages. The information cost of the external institution will be lowered while information can be shared within the internal institution. The information cost after joining up is less than or equal to that of the previous individual institutions. An advantage in information cost takes shape. Second, the comparative transaction costs of institutional compatibility. The main features of institutional operation in traditional rural finance are small scale, high frequency and high costs. They are also the reasons why financial organizations retreated from rural areas after commercialization. Due to its advantage of cost internalization, endogenous institutions can operate for a long period. On the contrary, exogenous institutions cannot internalize their costs. Financial establishments of this institution would suffer losses after a while. Joining up these two institutions can bring about an economy of scale in transactions and 172

lower the transactions costs substantially by internalizing the costs. A new coupling system will increase the efficiency of the institutional operation. Third, the comparative cost of moral hazard of institutional compatibility. The advantage of rural cooperative finance as an endogenous institution is the inherent constraint mechanism of moral hazard, whereas in exogenous institution, noncooperative game of strategy will result in adverse selection and uncontrollable moral hazard. Joining up two institutions may fortify the existing constraint mechanism and form a new comparative cost advantage in terms of moral hazard. (1)  Joining up exogenous and endogenous financial institutions and the optimization of the institutional supply. The essential function of rural financial institutions is to serve the san nong and achieve a healthy development of rural economy. This is the objective function of national financial institutional design and supply. However, after years of practice, it is evident that the rural financial institutional supply does not solve the malfunction of rural finance. What is more, the financial establishments of the state’s financial institutions continuously retreat from the san nong sector, running counter to the goal of its design. The root of this is the incompatibility between the exogenous institutions by the state and the endogenous institution of “folk finance”. Or put another way, formal finance always wants to monopolize the business and therefore suppresses the informal sector. Rural financial markets become distorted, and a distorted mode of supply in rural financial products entails higher costs and greater risks in supply. Accordingly, it is an imperative to conjoin the exogenous institution with the endogenous one. The conjugation of the two institutions is not simply a matter of compatibility. Most importantly, so doing will fortify their respective advantages and minimize the disadvantages. A new mode of institutional supply may emerge to achieve the goal of serving the san nong. The state, the financial organizations and the rural households would be unified in sharing the same interests. (2)  Innovate the financial governance mode and promote a sustainable development of rural finance. Rural household cooperative finance is a form of endogenous institution. In terms of the governance mode, it belongs to the category of informal financial organization. However, this mode is different from traditional folk financial 173

organizations. It is built on the framework of cooperative economy. For a long time, exogenous financial institutions have been supplying directly to the rural families. It has to face the problems of high transactions costs, small transaction scale and potential moral hazard. In this innovative model, the official financial organizations are conjoined with folk financial organizations. The chain of supply changes from “financial establishments—peasant households” to “official financial organizations—folk financial organizations—peasant households”. The supply chain is elongated. In this new chain, formal finance no longer deals with individual households, but with the collectives of rural households. The economies of scale not only benefit the official financial organizations but also their civil counterpart which increases its effectiveness by having access to the resources of formal finance. We therefore believe that this innovation in rural cooperative financial institution will greatly propel the sustainable development of rural finance. (3)  Incubate new market subjects and unify agricultural industrial development with the interests of financial organizations. The essence of finance is to chase profits. For rural households, both of the financial demands for consumption and production are necessary. Due to the lower productivity in rural areas and a lower family income standard than in the cities, the repayment for life-cycle consumption loans implies risk. In reality, a rural social security system has yet to be established. The function that should be taken up by the social security system is transferred to the financial demand for family consumption, which increases the risk of default. What is more, some loans originally intended for production investment have to be appropriated due to unexpected needs for family consumption. That results in formal finance, which faces the problem of information asymmetry, becoming even more cautious in lending. Cooperative finance at village level operates in the organizational framework of the cooperative economy, and avoids the misplacement of consumption financing and production financing. Cooperative economy and cooperative finance work together in allocating capital in production, circulation and technologies, etc. Rural households organize themselves in economic cooperation. And economic cooperatives can grow with the support from the financial sector. The market subject of rural economy changes from individual households to that of a collective of households. In cooperation, rural families propel the development of agricultural industry and increase their incomes, 174

while financial organizations can expand their interests in the development of the cooperative economy. The interests of rural households and financial organizations become unified. 6.4  Model of Conjoined Institution in Peasant Household Cooperative Finance 6.4.1  Basic Contents of the Model In the above analysis, we find that the “1+1” model of rural household cooperative financial institution can effectively solve the problem of financing cost and inconvenience of obtaining loan. However, this sort of funding is small in scale and unable to fully satisfy the demand for expanding reproduction. Although exogenous finance can provide a larger scale of funding, its effectiveness and performance is limited by a series of problems: information asymmetry and high collateral cost. Is it possible to conjoin the exogenous with the endogenous institutions into a new system? In view of this, based on the “1+1” model we further propose the “3+1” model: “(corporate champions, credit cooperative, agriculture-related banks) + the governments”. This model works in the following way. The leading enterprises in agriculture place orders to peasant cooperatives and purchase collectively the produce from different households. They also provide guarantees for the credit cooperative formed by individual households in their applications for loans from banks. Agriculture-related banks then offer credit to the credit cooperative which breaks up the fund it gets and lends to those households in needs of funding for production. The federation of credit cooperatives must provide services to its cooperative members and supervise their operation. The government must supervise the federations to ensure their healthy development and also takes the function of surety.


Diagram 6-3-1 ‘1+3” Model of Conjoined Institution of Peasant Household Cooperative Finance

6.4.2  Mechanism of the Model The structure of this model consists of three levels. First, there are the partnerships between peasant household credit cooperatives and corporate champions. The unity of this relationship is at the county level. Leading enterprises purchase agricultural materials directly from peasant cooperatives instead of from the market. They place their order to the cooperatives. After getting the order, a cooperative breaks down and assigns the task to different members. It must guarantee the supply of the produce to the enterprise according to the order. Second, there are the partnerships between agriculture-related banks and rural credit cooperatives. When a peasant credit cooperative applies for loan from 176

banks, usually it will be turned down. The reason is that rural credit cooperatives operating as financing organizations actually compete with banks. Furthermore, credit cooperatives usually do not have collateralized warrants. Now, with the participation of a corporate champion, the purchase order can serve as a shadow collateralized warrant for credit. The corporate champion can establish a partnership with the bank which can have the right to share a part of the profits the enterprise generates in the produce market. In this way, the credit risk of the credit cooperative in partnership with the enterprise now becomes a part of the risk in the business of the latter. When this risk is controllable and the information is transparent, an agriculture-related bank can get into partnership with the credit cooperative and offer credit to the latter. Third, there are the partnerships between the governments and credit cooperatives. The government puts great emphasis on the interests of peasants. Its concerns on the credit issues are expressed as coordinating the agriculture-related banks in lending to the peasants. However, academics regard it as “governmental intervention”. When an agriculture-related bank is willing to offer a large scale credit to a rural credit cooperative, it may request surety from the government, which forms a game partnership of the two parties. As the common goal of servicing the san nong becomes an objective function, the government will arrange a surety company to offer insurance for the bank concerning the risk implied. In terms of the operation mechanism, it is an incentive compatible institutional design. Firstly, there is an interest-sharing mechanism. The conjoined system of rural household cooperative finance is built on the cooperation of specialized production and mutual funding (the “1+1” model). Production cooperation is the precondition of this institutional arrangement. Under this precondition, a close partnership is formed between the parties sharing common interests. Apart from the cooperation among cooperative members, the participation of leading enterprises is of greatest importance. As the first interest groups in the partnership, they make the interest-sharing mechanism possible; secondly, there is a sharing of market interests. The production interests can only be realized in the market. When a corporate champion places an order to a credit cooperative, the realization of a potential market interest becomes possible. Sharing a part of this market interest, an agriculture-related bank becomes the second interest group taking part in the conjoined system of rural finance. The bank offers large scale credit to peasant credit cooperatives and shares the market interests created by the cooperative; 177

thirdly, there is a sharing of risk. All institutional operations entail costs of risk. The risk of conjoined rural financial system is correlated with the safety of the credit funding. As the fundamental solution, the government surety becomes the last bearer of risk, which is the key to the continuation of this system. The government’s offering surety is tantamount to governmental intervention, which are the two sides of the same coin. Governments at all levels have to support and service the san nong, which is also the objective function of agriculture-related banks. Under the constraint condition of this common objective function, the government becomes the third interest group taking part in the conjoined system by arranging a surety company for insurance. It can be seen that participation and sharing is the core of this conjoined system of rural household finance, where the incentive mechanism of institutional arrangement lies in. It is an institutional innovation overcoming the shortages of rural cooperative financial institution alone and exogenous financial institution alone. 6.4.3  The Model’s Theoretical and Practical Significance The significance of this model lies at two levels: theory and practice. Theoretically, it proposes and solves the problem of joining up the exogenous and endogenous institutions. For a long time, new institutional economics makes a strict delineation between exogenous and endogenous institutional arrangements and operations. The coupling of these two institutions is not a field of study. This opposition of institutions in theory has in practice hindered institutional innovation. The proposal of the conjoined model of rural cooperative finance is to join up two financial institutions, which is a new field in new institutional economics. Joining up the institutions of two categories opens up a new perspective not only in the field of finance, but also in wider scope , for example, conjoined economic subject, the range of joining up, the constraint precondition, and the conjoined goal of interests, etc. Furthermore, it suggests a complex subject of institutional change. There are two forms of institutional change: induced and imposed, which respectively correspond to interest groups in civil society and the government. And there is conflict of interests between them. Is the third kind of subject, a cooperative subject joining up civil society and the government, possible? This is the theoretical value of our model. Although it is not mentioned in new institutional economics, the incentive compatible mechanism proposed by Leonid Hurwicz, Eric S. Maskin and Roger B. Myerson, the laureates of the 2007 Nobel Prizes for Economic 178

Sciences has laid the foundation for this innovation. Based on this theory, we take the real condition of rural financial institution in China as the point of departure and propose the model of conjoined institutions. The civil subject (credit cooperative) and the government join together as the originator of this coupling (or conjoined) institution. This institutional arrangement implies significance in theoretical innovation. This institutional model has three aspects of practical significance. Firstly, it indicates a new path of cooperation between endogenous finance and exogenous finance. The exogenous financial organizations can do wholesale business with the endogenous financial organizations, while the latter can engage in retailing. The two parties become partners of business, gaining respectively what they aim at. Secondly, it can cut costs. The exogenous institution faces a high cost of credit in dealing with rural households while the endogenous finance contains a relatively low cost in this regard. Joining up two institutions can make use of the latter’s institutional cost advantage and cut a great deal of the cost on the side of exogenous finance. Thirdly, it innovates in the interest-sharing mechanism. Rural households not only cooperate in production by getting purchase orders but also in credit. The cooperation of credit becomes cooperation in risk management. This innovation in cooperative mechanism is made possible by the innovative cooperation of two institutions. The performance resulted by the innovative cooperation can serve as a solution to the present predicament of institutional arrangements in rural finance. 6.5  Comparison of Peasant Household Credit Cooperative and Formal Cooperative Institution The problem of rural finance in the last analysis is a matter of institutional selection and arrangement. In regard to cooperative finance, we can select the formal cooperative financial institution, i.e. that which is arranged and dominated by the government, or we can select the cooperative financial institution composed of rural credit cooperatives and led by rural civil society. In reality, some countries take a fixed system. Currently in China, cooperative finance is dominated by the government. In regard to the effectiveness of these two institutional arrangements, we select five core categories for comparison. That will facilitate a better understanding of the demand and supply of rural financial institutions. Before that we have to clarify that in terms of cooperative financial institution, there is 179

no delineation of formal or informal. However, in view of the current financial institutional arrangements in China, we divide them into formal finance and informal sector comprising folk financial activities for convenience of analysis. 6.5.1  Comparison of Objective Function of Institutional Supply (1)  Objective Function of Rural Cooperative Finance A. The institutional essence of peasant household cooperative finance The subject of rural cooperative finance is peasant household. The nature of this cooperative finance is the interpersonal cooperation among rural households. In this economic cooperative of peasant households, people are the associative subject and capital is the associative object. Internal management follows the democratic principle of “one person, one vote”, regardless of the size of share of stock a member holds. No one can enjoy privilege in management decision-making. This is the essence of cooperative finance. The difference of peasant household credit cooperative from other sorts of informal finance is that the capital rising of this form of financial organization is out of the motivation of mutual funding among rural households. The aim is to help overcome the financial difficulties its members face, and promote economic and social improvement. This funding cooperation can effectively suppress usury and provide satisfactory financial services to the members in favorable and flexible ways. It is a financial form welcome by the people (Zeng Saihong 2007). This form originates from rural households, being the fundamental form of financial cooperation. In comparison with credit unions and federation of credit cooperatives, its scale of organization is small. Its commercial credibility is low. The range of its activities is generally bound by the borders of the village. It is the primary organization of cooperative finance. B. The value orientation of peasant household cooperative finance It is determined by the objective function of cooperative organization. The members generally belong to the underprivileged social group. They are peasants who find it hard to get loans from commercial banks or local credit unions. Out of the common interests of mutual help, they form a cooperative. Since its founding, the aim is to provide funds and information to its members in production, circulation and consumption. The interest of the organization is embodied in the mutual help between individual members. They provide the least expensive services to each other and aim at maximizing their interests in cooperation. The 180

organization itself does not pursue profit. Hence the orientation of rural financial cooperative is not profit-making, but the maximization of its members’ interests. Assume the objective function of a rural financial cooperative is U , the objective functions of its members are respectively  U1,U2,U3, L , then, U =    Ui  i = 1, 2, 3, L i

(2)  Objective Function of Formal Cooperative Finance A. Value orientation of formal cooperative finance Here formal cooperative finance is relative to its informal counterpart comprising folk cooperative financial organizations. More precisely, any cooperative finance without the permission by the state’s financial supervisory authorities or related governmental departments falls outside of the category of formal finance. The only legal organizations of cooperative finance in China are the rural credit unions formed by the governments at different levels. Strictly speaking, whether it is formal or informal cooperative finance, the objective function is to maximize the interests of the members. The cooperative organization itself does not aim at profit-making. The difference is: compared with the rural credit cooperatives, formal financial cooperative organizations are generally larger in scale, with more members and higher commercial credibility. They transcend the boundary of villages, and therefore have a more diversified composition of members. The scale of capital stock is also larger. These cooperative financial organizations are usually supported by or formed with the participation of the government. Hence, the objective function of formal cooperative finance, in addition to that of the rural credit cooperatives, has to include the utility function of the government, as represented by U' . The objective function is: U = U +    Ui ,  i = 1, 2, 3, L i

B. Value Alienation of formal rural cooperative finance. Since the founding of the Republic, rural cooperative financial organizations have gone through numerous institutional changes. Since 2003, a new round of institutional change has taken place around the reform of property rights. It is difficult for the cooperative financial organizations to return to the original nature of the cooperative. Under property rights reform, rural credit unions aim at turning 181

themselves into cooperative banks or joint-stock commercial banks. Those credit unions which have found it difficult to turn into commercial banks have lost the nature of “cooperation” during the expansion of capital stocks. No matter in terms of the shareholders or the governance structure, the endogenous motivation of cooperation is lost. This form of rural credit unions exemplifies alienation in cooperative finance. The form of “cooperative” is retained but in reality they become local banks controlled by the governments. For this reason, rural credit unions currently adopt the governance model of provincial governments and are charged with the target of making profits for their organizations and at the same time the duty of supporting peasants and the agriculture. These double goals set up by the current institutional reform of rural credit unions are incompatible. In order to maximize profits, the target of financial resource allocation must be organizational efficiency. This orientation must lead to the commercial bank model in place of cooperative finance. If the target is to support the peasants, they should service their members, the shareholders. However, the role of the shareholders has been weakened. The management and decision-making of credit unions are controlled by the “insiders” or by the personnel appointed by the governments. The shareholders or members have neither the motivation nor the power to constrain the management. They are merely included for the unions to enjoy the policy preference by central or local governments. Accordingly, we can represent the objective function of rural credit unions, the formal cooperative financial institution in China at present as follows: U=U’+ △ U where U’ represents the credit union’s commercial objective function, △ U the governmental policy subsidy. 6.5.2  Comparison on the Credit Base of Institutional Supply (1)  Credit Base of Peasant Household Cooperative Finance A. Credit Form of Folk Finance The credit form of folk finance originates from folk credit, which is generated spontaneously in civil society. It comprises the lending behaviors or horizontal credit relations not included in formal finance. Compared with formal finance, folk credit has the comparative advantages of information symmetry between two parties of transaction, more flexible mechanism and efficiency (Shi Xuhui 2004). This credit system generally exists in the form of informal finance beyond the 182

supervision of the government. Due to its nature of private property rights and lack of proper legal status, it has worked as the opposition or the complement of formal finance for a long period of time (Wang Shuguang 2007a). As an informal form of finance, it is a folk form of credit based on folk lending relationships. According to Wang Shuguang (2007c), the development of folk credit has five stages: partially covert stage, grey contract credit stage, market-oriented and explicit credit stage, standardized and legal credit stage, society-oriented credit stage, depending on different forms of credit contracts. We think that folk credit mainly originates in the moral and cultural constraint of civil society. In a lending relationship, morality and culture are transformed into folk credit. Here folk credit limited within a boundary, usually the border of a village. Outside of the border, folk credit based on morality and culture becomes ineffective. Variables with information symmetry must be added. The weight of these variables becomes substantial in contract. The more standardized a contract is, the less emphasis is put on folk credit, which is bound and specific. It implicates the attributes of morality and culture. B. Credit of Cooperative Finance Rural household cooperative finance is a type of folk finance. According to the typology of Wang Shuguang, it is in a transition from partially covert to grey contract stage. On the one hand, this type of cooperative finance breaks through the previously one to one credit relationship among rural households, while the credit from being covert to becoming explicit. On the other hand, this type of cooperative credit is still confined within a society of acquaintances, entailing no commercial cost of transaction information. Although it is signed in the form of a contract, its constraint depends on the internal morality and culture of village. The credit of rural household cooperative finance is built upon the common moral and cultural foundation of the village. However, morality and culture is merely its foundation but not the totality of the credit. The partnership based on agricultural production is the subject of credit of cooperative finance. In other words, the credit formed in this partnership is the key to cooperative credit. Capital is an important factor in production cooperation. Cooperation in capital not only embodies the mutual credibility among rural households, but also the credibility of the cooperative organization, which transcends individual credibility of households. All co-op members become more concerned about their credibility in 183

the organization. Any act of breaching a contract will lead to great loss at personal costs. Folk credit thus becomes standardized and regulated in organization. (2)  Credit Base of Formal Cooperative Finance A. Formal Finance Credit under the State’s Credit The state’s credit is relative to folk credit. It is the credit activities with the state as subject. The state issue means like bonds according to the principle of credit to borrow money from domestic or foreign holders of money. The state’s credit is a national debt. The objective function of the state’s credit is realized through the financial institution led by the state. In the evolution of financial institution dominated by it, the state’s objective function contains four variables: maximization of stable rent by the state, maximization of institutional output, maximization of mandatory savings, stable increases in the efficiency of resource allocation in the financial system. To realize the maximization of this objective function, the four variables must be maximized. The state’s credit carries all the weight of institutional change. Folk credit is excluded from the objective function of national economic development. That means that on the one hand folk credit system is still underdeveloped, and is not able to have substantial influence on the national credit system. On the other hand, at the initial stage of reform, folk credit was deliberately excluded from the institutional design and regarded as an “inharmonious dissident” (Wang Shuguang 2007b). We agree with this point of view. If we contextualize the national credit into the economic institutional change and examine the transformation from planned economy to market economy, it is not difficult to find that the financial institution is also transforming. However, it has been lagging behind other reforms. In the period of the planned economy, national credit was the only subject of credit and the state became the dominant force in allocating financial resources. All folk credit was incompatible with the state’s objective function. Nationalized banks were the carriers of financial institutions under the national credit system. That means that people was in conflict with the state in financial resource allocation. In order to mitigate the conflict and lower the cost of state-owned banks, folk credit is still being repressed. This phenomenon is in accordance with R. I. Mckinnon and E. S. Shaw’s theory of financial repression. Under the dominance of state credit, the credit of formal finance in China is in essence the embodiment of the state’s credit. It is arranged through the state’s financial involvement. Compared with folk credit, formal finance is characterized 184

by the following features. 1. Economies of scale: in terms of lending and absorbing savings, its scale is much larger than folk credit and keeps expanding. The goal of maximizing formal financial rent is thus realized; 2. Standardization: the credit is not confirmed by oral agreement or conventions and customs. The lending activities are regulated by standardized institutional formality both sides must observe, which is essentially different from folk credit depending on cultural rules and conventions; 3. Contract: credit is affirmed in a contract. Lending and savings of all kinds are confirmed by contracts. The contractual forms and contents are being expanded and become increasingly complex, which are often regarded as the main contents of credit. Even though the credit form of formal cooperative institution is different from the civil counterpart, the foundation of credit of cooperative finance remains the same, which is the credit among members bound by a partnership, based on the commonwealth of members. This is essentially different from the contractual credit based upon the rights over collateral in commercial finance. B. Alienation of Rural Formal Cooperative Financial Credit. As a form of formal finance, rural formal financial credit shares the same features of the formal sector. After years of institutional change, rural formal finance has lost the genuine “cooperative” organizational form, i.e. rural credit unions. When investigating rural cooperative finance, we must take rural credit unions into consideration so as to understand the features of credit under this institution. The alienation of rural credit unions as cooperative finance has also resulted in the alienation of credit, which is expressed in two aspects. First, the alienation due to dependence on the central government’s policy. Rural credit unions take up the task of supporting peasants assigned by the state. The loss in policy-oriented operation should then be taken by the state. However, the amount of loss in this category is ambiguous. Out of consideration of its own interests, financial organizations may take a free ride to transfer other losses to the state in order to get a subsidy. This leads to the alienation of cooperative credit endowed by the state on rural finance; second, alienation of credit in lending to rural households. The credit relationship between credit unions and households do not have the advantage of folk credit. On the contrary, folk credit is excluded. All forms of lending should be formalized by contracts. Those households not able to provide effective rights of collateral required by contract-making become marginalized in formal cooperative finance. The cost to the households becomes unbearable. They either withdraw from cooperation or make a contract through “insiders”. As a result, the nature of “credit” 185

in formal cooperative finance has changed. It is no longer the credit shared among members based on partnership. The founding spirit of offering credit service through cooperation has been lost. Without true cooperation, its operation is costly. Profit-making is not supposed to be its target. However, in practice, credit union becomes commercialized and profit-oriented. It turns into a joint-stock financial establishment pursuing profit. It is a view-point commonly agreed upon by most of the researchers (Xie Ping 2001). 6.5.3  Comparison of Product Features of Different Institutional Supplies (1)  Comparison on Forms and Features of Saving Products Formal Cooperative finance, as represented by rural credit unions, provides all kinds of saving as in commercial banks, for example, current deposit, various forms of fixed deposit and mixed deposits. Informal financial establishments usually only accept the savings of their members. The stock of savings is smaller in amount. As sources of funds are limited, members prefer fixed deposits. The savings products of rural credit unions are welcome by peasant households as their business network is wide and the deposits are guaranteed by the government. The savings products of informal cooperative financial organizations are less competitive. (2)  Comparison on Forms and Features of Loan Products Table 6-5-1  Comparison of Loan Product Features by Rural Cooperative Institution and Formal Financial Institution         Institutions Product Features

Household Cooperative Financial Organizations

Formal Cooperative Financial Organizations (Credit Unions)

Loan Type

Mainly micro credit

Pledge loan, collateral loan, micro credit, and guaranteed loan

Credit Line

Generally under 5000 RMB. Different credit line on different types of loan; Single case not larger than micro credit: 1000-10000 RMB; loan to single 15% of total capital stock client not more than 30% of core capital

Interest Rate

Generally higher than credit 0.9-2.3 of benchmark interest rate; in practice unions differentiated rates according to ratings

Time Period

Less than a year, extendable Short, medium or long term

Application Procedure

Simple and short

Complicate and long

Repayment Form


One-off redemption, interest payment by seasons and one-off principal repayment, equal-amount payments of interests and principal

Sources: You Xiaohui (2008), Pan Lin (2008), Li Zhonghua and Jiang Bolin (2008), Wang Shuguang (2006)


In table 6-5-1, we see that the production of household cooperative financial organizations is mainly micro-credit, whereas the products of formal cooperative financial organizations are similar to common commercial finance. Apparently, they are quite complete. The features of household cooperative organizations are simple, flexible and quick in application. A lot of lending among relatives does not require an IOU. Just an oral agreement is usually enough. Take the example of the Village Credit Cooperative of Taihu County in Anhui Province. The application procedure for loan requires five steps: application form submitted by a borrower, credit cooperative looking into the case, loan agreement signed, (loan over 5000 RMB requires certificate of property rights of collateral or surety by a guarantor), issuing money. Basically, loans of small amounts can be obtained instantly, whereas large amount would take not more than 6 hours. Those prime households with good creditworthiness can have loan money delivered to their homes. The advantage of shorter application time is obvious compared with the 13-step procedure in local rural credit unions. In the latter case, the application procedure is complicated. The actual cost a rural household has to pay in order to get a loan is often very high. According to a newspaper report in Jingji Cankao Bao (Economic Reference Post), a peasant in Henan Province, Mr. Li Pengliang obtained a loan of 10000 RMB from credit unions. But what he actually got was only 4900. 5000 RMB was deducted as compulsory deposits. 100 was taken as stock capital. Then he had to spend another 1000 to dine those who had helped him in getting the loan. We can see that the financial product structures of formal and informal sectors complement each other. Household cooperative organizations are concerned with the needs of basic family consumption and investment of low-medium income peasant households, whereas credit unions provide products to relatively well-off households and for the development of rural industry and commerce. If the two sectors can work together, financial service in the rural areas will improve. 6.5.4  Comparison of Costs of Risk of Institutional Supplies According to new institutional economics, the founding and operation of any institution entails costs. In terms of forms of institutional change, there are imposed and induced changes. Imposed institutional change refers to the emergence of new institutional form or the reform of an older one, as generally pushed by the authorities. Induced institutional change refers to the emergence of new institutional 187

form generated in gradual reform on the old institution promoted by civil society. (1)  Risk Cost of Institutional Supply in Peasant Household Cooperative Finance A. Internal Operational Cost of Peasant Household Cooperative Finance Peasant household cooperative finance is a civil institution. It is founded by rural households as the subject of institution, being an innovation on previous civil financial institution. Its internal operational cost comprises three parts: internal transaction cost, management cost and supervisory cost. Peasant household cooperative financial organization is formed based on blood-ties, personal relationships and geographical ties (or proximity). Lending activities usually take place in a society of acquaintances, within a community where everybody knows each other well. On the one hand, the lender knows much about the borrower’s economic status, capability of repayment, morality as well as financial and credit conditions. This solves the problem of information asymmetry in financing. On the other hand, in a society of acquaintances, the consequence of breaching a contract or breaking a promise will incur a loss of reputation. Such a loss will have bearing on the condition and quality of his or her social environment in a community. His or her family and other related persons will also be influenced. What is more, on some occasions, the impact may last for generations, which is very intimidating. Consequently, the internal transaction costs of rural household cooperative finance are relatively small. The procedures are simple. The service is fast and efficient. As a whole, it can better serve the rural households. In terms of management cost, different rural household cooperatives have different arrangements. Generally speaking, the management staff works voluntarily without payment. In our field work, we did find that some management staffs were being paid. But the remuneration was lower than that of the standard of village cadres. As a whole, its management cost is lower than the credit unions. As regards supervision, some cooperative organizations practice collective consideration and approval, as well as supervision. Loans are granted only with a majority of two thirds of members. Emphasis is put on external supervision. A supervisor is elected by members’ votes. They also accept supervision by related authorities. The costs thus incurred can be quantified according to time spent. As the collective behavior of cooperative financial organization is voluntary, no financial costs are incurred. As for formal finance, all works must be paid. As for supervision, apart from the time spent, its cost must also be paid in funds. 188

External Operational Costs of Rural Household Cooperative Financial Institution Currently, the state does not seriously support this institution. The cooperative organizations usually function independently at their own risk. External political cost is zero. In contrast, formal cooperative finance is arranged by the state’s will. Its political objective function is a constraint precondition with little elasticity. Assume this operational cost is K, then it is necessarily that K﹥0. Costs of Institutional Supply in Formal Cooperative Finance We draw a table to compare the internal and external operational costs of formal cooperative financial institution and the informal counterpart. Table 6-5-2 Contrast of Costs between Formal Cooperative Finance and Informal Peasant Cooperative Finance Categories Formal Finance Rural Household Finance

Political 1 0

Market 1+1 0

Managerial 1+1 1

Supervisory 1 0

Total 6 1

6.5.5  Comparison on Managerial Model of Institutional Supplies (1) Managerial Model of Rural Household Cooperative Financial Institution A. Governance Structure and Function of Rural Household Cooperative Financial Institution In essence, the rural household financial cooperative belongs to the category of the cooperative economy. Its governance structure is similar to economic cooperative organizations. The historical development of folk cooperative finance has gone through the various phases of rotating savings and credit unions, cooperative funds, mutual aid saving societies, etc. Here, we discuss the cooperative financial institution in a general sense. It can be characterized as follows: 1. Cooperative finance is based on mutual funding cooperation; 2. Cooperative finance is interpersonal cooperation mediated by funds; 3. Its goal is not purely profit-making; 4. It is managed democratically; 5. It is managed in a flexible fashion (Zeng Saihong and Guo Fuchun 2007). These features determine that the governance structure of cooperative financial institution is that of the cooperative economy. Financial cooperative is an organization composed of three bodies: the general assembly, the board of supervisors and the board of directors. The general assembly is the highest decision-making body of cooperative financial organization. The board of management is a body of execution and the board of 189

supervisors is in charge of general supervision, as shown in diagram 6-5-1.

Diagram 6-5-1  Governance Structure of Cooperative Financial Institution

In this organizational framework, duties are well defined. Checks and balances between organizational bodies secure a healthy operation of cooperative finance. Under this governance structure of legal personhood, there are three major functions. 1. Mutual aid and cooperation. The bodies of decision-making, execution and supervision are functioning for the mutual aid of members. They are the embodiments of the wills and intentions of members who share the interests brought about by the organization. 2. Risk control. This is the main duty of the board of supervisors, but also a concern of the board of directors and the general assembly. The core of risk control is recognition of membership, which is its essential difference from commercial banks. The major consideration is not about the operational risk of the project a loan is being applied for, nor the risk mechanism of surety. The major criteria are the virtues and conduct of a member before he or she joins the cooperative. 3. Information sharing. Peasant household financial cooperative has built a platform for cooperation, not only for funding cooperation, but more of information sharing. Rural household cooperative finance is bound within the border of a community, with the concentric circles as its organizational carriers. However, the current economic institution is mainly about the household contract system whereas the family as a unit of production is a weak and underprivileged subject of exchange in market economy. Household cooperation constructs a new cooperative economic subject and facilitates the advantage of information sharing during cooperation. 4. Democratic decisionmaking. Compared with formal cooperative finance, this is the greatest advantage of folk cooperative finance. Decision-making proceeds democratically in the general assembly. The board of directors must follow the will of the general 190

assembly. Members enjoy the right to join and quit the cooperative. This function of decision-making is the foundation on which rural household cooperative finance can exist. B. Incentive Compatible Mechanism of Peasant Household Cooperative Financial Institution The mechanism of household cooperative finance embodies a positive incentive compatible mechanism. Its contents are as follows. ① Maximization of peasant interests. The rural households who join the cooperative organization are generally excluded by formal finance and find it difficult to obtain services from formal finance. They are underprivileged peasants in villages. Among the social classes in rural areas, they have neither the economic vitality of those involved in the secondary and tertiary industries, nor the power to formulate political discourse. They are the majority of the rural population. Or put another way, in rural areas of China, a majority of the population is still engaged in traditional farming. They cannot afford the capital needed for modern agriculture or secondary and tertiary industries, entrapped in the repetitive cycle of the peasant economy. Rural household cooperative financial organization can fulfill their wishes of getting financial resources. Compared with the case of dealing with formal finance, the cost of financing for peasants is lower in these organizations. Furthermore, transactions are not limited by the contract institution under formal finance, and therefore rural households can maximize their interests. ② Maximization of organizational interests. Financial cooperative is a union of rural households. Compared with formal finance, it does not have its own commercial interests. Maximizing the interests of its members becomes its core target. ③ The interests of members and organization are congruent. Satisfying the members’ demand for mutual funding is the core of the organization’s sustainability. The raison d’être of the organization is to function as a medium facilitating transactions with its members. In formal finance, an organization has its own goal of profit-making. The management entails costs of employment while its operation entails commercial costs. Consequently, the objective function of formal financial organization is not compatible with that of the members. When the external environment changes, formal financial organizations may pursue profit maximization with the products they offer, instead of maximizing the members’ interests. It is a kind of moral hazard. In contrast, rural household financial cooperatives do not entail commercial costs of various kinds. 191

There is not the issue of adverse selection of interest. Their organizational interests are congruent with that of their members’. (2)  Management Model of Formal Cooperative Financial Institution A. Governance Structure and the Function of Formal Cooperative Financial Institution According to the regulation of rural formal cooperative finance, a cooperative organization must contain a sound constraint mechanism with “three bodies and one layer,” which is the foundation and precondition of legal person governance. First, there is the general assembly for democratic decision-making. The general assembly is the highest power of an enterprise. It represents the owners of the property rights and has the right to control and make decisions. The general assembly should have full rights to nominate and democratically vote for the boards of management and supervision. The consciousness of participation in the management of credit unions must be enhanced. The standard must be improved. The general assembly must have the power to directly depose those management staff who perform badly in administration, or incur substantial loss because of a neglect of duty or misconduct. Second, there is the board of management. It is the decision-making body of daily business operation, which must be responsible to the general assembly. The board of directors must follow the principle of modern enterprise system in separating the ownership and the power of administration. The board comprises a chairperson and directors. Each of them has well-defined duties. They should prosecute their duties with the power entrusted to them according to regulations. There must be sound mechanisms of checks and balances. Overconcentration of power in one person or a few hands should be prevented. Third, there is the board of supervisors, which is the internal supervisory body of the enterprise and responsible to the general assembly, supervising the execution of duties in the board of management and the general staff. It should be a supervisory body in name and in fact, comprising departments for inspection and auditing. An internal supervisory system is thereby constructed. Currently, all rural credit unions have built a governance structure of legal personhood, i.e. a system of general assembly, board of directors, board of supervisors and managerial staff. It is fair to say that this cooperative institution is appropriate in regards to the real conditions of rural finance in China at present. It should have functioned effectively in financial resource allocation. If we 192

strictly follow the requirements of cooperative institution to build well-regulated cooperative financial organizations, an incentive compatible mechanism for rural finance is viable. Nevertheless, in reality, are those institutions and mechanisms under this governance structure successful in realizing the goals of cooperative finance? Is an incentive compatible mechanism taking shape to achieve an optimal allocation of financial resources in the cooperative institutional arrangements? If the answer is no, what is the reason? It is the problem we are going to analyze. B. Incentive Incompatible Mechanism of Rural Formal Cooperative Financial Institution At present, the formal rural financial institution in China is represented by rural credit unions. These organizations evolved from previous financial cooperatives. They were founded by the peasants but now become official bodies under the government’s regulation. Their cooperative nature is lost. It can be seen in three regards. ① The general assembly becomes a formality. The general assembly is supposed to be the highest power in the democratic management of rural credit unions. However, in most of the cases, the general assembly seldom convenes regularly according to the regulations. It becomes a formality and is replaced by the staff convention. Most of the important items like the whereabouts of loans, revenues and expenditures, etc, are not published regularly. Supervision becomes out of the question. The members become the underprivileged groups of credit unions. The democratic management is seriously undermined. In many cases the general assembly is convened by the board of directors. Under this procedure, they are self-elected, appoint the supervisory body and approve their own work reports. The general assembly becomes wanting in fulfilling its function. ② The duties of board of supervisors are not well-defined. The board of supervisors of the association of credit unions at the county level does not have a standing body. Usually there is a post of chair supervisor. A common practice is the officer who is in charge of auditing department will take the post. In so doing, the board of supervisors is turned into an internal section of the auditing. The board of supervisors becomes wanting in its obligation. ③ Checks and balances mechanism failure in management. A common practice is the board chairperson works as the managing director. All the power is concentrated in one person. There are no checks and balances in management. 193

Rural credit unions become the institutional arrangements of formal cooperative financial institution. For a long time, their operation has seriously deviated from the “cooperative system”. They emulate the model of commercial banks in terms of their business operation. Fund-raising depends on the state’s credit. The utilization of funds adheres to the state’s unified credit policy. The three basic natures (belonging to the people, democracy and flexibility) of rural credit unions are attenuated. Under this alienated institution, the governance structure has crippled its cooperative nature. Accordingly, rural credit unions do not have any institutional advantage. The incentive mechanism depending on cooperative institution has failed. In a word, rural credit unions are incentive-incompatible with cooperative financial institutions. That is the reason why in the latest round of reform, the authorities have to “spend money to purchase a proper mechanism” for rural credit unions. 6.6  Brief Summary In the modern commercial financial system, all financial organizations are pursuing maximal profits. As villages are scattered in a vast expanse of rural areas, they become marginalized in commercial financial organizations. In order to meet their financial demands for production and consumption, rural households spontaneously form financial organizational arrangements according to particular conditions. In this chapter, we first analyze in theory the arrangements and principles of rural financial institution, investigating the reasons and advantages of these arrangements. Then taking into consideration the real conditions of rural China, we propose two basic models: peasant household cooperative financial institutional arrangement model and the conjoined institution model. Their structures, contents, mechanism principles and the theoretical and practical significance are explored. Finally, comparisons with formal commercial financial institution are made. We show the necessity of rural cooperative financial institutions and suggest a solution to the sustainable development of rural finance: conjoined institutional arrangement of exogenous and endogenous finances.


Chapter 7  Analysis of the Efficacy of the Institutional Arrangement of Peasant Household Cooperative Finance 7.1  Analysis of Peasant Household’s Bounded Rationality and the Efficacy of Rural Cultural Credit 7.1.1  Hypothesis of Peasant Household’s Bounded Rationality The concept of complete rationality in modern economics can be summarized into four basic characteristics. First, instrumental rationality: an economic subject considers how to apply appropriate means to achieve a goal. Second, wish target: the target of an individual economic subject is his or her wish, which is termed as preference. Third, inherent consistency: the preference of an economic agent has good traits: transitivity, completeness, and reflectivity. Fourth, optimality: an economic agent chooses the most appropriate means to achieve its goal under constraints. Nevertheless, Amartya Sen (1995) points out the logical inconsistency of the complete rationality hypothesis and proposes the theory of bounded rationality. In my opinion, the rationality hypothesis of modern mainstream economists—be it complete or bounded rationality--is not a matter of right or wrong. The scope and level of the problem under scrutiny decides which hypothesis should be taken. As we study economic behavior in China, two particularities should be taken into consideration. First, the knowledge stock of the peasants themselves. Admittedly the quality and length of education in rural areas, especially in the Midwest region of China, cannot be compared with that in urban areas. For most peasant children, a junior school level education is adequate for them to start employment. The peasants’ investment in education is limited by the rural household income, which is just enough to provide adequate food and clothing. They are unable to take care of the issue of further development. Second, the measurement of the costs and benefits of behavior. The limitation of knowledge stock hinders to a certain extent the peasants’ acceptance of new information. There is a time-lag in their acceptance of new information. This can be attributed to three reasons. First, the target of action is unclear. Economists favoring the hypothesis of complete rationality will apply a utility function to express an economic agent’s target. However, in reality the target of an economic agent may be unclear. And even with a clear target, he or she may at the same time have one or several more incompatible targets. These targets together cannot add up to an intact preference 195

order. Hence they cannot be represented by an objective function. Second, the means of action is unclear. Empirical evidence abounds for this hypothesis. In his study of Chinese government’s decision-making, James Thompson indicates that Chinese elites take an empirical standpoint in decision-making. In the process of China’s transition, many important reforms were first tested by pilot experiments before their implementation. This reflects the uncertainty of the means taken by the agents of reform. It requires exploration to discover. Third, the correlation between means and result is uncertain. Under the hypothesis of bounded rationality, the cognition of the correlation between means and target may be uncertain. During the process of transition, many obtained results are out of the expectation of the policymakers. This reflects the characteristic of bounded rationality. We must take the family as the premise of constraint in analyzing peasant household behavior. On the one hand, the household contract system is the basic institution of the rural economy. The family is the basic unit of peasant households. Its nature and functions become the norms guiding peasant household behavior. It is very different from the family farms in advanced societies, like the USA and Europe. First, family in rural China takes up the function of social security. Since a sound social security system is yet to be established in rural China, essential matters in the life cycle of peasants, such as birth, sickness, old age and funerals, have to depend on the family. This essential function of family has limited rural households from investing in ventures. They do not accept the value of seeking maximal returns in venture investment as assumed by the hypothesis of complete rationality. Second, the family has the inherent requirement of satisfying family members’ survival and development. This objective function requires family to perform an economic function. And this economic function dictates the family to be involved in low risk and stable economic activities. That implies simple reproduction, including non-agricultural employment, etc. Third, the family has to fulfill a variety of targets for its members. It therefore establishes multiple relationships with other external economic organizations, in order to facilitate family members’ activities. Accordingly, it can be said that the economic activities of peasant households are founded on the basic functions of serving the family and meeting its needs. The peasant household’s economic behavior in China at present is characterized by bounded rationality.


7.1.2  Hypothesis of Rural Cultural Credit Efficacy In earlier analysis, we show the existence of “social circles” and “acquaintance society” in villages. If an agent breaks a contract in transaction, he or she will be collectively punished by the others in the circle. That may incur great loss. We therefore hypothesize that in these rural regions, credit is reliable and effective. 7.2  Strategic Game Analysis of Peasant Household and Endogenous and Exogenous Financial Institutional Arrangements Incentive compatibility theory is an important contribution of new institutional economics. It shows us that if an institutional design can facilitate the target congruency of the participants and the organization, it is incentive compatible. If the participants cheat or hide the information in order to maximize his or her selfinterest, that institution is not incentive compatible. Accordingly, we investigate whether the rural financial institutions in China contain an incentive compatible mechanism in meeting the demands for credit by peasant households. 7.2.1  Incentive Compatibility Analysis of Peasant Household Credit and Exogenous Financial Institution Whether a peasant household is willing to reveal its credit motivation is the key to determining if an exogenous financial institution contains incentive compatible mechanism in its implementation. Moreover, the question is whether the participants and the financial organizations generated in this financial institution can respectively fulfill their expected gains. We apply the tools of game theory to analyze the situation. Suppose the game participants are the peasant household and the bank. Their payoff function can be represented by table 7-2-1.             Household Repayment


Financial establishment Loan Offer No Loan Offer

I, K 0,0

- C, K* 0,0

Table 7-2-1 Peasant Household and Bank Credit Game

Where -I,C>0,K*>K>0 The Nash equilibrium of this strategic game (No Loan, non-payment) 197

corresponds to a gain (0,0) less than (I, K). If the government mandates that the bank offers loan, it must subsidize the loss –C in case of (loan, non-payment). The above analysis shows that in its one-time game with peasant households, formal financial establishment faces a persistent high ratio of bad loans and gets in difficulties in operation. 7.2.2  Incentive Compatibility Analysis of Rural Household Credit and Endogenous Financial Institution Unlike the above situation of the formal, exogenous financial institution, the endogenous financial institution and the rural households take part in a repeated game. In a repeated game, if the discount rate is d, to guarantee the equilibrium of (loan, repayment), the condition is

That is to say, for a repeated game, as long as N is larger than             , the rural household will select repayment. 7.3  Incentive Compatibility Analysis of Endogenous and Exogenous Rural Financial Institutions For a long time, the rural financial institutional arrangement in China focused merely on the institutional design of formal finance, but regarded informal finance as interference with and detrimental to the rural financial order. As a result, the financial institutional arrangement became a one-dimensional supply by exogenous institution. Formal financial establishments continue to be generated and adjusted, and informal (or folk) finance continues to be restricted and suppressed. A consequence of this arrangement is that formal finance on the one hand cannot supply the needs of rural financial demand and on the other hand becomes a monopoly without market competition. Under monopoly, financial establishments do not have incentive to explore the market. They merely transfer the huge operational cost to the institution designer [i.e. the government]. Obviously, in the mindset of the rural financial institutional design, there is a prejudice, asserting that the exogenous institution of formal finance and the endogenous institution of 198

informal folk finance are incompatible. According to the theory of incentive compatibility and in view of the reality of rural finance in China, we may analyze the compatibility of the exogenous and endogenous institutions of rural finance as follows. (1)  Analysis on the objective function of compatibility Regardless of whether it is exogenous or endogenous, the goal (utility function) of the financial system/institution is to meet the demand of rural finance. For the peasant households, the exogenous institution is represented by the formal financial establishments (mainly credit unions) whereas the endogenous institution is the informal loans among villagers, such as private lending, rotating savings and credit associations, fund unions and different kinds of mutual aid fund unions. In other words, these two kinds of institutions are congruent in their objective function for providing services to clients and acquiring their own interests. The difference lies in the fact that the exogenous institutional supply is dominated by the government whereas the endogenous, by civil society. Yet in terms of the goal of design, they are both serving the rural communities, the peasant households and the agriculture. That makes these two categories of institutions compatible rather than antagonistic. The institutional vehicles or the financial organizations formed under these institutions are homogenous in terms of the client base. The homogeneity may put them into a competitive relation. However they share the common goal of providing credit to peasant households and acquiring credit interests. (2)  Analysis of the information signaling mechanism of compatibility Whether the exogenous and endogenous institutions are compatible depends on the inherent information signaling mechanism between them. As to the exogenous financial institution, on the one hand, theories and long-term practices have proven that its transaction costs have delineated its institutional boundary, which is the bottom zone of the financial establishment setting. Accordingly the institutional costs have determined that formal finance would not go down to the village level. The greatest problem this institution faces is how to collect and process the client information. In fact, formal finance fails because of the problem of information asymmetry. Before offering a loan, it is unable to overcome the problem of information asymmetry in assessing the loan application. Afterwards, it also cannot solve the same problem again in payment. Such is the fatal weakness of the exogenous financial institution. On the other hand, as the endogenous financial institution is intrinsic to the rural economy, it is naturally compatible with the rural 199

families. It contains the information symmetry mechanism regarding the peasant households’ credit demand, and also the repayment. That is to say, the endogenous institution has the least information cost, which is its greatest advantage. Nevertheless, this institution also has its fatal weakness. In terms of scale, it fails to meet the needs of thousands of peasant households. Only point-to-point or household-to-household simple transactions can be conducted. Both the transaction size and frequency are limited by its poor capacity in fund-raising and management. Furthermore, these two institutions can complement each other. If the two cooperate or link up, they may overcome each other’s institutional disadvantages. Let’s say these two institutions can link up. Two categories of financial organizations under the two institutions can cooperate in the following manner: Formal financial organizations (wholesale)      informal organizations (retail)      peasant households By informal financial organizations, we specifically refer to cooperative financial organizations of peasant households, instead of all other informal organizations. It considers the fact that financial institution for household consumption is not included in the present rural finance. Or to put it another way: the state has yet to solve the problem of the typical rural family’s social security. Accordingly, the two institutions above can be expressed as:

In this cooperative model, as the formal finance and the peasant household cooperatives both face the demand of rural credit, the two sides can fulfill the goal of maximizing the common gains in cooperation. It can be expressed by a game of strategy matrix (table 7-3-1). Table 7-3-1 Game Matrix of Formal Finance and Peasant Household Finance      Peasant Household Finance



I, K 0,0

-1,2 0,0

Formal Finance Loan Offer No Loan Offer


C is the gains generated in the cooperation between the two institutions. It is not difficult to see that when C is relatively small, let’s say 1, the game of strategy is a typical prisoner’s dilemma. The relation is competition whereas informal finance is suppressed by the government. When C is relatively large, let’ say 3, the cooperation is balanced. The situation becomes that the government supports and guides the development of folk finance. Accordingly, if the government makes use of this condition and lowers the cooperation cost between formal finance and peasant cooperative finance, these two institutions can be complementary with their respective advantages, existing and flourishing together. (3)  Analysis of the transaction cost competiveness of compatibility This analysis is based on coupling the exogenous and endogenous institutions, i.e. the cooperation between formal financial establishments and informal financial organizations. Suppose the formal and informal finances cooperate and informal finance refers to the peasant household cooperative financial organizations. Let us investigate the new mechanism formed in cooperation and the change in transaction cost. Change in transaction scale. The transaction targets of formal finance will change from ten thousands of peasant households to the rural cooperative financial organizations. This change in transaction form rapidly enlarges the transaction scale. The cooperative organizations collect the peasant credit into an aggregate credit demand and form a consortium, which then deals with formal financial organizations. The transaction becomes inter-organizational and achieves an economy of scale. The sector of formal finance enjoys the benefits of scale while the cooperative organizations enjoy the benefits of comprehensible credit scale brought about by the formal sector. The coupling of two institutions facilitates the cooperation of the financial organizations under two institutions and alters the traditional transaction mode of the peasant households directly dealing with formal and informal finance. Now the households deal with cooperative finance, which then transacts with formal financial organizations. Compared with previous ways of transacting, the amount of transactions for both of the institutions will notably decrease. As a result, the transaction cost will also decrease. The efficacy and efficiency of operation will therefore improve. Change in moral hazard cost. Exogenous financial establishment has always been plagued by the problem of moral hazard due to the lack of collaterals by 201

the peasants. However, for an endogenous institution, the collaterals become unnecessary as the debtors and creditors are naturally interdependent and bound by geographical proximity, kinship or even blood-ties. When the two institutions are jointed together, the natural advantage of creditability in the endogenous institution can supplement the defectiveness of the exogenous one in this respect. In other words, when the formal financial establishments under the exogenous institution cooperate with the rural cooperative finance (the endogenous institution), the previous credit relationship between formal financial establishments and the peasant household is transformed into an inter-organizational relationship. Rural organizations based on joint households can avert the problem of moral hazard. This creditability advantage can be included in the coupling of two institutions. The cost of moral hazard can thereby be effectively controlled. 7.4  Analysis of the Transaction Costs of the Endogenous and Exogenous Financial Institutional Arrangements In analyzing the transaction cost of rural finance, we mainly depend on the demand and supply of the peasant families. We analyze two categories of cost when assessing how different financial institutions and organizations meet the peasant household’s financial needs. The first is the cost paid by the households. The second is the cost generated by different forms of financial institutional supply. Based on the theory of transaction cost, we can rank the sizes of costs by different kinds of expenditure the peasant households have to pay in order to meet their financial needs. Accordingly, the costs of different financial institutional supplies can be ranked. 7.4.1  Comparative Analysis of the Cost of Financial Demand by Peasant Households (1) Financing Priority and Financial Preference Structure Although the financial needs of the peasant households vary, the consistency in the priority of financing has been confirmed by many researchers. Here we analyze the data collected in the Ten Thousand Peasant Households Survey conducted in Fengyang County in Anhui Province.


Table 7-4-1 Financing Structure of Peasant Households Relatives, Neighbors

Credit Unions, Banks

High-interest loan






Table 7-4-1 shows the order of financing priority by peasant households. They first seek help from the relatives, friends and neighbors. If it is still inadequate or hopeless, they turn to formal finance. When supply by formal financial establishments is not enough or fails, they take the last resort of obtaining unregulated high-interest loans offered by loan-sharks. This order of priority reflects the cost selection of the peasant households in meeting their financial needs, but also their financial preference. In terms of cost, the first choice, lowestcost option of financial supply is naturally obtained from relatives and friends instead of financial organizations. This choice is in line with the rural culture and the Chinese traditional virtues of mutual aid. This kind of interest-free credit is the financial product that entails the least cost, the greatest creditability and minimal moral hazard. In terms of space, this credit contract among rural households is basically formed within a village. Even though in terms of contract the cost of this kind of credit is zero, the base of this zero-cost is the debt of gratitude. When the beneficiary household repays this kind of interest-free loan, they have to do something to show their gratitude. Usually, they may help the benefactor in laboring, or give them some products of labor as gifts. Furthermore, it implies that they have to do the same thing in the future to reciprocate in case of the benefactor’s needs. If this recourse is not enough, the peasant household may turn to formal finance, such as credit unions or the Agricultural Bank. This kind of loan bears interest and the rate is fixed. The cost is definitely higher than the previous category. Now here is the problem: apart from the formal finance option, why do peasant households have to resort to usury? We can take a look on the questionnaire survey on Credit Union Application in Fengyang County in 2008. Table 7-4-2 Questionnaire Survey on Credit Union Loan Application in Fengyang County (2008) Total Application



Turndown rate

Ineligible cases






Table 7-4-2 shows the credit satisfaction rate of the peasants from the credit unions is only 72.1%. This relatively low rate explains why the peasant households tend to give up on formal finance. The turndown rate has reinforced the impression 203

of the difficulty getting loans. Many peasant households therefore give up formal finance in terms of credit selection. Apart from the formal financial sector’s failure to meet the peasant’s credit needs, which forces them to turn to loan sharks, we discover an additional cost associated with the former. When a peasant household applies for a loan from the formal financial sector, it is not unusual for them to provide a sort of a “bribe” to the customer officer in charge of the application, which represents an additional interest cost. It is a typical rent-seeking cost. Those peasant households who cannot afford this rent-seeking cost or lack the opportunity will choose to give up using formal finance. Usury is the last option for getting a loan. The interest cost of usury is apparently higher than the institutional cost of the previous two categories. Its cost depends on the creditor’s will. The peasants seek this kind of loan usually for the purpose of survival or development consumption. They are not capable of making current repayments. The purpose is usually for meeting an urgent need. This inelastic demand puts the lender in an unfavorable position. The creditor will usually make decisions according to the debtor’s local creditworthiness. The concern of risk of default in this category of loans is different from that of formal finance. As long as the usury practitioner regards the debtor as a creditworthy person in the village, it is good enough. The repayment arrangement is not the main concern. We can come to a brief conclusion. The financing preference of peasant households is highly related with the cost of financing. The order of priority is: firstly the costless loan from relatives, friends and neighbors, then from the interestbearing formal financial sector, and finally from usurious lenders. This conclusion has confirmed our earlier analysis: under the peasant economic system in China, the institutional arrangement of commercial finance is inappropriate for rural finance. We should provide room for informal (or folk) finance to develop to an effective scale, replace formal finance so as to suppress the room for usury. In reality, the amount of friendly loans most of the well-funded rural households are willing to offer to the needy is limited. Appropriate financial organization can function as a medium between the well-funded households and the cash-strapped households in arranging credit for production. This sort of establishments has for a long time been regarded as illegal and been repressed. Accordingly, under such conditions, peasant households’ credit demand (especially the loan for production) has not been met effectively. Additionally, large amounts of rural savings have been absorbed by the formal financial establishments and transferred to non-agrarian sectors, contributing 204

to financial excesses and the support of state-owned sectors. (Zhang Jie 1998b) (2) Analysis of the costs of credit supply to peasant households in different institutional arrangements We can classify interest-free private lending, usury and official finance respectively into informal and formal finances; they can alternatively be classified as unregulated or regulated finance. (In China they are also dubbed as “folk” and “official” finances.) According to the paradigm of transaction cost in new institutional economics, the cost of supply of rural credit by different institutions can be viewed as the cost of market transaction. As Coase puts it, “[i]n order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.”(Coase 1960:15) The cost includes: 1. the cost of searching and information; 2. the cost of negotiation and decision-making; 3. the cost of supervision and enforcement. We are going to investigate the market transaction costs of different financial institutions. The cost of informal finance in providing credit to the peasant households usually does not entail the cost of searching and information gathering, because of the existence of information symmetry, where the players come from villages sharing traits such as geographical proximity, kinship and blood-ties. The cost is only related with the opportunity cost. As the fund comes mainly from relatives, friends and neighbors, and does not bear interest, the balance of loss and gain can be assessed by the interest rate of deposits offered by the formal financial establishments. The cost of funds from usurious sources also includes, apart from deposits interest rate, the potential cost of legal risk. Although the creditor holds the power over the debtor’s credibility among acquaintances, usury is illegal and suppressed by the state. It may be liquidated by the government. The unregulated operation of usury is therefore always underground. Here we suppose the interest rate of formal finance is I and the repayment rate of usury is I '. Then the cost of friendly loans is I whereas the cost of usury is I + (1- I ')Q where Q represents the total value of the loan. The cost of formal finance, besides interests, mainly includes management cost and loan risk cost. Let’s suppose the management cost is C, and the solvency rate is I ''. The cost of formal finance is I + C + (1- I '') Q' where Q' represents total loan amount. 205

7.4.2  Comparative Analysis of the Operation Costs of Different Institutions of Financial Supply (1)  Analysis of the operation cost of formal financial institution According to the analytical paradigm of transaction costs in new institutional economics, the cost of using the formal financial institution includes the politicsrelated transaction cost, the transaction cost of management, and the market transaction cost. We can break it into two parts: the external institutional cost which facilitates its operation, and the internal management cost which are those costs expensed in the running of business. The external facilitating cost can be investigated in the institutional arrangement of rural formal finance. ① Commercial financial institution is represented by the Agricultural Bank of China. According to its functions directed by the state, the development of the Agricultural Bank can be divided into two stages. First, the period of comprehensive functions from 1979 to 1993 when it performed both policyoriented and commercial functions. During this period, the subsidy by the state’s revenues and the policy-supported preferential credit institution can be viewed as the facilitating cost of the Bank. Second, from 1994 onward, we have the period of commercial functioning. The state canceled the policy of preferential policysupported credit provided by the Bank. In 1999 the state peeled off the nonperforming assets from the Bank by transferring the 345.8 billion RMB of nonperforming loans into the new China Great Wall Asset Management Corporation established for this purpose. In 2008, the Central Huijin Investment Company invested 130 billion of capital into the Bank in order to qualify its asset structure for the requirements of getting listed in the stock market. The total cost of these two occasions of improving the Bank’s solvency for its commercialization represents the institutional cost of rural commercial finance. Evidently the external cost of institutional operation of the rural commercial finance is remarkable. ② Policy-oriented financial institution is represented by policy-oriented banks. As the particular institutional arrangement has determined the low profitability of the policy-supported services, they were peeled off from the Agricultural Bank. Policy-based bank was then set up to provide credit for supporting rural public goods or quasi-public goods. In recent years, its credit business has focused on the purchasing of staple foods, edible oil and cottons from the peasants. It has become the specialized reserve bank of staple foods, edible and cottons. In order to establish 206

the national strategic reserve, the state annually invests low-interest or interestfree funds into the bank. If the policy-based bank had to obtain these funds from the capital market, the difference in the cost of funds would become remarkable. Hence, the external cost of institutional operation is equally enormous, which is taken up by the state. ③ Cooperative financial institution is represented by rural credit unions. The rural credit union, as a cooperative financial institution, should be a local nongovernmental financial organization set up by its members as stock holders. However, after numerous institutional adjustments, the rural credit unions in China have in fact become local government-run financial establishments. They are managed by the corporations at the county level under the Credit Unions Association of the provincial government. The external institutional cost mainly includes the bills discounting of debts by the Central Government in the new round of credit unions transformation, and the preferential policies by the local governments, such as tax exemption and debt-issues during reform. These costs are equally enormous. Compared with the above two categories, the institutional cost of this system is also immense. The Internal cost of operation includes market transaction cost and management transaction cost. It comprises the investment of setting up establishments and offices as well as the management costs. This cost is homogenous in different organizations of formal finance. Hence, we analyze the content structure of these two aspects so as to allow a comparison with informal finance. ① The cost of facilities, including offices and equipments. The Agricultural Bank, the policy-supported banks and credit unions all invest a lot of money to build new office buildings. The enterprises strive to promote their images and there is emulation among them in this regard. Even at county level, any organization will spend millions of dollars. And the offices are equipped with modern facilities with a team of vehicles. ② Management cost includes salary, benefits, and cost of public relation activities and conferences, etc. (2) Analysis of the operation cost of informal financial institutions. Compared with formal finance, the most remarkable characteristics of informal finance is the absence of political transaction costs. The state does not have to support the external cost of facilitating its operation. The governments at all levels, be it the central or the local, are very cautious about unregulated finance. Discouraged by the lesson of the rural fund unions in the 1990s, the governments have not supported 207

folk finance, regarding it as illegal and disturbing the financial order. The reaction is repression. In terms of institutional arrangements, the external cost of facilitating its operation is zero. In terms of internal operation cost, the market transaction cost and management transaction cost of informal finance is very different from its formal counterpart. ① In terms of market transaction cost, the interest-free loan from relatives, friends and neighbors embodies morals and rural culture. As a form of mutual aid among peasant households, it represents Chinese traditional virtue. As it involves personal interactions, both sides are the transacting agents of financial supply and demand. There is information symmetry between them. The cost in this case is zero. As for interest-bearing usury, even though both sides are symmetric in terms of the distribution of information, two kinds of transaction costs are involved as it is an illegal financial institution: the cost of negotiation and decision-making, as well as the cost of supervision and enforcement. As usury is illegal, the debtor and creditor are in unequal positions. The risk of default is then incurred. This risk is less the risk of usury as a financial product than that incurred by unfair treatment under the state’s supervision. ② In terms of the transaction cost of management, the fixed transaction cost is zero for whichever kind of informal finance. They do not maintain offices or other facilities. The deal is directly between the creditor and the debtor. The main form is contract-less credit. In terms of variable transaction cost, the interest-free loan in informal finance also carries no operational cost of organization. Its transaction cost is zero. As for usury, there may be two kinds of costs. The first is the cost of commissions for the “broker”, or the credibility guarantor. The second is the cost of agency. Sometimes the usurers have to collect funds from others in order to run the business. They have to pay certain amounts of “profits” for those who provide the fund. (3) Comparison of institutional operation costs of the formal and informal finances. We can summarize the above discussion in table 7-4-3. For the convenience of comparison, we suppose each item of transaction cost equals to one unit of measurement. The result is as follows: Table 7-4-3 Institutional Operation Costs of Formal and Informal Finances Category





Formal Finance





Informal Finance











7.5  Analysis of the Competitiveness of Coupling Endogenous and Exogenous Financial Institutions According to the theory of new institutional economics, there are two categories of supply in rural financial institution, namely the induced institutional change and the imposed institutional change. These two supply-side institutional changes are both meeting the demand for the financial institution. However, the performances they represent are different. Here we compare their competitiveness through looking into these two different forms of institutional change. In terms of the rural financial institutional supply in China, formal finance’s institutional change is mainly imposed whereas informal finance’s institutional change is mainly induced. We are going to look into three aspects. 7.5.1  The Comparative Advantage of Asymmetric Information Asymmetric information refers to the condition when one economic player knows something another economic player does not know. It cannot be verified by the third party. Even if it can, that will incur some costs. There are two categories of rural finance’s institutional supply: formal finance and informal finance. In terms of information acquisition, the difference between the organizations under two categories is quite large. The difference directly expresses itself in the competitiveness of institutional arrangement. (1)  Information Asymmetry in Time First, it concerns the information asymmetry before the lending. In terms of temporality, information asymmetry can happen before or after the lending. We would at first look into the pre-lending information asymmetry of formal and informal finances. In formal finance, the institution is supplied by the state or local governments. It is an institution generated outside, faraway from the lives and production of the peasant households. In terms of establishments, the offices of this institution are located in the county or townships. In reality, the credit unions are the only organizations of formal finance now dealing with the peasants. Here we look into the credit union as a formal financial institution. In terms of the timeline of rural credit information acquisition, the normal procedure of formal financial supply is usually as follows. A peasant household applies for credit. Then the credit union will assess the application by sending a local customer officer to inquire into the applicant household. However, as the applications are numerous, the officers are incapable of covering all clients immediately. A time-lag in meeting the household’s 209

needs is inevitable. This time-lag not only affects the efficiency of formal finance, but also the regular operation of the households applying for the credit. Most of the demands for formal finance by the peasants are related with agricultural production and reproduction. The natural cycle of agricultural production makes it imperative for the household to obtain credit in time. When this urgent need cannot be met in time by formal finance, the peasant household has to seek recourse to informal finance. As informal finance is endogenous in the villages and geographically bounded by the proximity of neighborhoods, there is no specialized organization or establishment. A duality of supply and demand is formed among the peasant households. Whenever there is demand for credit, there is information symmetry among the peasant households. The information shared by the credit supplier and the demander concerning the veracity of the credit demand and the reliability of the demander’s solvency is highly symmetric. In terms of pre-lending information, informal finance has obvious advantages over their formal counterpart. Second, it concerns the information asymmetry after the loan. After the peasant household’s need for credit is satisfied by formal finance, the information becomes asymmetric between the two sides: it would be hard for formal finance to find out whether the loan is really used for the purpose the credit has been applied for, or whether the debt can be paid off on time. The reasons of demanding credit by peasant households vary considerably. The credit fund by formal finance is far from enough for the peasant household’s gross demand. The demand for household consumption is especially larger than production. Very often, the loan fund applied for production will be used to meet the family’s urgent needs. If the formal financial organization wants to get information about the use of the loan, it has to pay a certain amount of information cost. However it is impossible for a formal financial establishment to get hold of and manage the complete information of all families-borrowers. Furthermore, this information is dynamic. Important events may happen to a household any day. Only those neighboring peasant households (usually within the same village) can get the news. The situation of informal finance is different from formal finance. First, the credit providers, whether they are informal financial organizations or persons, usually meet the household-borrowers on a daily basis. Not only do they know the use to which the funds have been put, but also the information about the borrower’s solvency. Second, the point of view of the informal financial organization or person providing credit is different from the formal sector after the loan. For formal finance, the debtor is expected to 210

fulfill the obligation when the loan is due. When the payments are in arrears, the loan may become bad debt. For informal finance, the concern is more about the debtor’s solvency on the due date. If the debtor becomes insolvent, a rollover has to be arranged or the debtor has to seek new solvency from new sources in order to sustain the household’s creditworthiness. In terms of post-lending information, informal finance also has advantage over the formal finance. (2)  Information Asymmetry in Contents Information economics classifies information content-asymmetry into hidden information and hidden action. In both situations, one side of the player prevents its counterpart as stakeholder from getting correct information in terms of the contents. Formal finance is an exogenous institution and an imposed supply for the rural economy. It lacks inherent interactive information about the borrower’s (demander’s) individual information. In terms of the hidden information, the credit supplier cannot fully grasp the matters such as the veracity of the demand, for which purpose is the fund specifically used, the operability of the project, etc. As for the hidden action, the same problems emerge. For example, how is the fund going to be used? Or what is the difference between the actual outcome and the expectation of the project? The hiding can be due to subjective or objective reasons. For example, in order to get the loan, the borrower may have the motive to hide some information about the content and the scale of the project in order to satisfy the loan requirements and conditions. When the creditor is not capable of verifying this information, the goal of hiding information is achieved. Or after a loan is gotten, the particular risk of agriculture may impede the borrower from repaying the debt that is due. Then the debtor may hide his or her action in order to get a rollover. Formal financial establishments must spend a preliminary amount in getting the primary information of the borrower. To overcome the asymmetry in terms of hidden information, a secondary cost is incurred. To get further information about the hidden action, there shall be follow-ups, and the cost thus incurred is a dynamic unknown. Facing this expensive information cost, formal finance will eventually have to give up trying to make amends for asymmetric information. The situation of informal finance is different. This supplier is endogenous to the rural economy. The credit supplier and demander are highly interactive. The borrower will not deliberately hide the information, for example, his or her real situation, whether the fund is specifically used for the project, or the outcome of 211

the fund application. As the creditor has natural multiple advantages in terms of proximity, kinship or blood-ties, both sides are willing to share maximally the information. On the one hand, the debtor increases his or her creditworthiness by symmetrically sharing information. On the other hand, the debtor is willing to share information symmetrically about the consequence of using the fund. If the loan cannot be paid when it is due, both sides can adjust accordingly to come up with a new arrangement. As there is no information asymmetry between the two sides, no cost of information asymmetry is incurred with informal finance as in the case of formal finance. In sum, when it comes to information asymmetry in terms of information gathering and related costs incurred, whether it is hidden information or hidden action, formal finance does not have the advantage enjoyed by informal finance. 7.5.2  The Comparative Advantage of Adverse Selection Adverse selection is a problem directly related with information asymmetry. In information economics it refers to the ex-ante information asymmetry. Under this condition, the behavior of the ones who have information tends to be opportunistic. Adverse selection is a model of principal-agent question in new institutional economics. It represents the information asymmetry among the stakeholders before a contract is made. The principal does not possess the corresponding information the agent has. Because of information asymmetry, the agent tends to hide his or her private information before making a deal in order to get the most out of a contract. As the principal knows little about the situation, he or she may come up with a situation of adverse selection. The most well-known case of adverse selection is the “market for lemons” described by Akerlof (1970). In a second-hand car market, there are some good-quality cars dubbed as the “peaches” and some bad ones dubbed as the “lemons.” Due to information asymmetry, the car sellers have more information than the buyers. As the buyers cannot tell the differences, the good and bad quality cars will be sold at similar prince level. Akerlof believes that under such a condition, most of the cars available in the market will be the “lemons”. Good quality cars will not take part in the transaction. Good quality cars will tend to be squeezed out of the market. Rasmusen (2006) presents an action order of adverse selection. The nature (N) takes the first action and chooses an agent’s cost function (high or low cost) which is known only by the agent. A principal then takes action and provides a contract for the agent. The agent accepts or declines the contract. 212

(1)  Analysis of the borrower’s adverse selection behavior in the formal financial institutional supply According to principal-agent theory, the principals under the institutional arrangement of formal finance are the financial organizations. In China’s rural formal finance, they are the rural credit unions whereas the agents are the peasant households. The relation between them constitutes the principal-agent relationship. The peasant household has full information about the project applying for credit, while the credit union does not know the private information of the debtor. In order to avoid welfare loss due to information asymmetry, i.e. the dishonesty cost, the principal (credit union) usually requests a guarantor or collateral. However, the help of a guarantor or collateral incurs cost, which is tantamount to information rent. For the principal, it may be considered a benefit. But for the agent, it is a cost. If the agent cannot afford this cost, he or she may choose to give up signing the contract. The more the households give up, the more the principal’s potential benefits shrink giving rise to a “prisoner’s dilemma’. The formal financial institution eventually chooses credit rationing as the Nash equilibrium solution of the strategic game. However, this equilibrium is the second best optimum. Similarly, the peasant household withdraws from making this credit contract and seeks other financial products. This is the problem of adverse selection faced by the agent. The relationship between peasant households and formal finance is not limited to the principal-agent relation. There is also a non-cooperative strategic relationship, which prevents formal finance from achieving Pareto efficiency in terms of resource allocation. The remaining part of the allocation is the welfare-loss of adverse selection in formal finance. (2)  Analysis of the borrower’s adverse selection behavior in the informal financial institutional supply In the institutional arrangement of informal finance, the principal is usually a natural person. Unlike the formal financial establishment as a legal person, a natural person has the natural advantage in cost when getting the information about the agent and the peasant family. For the interest-free financial product from relatives, friends and neighbors, there is information symmetry between the principal and the agent. That avoids the situation of adverse selection. As for the interestbearing usury finance, the principal sometimes requests guarantee from the agent in addition to information symmetry in order to avoid the risk of moral hazard. The guarantor is usually a local reputable acquaintance. It is different from the practice 213

of formal finance, which requires a person with a stable income or a public servant as the guarantor. In informal finance, the guarantor generally requests no or very little fee as insurance out of consideration for reputation and face. It is therefore more acceptable to the agent. In the informal financial institution, there is also a strategic relationship between the principal and the agent. However, as both sides of the strategic game have satisfied their respective utility functions, it becomes a cooperative game. If we neglect the externality, i.e. the problem of legality, the allocation of financial resource may theoretically achieve the goal of Pareto efficiency. 7.5.3  Comparative Advantage in Moral Hazard In principal-agent theory, there exists an ex post information asymmetry between the principal and the agent. The party who has the upper hand tends toward ex post opportunistic behavior, which is the moral hazard. (1)  Moral Hazard in Formal Financial Institution Whether the problem of moral hazard arises in the institutional arrangement of rural formal finance, the key is if the principal and the agent can achieve the goal of a common objective function. Suppose both sides are risk-neutral. If their objective functions are not congruent, there will be moral hazard. The key factor of the agency cost generated under moral hazard is the conflict resulted from which behavior to be taken by the two sides. The unverifiability of the agent’s behavior prevents this conflict of interests from being effectively resolved. The key of the solution lies in an incentive compatible contract design. That means in the contract an incentive mechanism is designed so that the person under information asymmetry will act more efficiently (Furubotn and Richter 1998). Nevertheless, under China’s present formal financial institution, is it possible to find an incentive compatible mechanism to solve the problem of information asymmetry? We investigate the question in two aspects. First, the problem of incentive incompatible mechanism. The institutional arrangement of formal finance in rural China has evolved from an endogenous institution to an exogenous one, from an induced institutional supply to an imposed one. At present, formal finance is mainly composed of three sectors: policy-based, commercial and cooperative financial establishments. However, cooperative finance has in reality, evolved into commercial finance. As the Agricultural Development Bank and the Agricultural Bank generally do not deal with the peasant households, 214

we focus on the credit unions. Is it possible to design an incentive mechanism in the principal-agent relationship in the rural credit unions? The problem is whether this incentive mechanism can satisfy the condition of incentive compatibility in the principalagent relationship. The principal wishes to have the ex post information about the agent. However, getting this information requires a great deal of collecting and processing which incurs considerable cost. And even if the agent provides the ex post information, it can be confirmed only through verification. In terms of objective function, the principal hopes to secure the credit fund and interest, and avert the moral hazard of ex post information. As for the agent, he or she hopes to maximize the utility and returns of the fund, and duly meet his or her engagements of the contract. The objective functions of both sides are the same. There should be no moral hazard. However, we can find the problem of externality in the execution of the contract between the principal and the agent. If there exists moral hazard on the side of the agent, he or she may have gains instead of losses. This is the problem of incentive incompatibility in formal finance. Second, rent-seeking and the bilateral moral hazard problem. In the above problem, we also find a new factor affecting incentive compatibility, which is the crux of moral hazard in formal finance. When an agent gets into a contractual relationship with the principal, he or she may not deal directly with the organization, but through several persons. These persons as the principals may be opportunistic in seeking their own interests. They may engage in rent-seeking by colluding with the agent. This rent increases the credit cost of the agent. In order to maximize his or her gains, the agent may transfer the cost of rent to the principal, resulting in the moral hazard of deliberate non-performing debt. That is the bilateral moral hazard problem in the principal-agent theory. In addition to the previous moral hazard model, one must consider one more important factor, i.e. the moral hazard of the regulator. According to the multi-level agency theory, the regulation activity itself also has to do with information symmetry. The moral hazard in regulation is often related with the problem of collusion (Cooper and Ross 1985). In formal finance, the scope of management of an organization is limited; it is difficult to form a single level principal-agent relation. Usually, there are multi-level principal-agent relations. The more levels there are, the higher is the probability of moral hazard. (2)  Moral Hazard in Informal Financial Institution 215

In the principal-agent relation in rural informal finance, interest-free lending is typically a single-level principal-agent relation. There is information symmetry between the borrower and the lender. No private information is available for opportunism. The problem of moral hazard therefore does not exist. As for interest-bearing lending, especially usury, the principal-agent relation can be single or multiple-level. There may be joint-agency of multiple agents, involving for example, go-betweens and guarantors. These agents share high symmetric information among the principal and multiple agents. The function of these agents is not information replacement but to increase the weighting of creditworthiness. It adds the variable of reputation (brand) to the principal-agent model and thus facilitates the constraint of incentive compatibility in the informal (folk) lending mechanism. That explains why usury financial products do not retreat from financial market despite suppression by the government. 7.5.4  The Advantage of Joint Endogenous and Exogenous Institutions (1) Advantage of Joint-information. The endogenous financial institution has natural information symmetry within the village. This enables the minimization of its transaction cost. On the contrary, the exogenous institution lacks this advantage of information and cost. If these two institutions can be joined together, the integrated institution can fully enjoy this advantage. Is it possible to integrate them properly? How to? These are the questions to be investigated in the core model of this research: the joint-institutions model of the rural household cooperative finance. The feasibility of this model has been analyzed in theory. In the next chapter we are going to provide analysis of empirical case studies. (2) Advantage of Joint-Creditworthiness. Creditworthiness is a major concern for both exogenous and endogenous institutions. In the exogenous institution, it is expressed in the form of standard commercial credit, with rigid constraint in operation. In the endogenous institution, it is expressed as folk credit, without rigid constraint, and embodied in the invisible form of moral convention of a rural community. These are implicit rules everybody abides by. The replacement cost of this credit does not need to be materialized. Joining these two forms of credit can avoid the problem of adverse selection when peasant households apply for credit, and also greatly reduce the cost of collateral. (3) Advantage of Joint-interests. The interests are represented in the objective functions of two institutions. The objective function of exogenous 216

financial institution is the maximization of organizational interests. The goal of the organization is to pursue maximal commercial interest while securing the interests of the share-holders. It aspires to develop and expand. The organization of endogenous finance is the internal cooperative body of members. To maximize the members’ interest, it should minimize its organizational interest. Joining these two institutions together forms a cooperative interest mechanism between the organizations. That is what we have explored earlier in the discussion of exogenous—wholesale—endogenous—retail. This joint-interest model can satisfy the interest of the exogenous institution and at the same time meet the needs of the endogenous institution. 7.6  Brief Summary According to the theory of incentive compatible mechanism, an institutional arrangement can be effective only when it contains an inherent incentive compatible mechanism. Whether the peasant household cooperative financial institution is effective depends on whether it contains an incentive compatible mechanism. This chapter analyzes the economic behaviors of peasant households and investigates their financial behaviors under bounded rationality, as well as the particular cultural creditworthiness. We look into the incentive compatible mechanism in the exogenous and endogenous institutions, analyze the transaction costs of the two financial institutions, and compare their respective advantages as well as the jointadvantages. We finally explore the feasibility of a new model in the framework of cooperative finance by the two institutions.


Chapter 8  Case Studies in the Household Contract System’s Birthplace: Fengyang County Fengyang County of Anhui Province is situated in the central region of China, and it is the place where rural reform started, making it more representative as a place to conduct research for rural financial issues. Another important reason for choosing this county for case study is that I have conducted comprehensive experiments in the county regarding the core concerns of this book, particularly the ideas about the institutional arrangement of the peasant household cooperative finance. The ideas were continuously reviewed and improved during the experiments. The rural cooperative financial institutional arrangement was fully embodied in the experiments, not only the value of the institution, and even what goes beyond the value. During the process, we encountered different thoughts and opinions, reflecting how rural finance is perceived by different sectors of the society. 8.1  Basic Information Fengyang County is located in the Northeast of Anhui Province, along the south bank of the middle reaches of the Huai River. There are 15 townships, one province-level industrial park, 198 administrative villages and 26 rural communities under its jurisdiction. Its land area is 1949.5 km2, with a population of 740 thousand people, of which 580 thousand is agricultural population. 8.1.1  General Descriptions Fengyang was the territory of the tribe Huaiyi in ancient times, and during the Spring and Autumn Period of the Zhou Dynasty (ca. 7th-4th Century B.C.) the feudal lords of the small state Zhongli held the land. In the second year of the Kaihuang era of the Sui Dynasty (582A.D.), it was named Haozhou, and in the seventh year of the Hongwu era of the Ming Dynasty (1374A.D.), Emperor Zhu Yuanzhang gave it the name “Fengyang,” which lasts till this day. Fengyang gains its renown in history for two events: 600 years ago the first peasant emperor Zhu Yuanzhang was born here, and he founded the Ming Dynasty; 30 years ago the very first agricultural “all-round production task responsibility” contract was signed here in Xiaogang Village, inaugurating the rural reform in China. Xiaogang Village 219

thus gains the reputation of “the first village in Chinese rural reform.” Flower drum dance of Fengyang is known as the “Oriental ballet.” It was among the first to be selected as the national intangible cultural heritage. “Phoenix painting” is a unique folk art form of Fengyang; known as one of the “three wonders of Northern Anhui,” it is included in Anhui Province’s list of intangible cultural heritage for conservation. The whole county comprises 1.08 million mu of contracted arable land, 300 thousand mu of mountain field, and 165 thousand mu of cultivable water area. It is among the first county to be assigned as the commodity food production base in China, one of the top 100 staple-food-producing counties, and one of the base counties for commodity-lean-pork production. 37 mineral sources have been detected in the county, and quartz and limestone reserves account for 10 billion tons and up. The quartz mined here in particular is of high quality; the county is a premium quartz sand mining base in China. Tourists are drawn to Fengyang for natural and humanistic resources: it is a top county for tourism in Anhui Province, an important county for cultural tourism in China, and an excellent example for Anhui Province’s work on building civilized counties. It enjoys its reputation as the county of “the emperor, the flower drum, the reform, the quartz, and the art of music.” Fengyang is situated in the watershed zone between the Yangtze River and the Huai River, with higher elevation in the south and lower in the north. Mountainous terrains are in the south, which descend into gentle-sloped mounds and hills in the center, while alluvial plains along the Huai River lie in the north. The average altitude is 15-17 meters above sea level. The largest lake within the terrain is Huayuan Lake, with a surface area of approximately 30 km2 at normal water level. The highest peak is Mount Langwuo, with an elevation of 340.3 meters high. While 52.5 km of the Huai River flows by the northern county, main tributaries like Xiaoxi River, Banqiao River, Hao River, Tian River and Yao River all flow from south to north to join the Huai River, with a drainage density of 0.19 km/km2, and an average annual runoff of 321 million m3. Situated in the northern subtropical zone, the county is affected by sub-humid monsoon climate, typical of regions north of the Yangtze River. The average annual temperature is 14.90C. The annual rainfall is 904.4 mm2 and the annual evapotranspiration is 1609.7 mm2. The frostfree period per year is 212 days, growing period 220-240 days. The annual sunshine duration is 2248.7 hours, and annual solar radiation is 120.0 kcal/cm2. In Fengyang County, Anhui Province, the rural reform triggered rural 220

economic development, and the 30 years that followed have been fruitful. The past 30 years bear witness to numerous changes to Fengyang County’s rural economy. It is a process of continuous exploration confronting economic stagnation to search for new development paths and unleash new energy from various factors for economic development. It is also a process of furthering rural reform, expanding domains of reform, and improving reform mechanism. The accomplishments can be summarized as follows: the augmentation of agricultural production capabilities, appropriate adjustments of agricultural industry structure, prosperous development of agricultural industrialization, the advent of new economic forms, the growth of peasant incomes, the improvement of rural living standards, the mitigation of peasant poverty, the gradual implementation of rural social security system, and the improvement of fiscal and financial policies in supporting agriculture. The fact that peasant incomes have increased and their living standards have improved is especially worthy of attention. At the initial stage of the reform, the “allround production task responsibility” pushed for innovated operation modes in agriculture, and greatly increased peasant incomes. Since 2000, responding to requests from related Anhui Province authorities, measures have been adopted to enact rural tax reform in Fengyang County, i.e., to apply rural tax reduction or exemption for the benefit of peasants. Agricultural tax was annulated. The policies like direct staple food subsidy, grain seed subsidy and agricultural machine subsidy, among others, have been put into practice. As a result, the income growth increases peasants’ consumption power and the variety of consumption contents, provides relief for peasants’ daily life expenditure, and improves their diets and health. Peasants are enjoying more and more exemptions and tax breaks, as well as benefits. In addition, there are other comprehensive measures such as developing township enterprises and county economy, and implementing the sunshine programs for labor training and peasant skill cultivation so as to divert labor force for migrant jobs in non-agrarian areas. The county government has been exploring different ways to contribute to the income growth of peasants, as well as mechanisms to ensure long-term effects of such growth. (See Chart 8-1-1) Currently, the peasant incomes in Fengyang County continue to grow, and peasants’ living conditions continue to improve. Major durable appliances in peasant households such as electronic devices, cars, telephones are increasing in quantity. The housing conditions are constantly improving. The areas of peasant residences are augmenting while the house structure is upgrading. The home 221

sanitary facilities are ameliorating, and tap water system is covering more and more households. The county’s economic base is still rural economy. In 2008, the ratio for the first, secondary, and tertiary industries in Fengyang comes to 30:38:32. And agriculture accounts for one third of the economy. Agricultural population comprises 78% of total population, and the average annual peasant income is 4448 RMB.

Chart 8-1-1 Net Income Per Capita in Fengyang County Since 1975

8.1.2  Trajectory of Economic Development China’s economic reform starts with rural economic reform. As the birthplace of rural economic reform, Fengyang County of Anhui Province can serve as an indicator for studies on rural economic reform and development. In the 1960s, the Great Leap Forward movement and the bureaucratic practice of reporting exaggerated production figures, along with other factors, proved to have destructive influence on agricultural production in Anhui Province, causing bad harvest and food shortage. To solve the problem, several pilot programs were initiated in the province to test out “production contracted to groups,” and further experiments on farmland management responsibility system——“production contracted to teams, scheduled output assigned to fields and responsibility assigned on individual” ——were tried out. In the process “production contracted to households” was practiced in many places. The pilot programs greatly motivated the production zeal of peasants. The food production greatly increased within the same year. Hunger and starvation problems were eliminated as a result. But the central government held negative attitude in regard to such “individual operation 222

practice.” The “contracted farmland” programs were terminated prematurely, though they laid foundation for the future rural reform in Anhui. In 1978, with the “all-round production task responsibility” agreement, the peasants in Xiaogang Village started an era of rural reform. Since the Reform, the economic development in Fengyang has been through four phases. First Phase: breakthrough in reform and rapid development for rural economy (1978-1984). In December 1978, the path for the Reform was ascertained in CPC’s 11th Third Plenary Session, but it was not until October 1984 that the decision to change the economic institution was made during the 12th Third Plenary Session. This period marks the initial stage of reform: the household contract operation was implemented to break through the people’s commune system. A major character of the rural reform is to enable a micro-economic operation system that meets the demands of market economy. The “all-round production task responsibility” system changed the collective land ownership system. The land operation rights, the jus fruendi aut fructus (the rights to earnings) and the concession rights were dissociated from the collective ownership, so as to make it legally possible to contract the land for a long term or permanently to individual peasant household. The household production is thus based on autonomous operation and selfdecision, no longer under the collectivized demands of production teams. It is an agrarian institutional change. The village collective entrusts the land to the peasants to operate on. Such a change has brought out much production fervor and the motivation for self decision. In the year Xiaogang Village production team started to practice the “production task contracted to households,” there was a great harvest for staple food production, with the amount of 66 thousand kg— equaling the sum total of previous 20 years and over 8 times more than the target assigned by the State. Xiaogang Village immediately removed itself from the “beggar team.” The next year, the same positive result was shown in agricultural production of Fengyang County, with a food production totaling over 200 million kg, a 48% growth from the previous year. The wave of “all-round production task responsibility” system soon spread throughout the country. As a result, the repressed production force was released after so many years. Food production in Fengyang County was increasing with the growth of almost 100 million kg a year. In 1984 the over production made peasants find it “hard to sell” their products. Peasants permanently eradicated the problem of hunger. Second Phase: exploration to advance the reform in all aspects (1984223

1992). This marks the time when township enterprises developed rapidly; it is also a period of exploration to advance the reform from a single breakthrough in rural sector towards all-round comprehensive reforms in urban and rural sectors. From the CPC’s 12th Third Plenary Session in October 1984 to the 14th National Representative Assembly in October 1992, the economic institution in China had been going through a process of continuously deepening reform. At this phase Fengyang County has turned from its rural reform of the previous phase to the urban economic institutional reform. Unified purchase and marketing was abolished. Agricultural products circulation and rural production factors were activated. Township enterprises were encouraged to develop. Peasants were diverted to other career possibilities. The market mechanism was developed and diversified market agents were being cultivated. Combining planned economy and market economy, Fengyang applied the experiences obtained from agricultural “all-round production task responsibility” to factories, enterprises and circulation domains. Funding cooperation among the peasants was promoted so that they could organize and establish township enterprises running staple foods transportation and marketing, agricultural product processing, etc., after raising sufficient funds. Township enterprises as such emerged within the county, operating in the domains of agricultural production, on the one hand, and absorbing some parts of labor force for non-agricultural production, on the other hand. Individual industrial and commercial operators in rural commodity circulation and trading began to appear. They were mainly involved in food transportation, marketing and processing. Towards the end of the 1980s, the sale of grains and oils from Liufu area of Feungyang accounted for 100 million catties per year. It became well known throughout China. 28 kilns were built within 45 townships of the county. Small-scale cement plants and quartz sand manufacturing plants were constructed taking advantage of the quartz and limestone resources. Individual or associated operators of the tertiary sector such as professional transportation team trucks and construction engineering teams also emerged. In this county, “each household is a factory, every person a craftsman” was once part of the rural landscape, where furnace fire burned high from village to village, and smoke fumed up from door to door. Third Phase: transformation of rural economy towards marketization (19922003). Between the period of the CPC’s 14th National Representative Assembly in October 1992 and the 16th Third Plenary Session in October 2003, China’s 224

rural economy had advanced with an accelerating pace towards market economy. Deng Xiaoping’s remarks on the trip to the South had inspired Fengyang to push for further reforms in the direction of a socialist market economy. The strategies of “strengthening industry, adjusting agriculture, developing tourism, and promoting the tertiary industry” were formulated, with emphasis on financial and taxation reforms. However the State then adopted the policy of separating the rural economic development from the urban, and insisted on a city-oriented path for development, neglecting economic development for peasants and rural areas. As a result, the township enterprises that arose with the thriving rural economy were restricted from further development once the rural financial supervision and fund control were put into place. Surplus labor force began to move to towns and coastal cities in search of job opportunities while the household registration system severely undermined the mobility of labor force. Peasants could only reply on agricultural production as their main income source, which limited their continuous income growth from non-agricultural production or in-town jobs. In Fengyang, related policies were therefore carried out to confront the problems. First, the reform on rural land use rights was enacted. An appropriate land rights transfer mechanism was established. Land was able to be concentrated into the hands of capable peasants, with easing measures implemented on land systems. A total of 300,000 mu of the “four kinds of desolate resources” (desolate mountain, desolate beach, wild water, desolate slope) in the whole county were contracted and auctioned. Second, the agricultural “all-round production task responsibility” system was turned into formal contract management. An array of management systems was implemented to protect peasants’ rights, including land operation contract, levies and fees (for village and township administrations) contract, and the monitoring of the burdens over peasants. Third, the household registration system in small towns was reformed. This facilitated the appropriate transfer of rural labor force, allowing many peasant workers to find job in towns. At that time, the population of small towns in the county rose to 200 thousand people, more than a double-fold growth compared to the time before the all-round production task responsibility system. Fourth, pilot programs for rural taxation reform were put into practice. Agricultural tax and agricultural and forestry specialty tax were canceled while the township financial system was established. After merging some administrative regions into townships to accomplish the county and township-level organizational and human resource reform, rural economy developed further. 225

Fourth Phase: a new phase of new rural reconstruction and integrated urbanrural socio-economic planning and development (2003-present). The CCP Central Committee has issued consecutively several yearly No. 1 Documents, giving such guidelines as “bring agriculture forward with industry, advance rural development along with the cities,” “the industry pays back to and nourishes the agriculture, the urban areas support the rural areas,” “give more, take less, further activate,” etc. It is clear that the State shows much concern about the san nong issues. Fengyang, as the forerunner of the rural reform, holds a certain advantage in regard to agricultural policies. The policy of new rural reconstruction has to do with the agricultural modernization, and in the process of modernization, the exploration and cultivation of new industrial bases for agriculture becomes a major task in Fengyang County. The guidelines for agricultural production are formulated to reflect realities in different villages: different measures are adopted according to different local conditions, and specific instructions are given to fit different categories. The thoughts are reflected in diverse programs as “one village, one product; one township, one industry,” “every village has a group of college graduates” “bring more PhD graduates to the enterprises,” etc. The concept of industrialization is adopted for agricultural production, so as to cultivate corporate champions out of agricultural enterprises. To solve the problem of fund shortage in the new rural reconstruction, private entrepreneurs are encouraged to return to their hometown and start up business there whereas peasants are engaged to start various production cooperation and mutual financial cooperation. Some out-of county financial institutions are brought into Fengyang for operation. In short, efforts have been made to expand channels for rural financial services. From 2005 to 2008, 22 PhD graduates were employed in Fengyang, and 77 college graduates were recruited to serve as village cadres to lead the peasants upon the road of modern agricultural development. In regard to rural infrastructure construction, farmland irrigation, food safety, county road construction, agricultural network improvement, potable water safety, rural energy and village-wise radio and television broadcast, etc. have been upgraded in Fengyang. At the same time, the county authorities continue to explore new mechanisms for rural administration. An array of comprehensive rural reforms has been advanced, including rural obligatory education, township administration and county fiscal management reform. A preliminary policy system to empower agriculture and support peasants has been set up. A preliminary institutional framework has also been established for the integrated planning of 226

urban-rural development. A sound county-wide social security system has been gradually established, with the implementation of minimum livelihood security for rural residents. Other policies include the “five basic supports” (food, clothing, healthcare, housing, entombment for the deceased/education for orphans) for the disadvantaged, the new rural cooperative medical and healthcare system, the urban and rural sanitation service, the urban and rural obligatory education expense assurance, the assurance for landless peasants, etc. The economic development in Fengyang has greatly accelerated between 2003 and 2006, and the county’s GDP, revenues, and fixed assets investment enjoyed an annual growth rate of 13.5%, 22.8% and 55% respectively. 8.1.3  Rural Financial Development Ever since the Reform, China’s economic institution has changed from planned economy to market economy. The rural economy has become increasingly market-oriented. The rural financial sector has been through several phases of development to adjust itself to the institutional changes. Up to the end of May, 2009, the total deposits in Fengyang County amounted to 5978.13 million RMB, a growth of 5966.08 million since 1978, a 494.91% up, of which rural deposits composed 1958.41 million RMB, a growth of 1957.92 million since 1978, a 4053% up. The total loans amounted to 3168.63 million RMB, a growth of 6116.04 million since 1978, a 116.29% up, of which rural loans composed 875.57 million, a 68.77% up. I. Rural Financial Development: Phases and Characteristics (1) Specialized banking system during the institutional transformation (19791993). During the era of planned economy (1949-1978), there was a singlebank banking system in China, with only two kinds of financial establishments in rural areas, the People’s Bank of China and rural credit unions. After the Reform, due to the household contract responsibility system and the development of rural industrialization, peasant incomes increased significantly, providing the prerequisites for the commoditization and monetization of rural economy, and the development of credit economy in rural areas. As peasant households, township enterprises and various rural economic consortiums made diverse demands for financing, the single-bank system could no longer cope with those demands. A diversified rural financial system became a necessity. The financial institutional reform at this period involved mainly the division of the People’s Bank of China. 227

Its operation function separated from its administration, it became the Central Bank to take charge of the national financial industry. Four major state-owned commercial banks—the Agricultural Bank of China, the Bank of China, the Industrial and Commercial Bank of China (ICBC) and the China Construction Bank—were gradually restored and established. In 1978, the China Construction Bank set up county-level offices, which were upgraded to county branches in 1980. The Agricultural Bank was separated from the People’s Bank in the same year, taking over the management of rural credit unions that used to be under the charge of the People’s Bank. In 1984, the ICBC was established. At that time, there were already 3 specialized banks in the county (the People’s Bank and the ICBC shared the same offices), evolved from the previous single institution of the People’s Bank. In 1983, the State reorganized the rural credit unions and restored its status as a rural cooperative financial institution. (2) Transition from specialized banking system to commercial banking system (1994-1996). The CPC’s 14th National Representative Assembly in 1994 confirmed China’s socialist market economic system. As the development of market economy went further, the State Council made it a clear objective to “establish and improve the rural financial institution based on cooperative finance, with collaboration from commercial finance and policy-supported finance” in the 1996 document Decisions Regarding Rural Financial Institutional Reform, aiming to start constructing an all-round, multi-leveled and wide-ranged rural financial system. In April 1994, the State Council decided upon the founding of the Agricultural Development Bank to undertake the policy-supported financial operations, so as to facilitate the Agricultural Bank’s commercialization. In 1996, in accordance with the State Council’s Decisions Regarding Rural Financial Institutional Reform, the rural credit unions were separated from the administration of the Agricultural Bank. They continued on the path of reform in accordance with the principle of the cooperative system, under the business management and financial supervision of the county-level associations of rural credit unions and the People’s Bank of China. Four major state-owned banks started to transform into state-owned commercial banks. With the operational objective to pursue maximized profits, the Agricultural Bank became inclined to loan to non-agrarian clients and therefore reoriented its organizational network and loan permissions in favor of cities. During that time (continuing with the example of the Agricultural Bank), the Bank’s branches began to decrease: in 1989 it had 29 branches in the county, in 1999 there were 24, 228

and now only 4 remain. At the same time, the funds from less developed regions were transferred to big cities and highly developed regions. Financial institutions in the county aim at absorbing savings. The money deposited in the system is increasingly transferred toward the urban sector. As a result, the credit allocation to rural areas was insufficient. (3) Commercialized banking system in the establishment of market economic system (1996-present): it can be further divided into three periods according to the progression of the rural financial reform. The first period is one of regulation and development. At the end of 1996, the rural credit unions were separated from the Agricultural Bank and submitted under the financial supervision and business management of the People’s Bank (and the China Banking Regulatory Commission from 2003). They proceeded with regulatory reform complying with the principle of the cooperative system, with an emphasis on improving agriculture-supporting services. The second period bears witness to deepening reforms. The State initiated the shareholding system reform of state-owned commercial banks. The ICBC, the Bank of China and the China Construction Bank got listed in the stock market after the reform, while the Agricultural Bank was still in the process. In June 2003, the State Council issued Proposals Regarding Pilot Programs for Deepening Reform of Rural Credit Unions, demanding clear property rights, fortified restraint mechanisms, improved service functions. The State would give appropriate support while the local governments were in charge of the unions. A new cycle of rural credit union reform was launched. Its main objectives were to establish the province-level associations and reform the property rights system of countylevel associations. The government approved effective supporting policies such as subsidies against devaluation, the Central Bank bills, as well as tax deduction, exemption and refund, etc. The third period is marked with the innovation and development of the reform. To effectively expand supplies for rural finance, the State initiated the reform of the Postal Savings Bank, lowered the entrance barrier of rural finance, and encouraged the innovation of rural financial products and services. On April 28, 2008, the Limin Village and Township Bank of Fengyang County was officially registered and started business with the capital fund of 41 million RMB. On May 29, 2008, the Fengyang County branch of the Postal Savings Bank of China was set up. On April 29, 2009, China’s very first countylevel association of peasant credit cooperatives was established. In the first half of the year 2009 Fengyang proceeded with initiatives for innovative rural financial 229

products and services. II. Changes in Deposit and Loan and Credit Input Fields Up to the end of May, 2009, the total deposits in Fengyang County amounted to 5978.13 million RMB, a growth of 5966.08 million since 1978, 494.91% up, of which rural deposits composed 1958.41 million RMB, a growth of 1957.92 million since 1978, 4053% up. The total loans amounted to 3168.63 million RMB, a growth of 6116.04 million since 1978, 116.29% up, of which rural loans composed 875.57 million RMB, 68.77% up since 1978. The main areas for loan fund investments were as follows: the industrial loans were mainly invested in cement, quartz sand, and glass manufacturing, with a current remaining balance of 324 thousand RMB. The agricultural and subsidiary products purchase loans totaled 396.08 million RMB, infrastructure loans 321.8 million RMB, individual housing consumption loans 321.41 million RMB. The agricultural loans totaled 875.57 million RMB. In the first place, the credits were provided to peasants for timely and sufficient fund support when they needed to invest in the means of production. Secondly, services were offered to push for adjustments in rural industrial structure according to local conditions, on the basis of satisfying peasants’ demands for production and living. To extend the support for structural adjustments of agricultural industry, loan priority was given to develop crop farming and breeding industries, as well as high quality and cost-effective agrarian activities. For example, credits were given to aquaculture in places like Daxihe, Zaoxiang, Huangwan, Guantang, along the banks of Huayuan Lake and Gaotang Lake; over 4 million RMB were loaned to support aquaculture in the areas. Thirdly, the agricultural intensive processing industry was supported for better economic benefits. The major target staple foods were wheat and rice. The rural financial organizations in the county have given timely loans to support flour and rice processing enterprises, to help with the purchase of staple food and with agricultural and subsidiary products intensive processing, and have effectively provided for the fund demands. Fourthly, emphasis was given to the funds supporting peasants’ needs for production and daily life. III. National Policy Support and Its Impact on Rural Finance In recent years, the state has expressed its support for rural finance (mainly rural credit unions) chiefly through monetary and fiscal and tax policies. Related policy support for Fengyang County is as follows: the Central Bank’s bill replacement of 15.915 million RMB, subsidies against devaluation and interests for 714 thousand RMB, enterprise income tax exemption of 390.6 thousand RMB, cut 230

in sales tax by 7.38 million RMB, and reduction in miscellaneous expenses by 13.6 thousand RMB. The impact of the state’s support policies on rural credit unions is reflected in the strengthening of their financing capabilities, the improvement of profitability, and better offers for agrarian-related credits. In regard to deposit and loan conditions, up to the end of May 2009, the total deposit balance of all rural credit unions in the county comes to 2043.56 million RMB, a growth of 1552.86 million RMB since the end of 2002 and a growth of 391.34 million RMB since the end of 2008, the growth rate being 281.65% and 14.69% respectively. IV. Major Problems in Financial Administration at Fengyang County Firstly, the financial funds in the county are not sufficiently utilized, while the fund outflow remains a serious problem. At the end of May 2009 (excepting the Agricultural Development Bank), total deposits of all financial institutions in the county added up to 5959.49 million RMB, and total loans 2749.55 million RMB, the loan to deposit ratio being 46%. This implies the available resources were considerable, for there should still be 2.6-2.8 billion funds available apart from the reserve requirement and other factors. In 2009, there was a growth of 714.7 million RMB in the deposit total, and a growth of 432.3 million RMB in the loan total, but the growth for loan-deposit ratio was only 60.48%. Secondly, the service system for customers at grass-root level is inadequate. Currently most service networks for the state-owned commercial banks are concentrated on the county capitol. There are 64 financial branches and stations in 15 townships, of which 42 belong to the credit unions. In some remote areas there are no financial services accessible. Thirdly, the bottleneck for SME loan collateral is hard to break through. The problems such as limited options and outdated measures, etc. seem to be universal, constraining the financial institutions from giving better support for SME development. Fourthly, the credit environment is in urgent need to be improved. The general public’s values of honesty and credibility are still to be improved. In addition, other factors such as the flaws in the financial management of some enterprises, incorrect accounting information, and low credit ratings also affect their credibility. Fifthly, large loans to the “san nong” are insufficient, affecting the improvement and adjustment of the structure of the agricultural industry. V. Major Measures to Push for Innovation in Rural Financial Products (1) Better leadership to promote innovation: a task force working on the promotion of innovation in rural financial products and services is headed by the county magistrate, in charge of leading, guiding, supervising and coordinating the 231

work in this aspect. (2) Formulation of proposals for the innovation in rural financial products and services: Proposals for Fengyang County Pilot Programs to Innovate Rural Financial Products and Services is formulated based on the viewpoints and information collected through research and survey specially tailored for each financial organization. (3) Promotion of micro credits and joint-collateral loans for the peasant households. First, the database of peasants’ economic profiles is expanded. Basic credit information of each household is to be registered in the credit business management system and an economic profile database for peasant households is established. The database strives to cover over 90% of the peasants qualified for credit loans. Second, the credit unions are improving the credit rating assessment for the peasant household micro credit. Loan certificates are given to the peasant households granted with credit loans. Third, the credit lines are increased. For those with excellent credit score, the maximum credit line is increased to 30 thousand RMB, for those with good credit score, 25 thousand RMB. As to the joint-guarantee loans, the credit unions will give joint-guarantee groups the maximal credit lines, and grant loans to group members according to the agreement of the group. The group is composed of borrowers living in the service area of the creditors, generally no less than 5 households. Up to the end of May 2009, 18,850 peasant households were granted micro credit loans, with the amount of 304.31 million RMB. (4) Exploration of financial tools based on purchaser orders and insurance policies. Up to the end of May 2009, the Agricultural Bank granted 4 cases of loans to companies and peasant households, with the amount of 120 thousand RMB. All transactions were completed in April. Fengyang Limin Village Bank granted one case of loans to a peasant household with a purchaser order, the amount being one million RMB. (5) Innovative financial products are made available for returning migrant workers and college graduates. Up to the end of May 2009, Fengyang Limin Village Bank granted one start-up loan, with the amount of 200 thousand RMB. (6) On April 29, 2009, China’s first county-level federation of peasant credit cooperatives was established. The federation currently has over 120 rural cooperative economic organizations, and proves to be a beneficial supplement for the county’s rural financial system. In April and May 2009, the official financial sector have loaned to the federation 755 thousand RMB to support the development 232

of peasant credit cooperative organizations. 8.2  Conditions of the Development of Peasant Credit Cooperatives Rural finance is the core of modern rural economy. At present, peasants are facing a series of problems that make it hard to get credit loan. One the one hand, there is a tremendous outflow of financial funds from rural areas. One the other hand, the deficiency in rural financial services and the thriving demands of rural financial market have constituted a paradoxical situation. The peasant credit cooperatives come up as a new form of cooperative economic organization, and play an important role in solving the difficulty of getting loans, pushing for agricultural development and increasing peasant incomes. 8.2.1  The Course of Development for Peasant Credit Cooperatives The development of peasant credit cooperatives in Fengyang County has gone through the phases of initiative, pilot experiment, developing, flourishing and beyond. (1) Initiative Phase. In September 2009, 12 peasant households in Guan Village of Linhuai spontaneously formed the first peasant credit cooperative in Fengyang County, the Haozhou Peasant Credit Cooperative. The founding fund totaled 30 thousand RMB, with 2000 RMB per share. The cooperative launched mutual aid service among members, becoming a pioneer for peasant cooperative finance in Fengyang County. Currently the credit cooperative has 18 households as members, and the fund has increased to 60 thousand RMB. To date, there have been 12 cases of loans. Nine cases have been settled. And the revenue from interests came to around 1000 RMB. At the same time, similar rural financial organizations have started to emerge in other townships and villages in Fengyang County, such as the Randeng Village Xiaoxihe Towship Huangzhuang Peasant Credit Cooperative, the Xiquan Towship Guanzhuang Village Peasant Credit Cooperative, and the Xiaogang Village Limin Edible Mushroom Farming Cooperative and Credit Cooperative. The above-mentioned cooperatives are founded upon the basis of crop farming, breeding, agricultural materials supply, agricultural and subsidiary products purchasing, processing, business operation and service. They bring together idle rural funds through the collaboration and association of members, to provide micro credit guarantees and mutual aids. 233

(2) Pilot Experiment Phase. In June 2008, peasant credit cooperative pilot programs were tried out in the whole county, in order to foster the sound development of peasant credit cooperatives. The programs aim to explore solutions for financing problems in the economic development of the rural society, and to accelerate the process of new rural reconstruction. To promote financial cooperation and mutual funding among peasants, the Fengyang County pilot program task force was established. It was organized by members from the county party’s agricultural commission, the National Development and Reform Commission, the People’s Bank and officials from divisions of finance, audit, industry and commerce administration, civil affairs, quality supervision, credit unions, etc. The task force made numerous field trips to conduct on-spot investigations. It also held discussion sessions and gathered public opinions before it formulated a proposal for the pilot programs. A whole-county mobilization meeting was convened opportunely, demanding the townships and villages authorities as well as related departments to recognize the importance of the pilot programs and give them due support. The programs went well with smooth financial operations. (3) Developing and Flourishing Phase. To support the work of peasant credit cooperatives and to ensure their positive development, Fengyang County Party Committee and the county government formulated specific policies. At the same time the supervisory measures for peasant credit cooperatives were fortified. These support policies included tax exemption, financial credit extension, loan support and subsidy, etc. For example, the agricultural products produced and distributed by the rural cooperatives as well as the production means they own were considered as produced and marketed by individual peasant households, and could enjoy tax exemptions. The financial establishments in the county were requested to give support to the rural cooperatives as an important task to offer credit loans to support peasants. The requirement for applying loans was relaxed. The cooperatives were granted credits at favorable conditions. In accordance with the proposals formulated for the programs, the county committee and county government allocated 87 thousand RMB to 29 cooperatives as a reward in the place of subsidy after vigorous assessment. These cooperatives were recognized as having better financial operation performances. Moreover, strict supervisions were enforced to ensure financial stability. There were three aspects. Firstly, specialized rural cooperative training and financial management training were offered. Experts in the field were invited as instructors to clarify the services the cooperatives should 234

provide, the development missions and the founding principles, etc. Professor Wen Tiejun and Dr. Zhou Li (associate professor) of the School of Agricultural Economics and Rural Development of the Renmin University of China, and Mr. Jiang Bolin of the Jilin Province Siping Baixin Cooperative came to give lectures, and helped formulating supervisory measures to regulate the financial management of the cooperatives. Secondly, internal management was fortified. The cooperatives were encouraged to better formulate their regulations, and abide by the rules set up accordingly. The principles of democracy, openness and transparency were emphasized so as to raise the cooperative and democratic consciousness of the peasants involved, and ensure the sound development of cooperatives. Thirdly, there was strict assessment and evaluation. A task force was formed to formulate an evaluation system. The emphasis was on assessing the regulatory system, fund security, turnover rate, profit rate and social effect, etc. Those cooperatives that did not manage well, or those whose funds did not work to benefit were commanded to improve within a definite time. If the management was discovered to violate regulations, the cooperative would be banned and the liabilities would be prosecuted according to the law. Because of the effective support and supervision by the government, the peasants responded positively. Up to the end of 2008, there were 57 peasant credit cooperatives established in the county, with 1269 households as members. The total share capitals were 12.06 million RMB, of which 8.116 million RMB had been put in operation. 8.2.2  Characteristics of the Operation of Peasant Credit Cooperatives When we look back at the process of founding peasant credit cooperatives, we find that, in the first place, the cooperatives have clear missions and principles. They aim to provide services to agricultural industries, to increase agrarian fund investment, and to fortify the extents of peasant organizations and their competitiveness in market. The peasants are the subjects of cooperatives, which reflect the populous nature in organization, the democratic nature in governance, and flexibility in operation. In terms of the founding principles, the government guides but does not operate the cooperatives, and holds to the tenets that they are operated and managed by the people for the benefit the people. The domain of operation is limited within villages or inside the cooperatives. Peasants join the cooperatives out of their own will, and they are free to quit as they like. The cooperatives are 235

managed democratically, with autonomous risk-control measures. Secondly, the cooperatives formulate regulations and management systems according to the legal requirements about specialized rural cooperatives. Their operation and management are regulated. The board of directors, the board of supervisors, and the operation and management bodies of the cooperatives are officially registered in accordance with legal procedures. They have the business licenses and copies granted by the industry and commerce administration authorities, the organization code certificates granted by the technical supervision authorities, the account permits granted by the financial authorities, the tax certificates granted by the taxation authorities, etc. Thirdly, the cooperation of production and fund should follow the model of “1+1,” i.e., the organic combination of production cooperation and mutual funding, with the aim of servicing production so as to increase the wealth of the peasants. A diversity of cooperative modes is developed around the “1+1” model, promoting the agricultural development with distinctive characters such as “one product one village, one industry one township.” 8.2.3  Existing Problems of Peasant Credit Cooperatives The foremost problem concerns the small scale of capital amounts. There are 57 credit cooperatives in Fengyang County, with 12.06 million RMB share capital. Overall, the amount is relatively small. Three cooperatives in Banqiao Village have larger shares, totaling 7.89 million RMB, accounting for 68.57% of total share capital of the whole county. Other cooperatives have smaller capital amounts, mostly only 40-50 thousand RMB. Secondly, the credit lines for peasants are quite limited. In the credit cooperatives in Fengyang County, generally it is 300, 500 or 1000 RMB per share, in very few cases 5000 RMB per share. The maximum credit line for peasant members is 20-30 thousand RMB only, which is far from sufficient for developing modern agriculture and undertaking larger scale agricultural production. Thirdly, the service coverage is quite small. There are 198 administrative villages and 26 rural communities in the whole county. Averagely speaking, 5 to 6 administrative villages share a credit cooperative—this is obviously too spare to meet the credit needs of peasants.


8.3  Conditions of Development of the Federation of Peasant Credit Cooperatives 8.3.1  Founding Background for the Federation of Peasant Credit Cooperatives Since the second half of 2008, in full respect of the innovative spirits of the peasants, the county committee and the county government of Fengyang have been promoting the financial cooperation and mutual funding among peasants, with the principle of “operated and managed by the people, for the benefit of the people,” and the management concepts of “security, convenience and petty profit.” Pilot programs of peasant credit cooperatives were implemented. The smooth operations of peasant mutual funding were largely due to the great support from related authorities. In particular, breakthrough has been made in pushing for the “1+1” model combining cooperation in production and mutual funding. Up to April 2009, 57 peasant credit cooperatives were organized in the county, with 1269 households as members. The goal of having one credit cooperative in each village was realized in Hongxin Village and Yinjian Village. Still, the pilot programs are in a relatively preliminary stage, far from satisfying the needs of rural economic development and financing the production of the vast rural population. The major problems are insufficient capital for the credit cooperatives, limited service coverage and extension, lack of market information and lack of larger scale credit support. What’s more, those in charge of the cooperatives do not always have the necessary knowledge to maintain the well functioning of the organizations. To follow the agenda revealed in the CPC’s 17th Third Plenary Session, in which important decisions were made to better adapt the rural finance to the new situation, Fengyang County sent representatives abroad to learn about comprehensive agricultural associations in Japan. The objectives were to promote the sound development of peasant credit cooperatives in the county for better risk management, to establish cooperative economic organizations and operation modes compatible with market economy, to maximize the functioning of the cooperatives in pushing for the development of modern agriculture, adjusting the industrial structure, as well as fortifying the extent of peasant creditworthiness and their organization level, etc. In short the aim is to promote fast and robust socioeconomic development of the rural areas in Fengyang. The delegations learnt 237

from Japan how to promote rural cooperative finance, and started to organize the Fengyang County federation of peasant credit cooperatives. This is not only an important event in Fengyang to push for further rural financial reform and the sound socio-economic development, but also the first rural cooperative financial organization set up by peasants under the guidance of the government. 8.3.2  Founding Process for the Federation of Peasant Credit Cooperatives Since June 2008, amid the 57 peasant credit cooperatives (with 1269 households as members) in the county, 50 cooperatives adopted the “1+1” model. The peasant credit cooperatives of Huangzhang, Wudian Cainong, Jiangzhuang, Songji, and Dawangfu boasted of better operation performances, all of them organized upon the basis of cooperatives of production. The Wudian Cainong and the Huangzhang have fared particularly well. Under governmental guidance, in the end of 2008, a new model of cooperative finance was started linking the corporate champions, banks and the credit cooperatives to expand the loan scales of agriculture-related banks for agricultural production. The credit cooperatives obtained raw material purchase orders through the corporate champions, and obtained loans from agriculture-related banks, with the guarantee from the federation members. When the credit and production cooperatives secured funds, the expansion of production was made possible. Through intensive research and over 4 months of preparation, the Fengyang County Federation of Peasant Credit Cooperatives was officially set up on April 29, 2008, encompassing 14 county authorities and financial institutions, 23 corporate champions, and 57 Peasant credit cooperatives as its members. In April 2009, on the same day when the federation was open for business, the financial sector granted 850 thousand RMB of loans to peasant credit cooperatives and their members. This included the Association of Credit Unions’ 310 thousand RMB loaned to 5 members of the Yinjian Village Songji credit cooperative and 90 thousand RMB loaned to 6 members of the Fucheng Village Dawangfu credit cooperative, and the Postal Savings Bank’s 150 thousand RMB loaned to 3 members of the Wudian Cainong credit cooperative. On April 25, 2009, the association of credit unions loaned 200 thousand RMB to the Hongxin Village Jiangzhuangfu credit cooperative; on April 27, 2009, the Agricultural Bank loaned 90 thousand RMB to 3 members of the Zongpu Village United Credit Cooperative for Fruits and Melons. 238

8.3.3  Operation and Supervision of the Federation of Peasant Credit Cooperatives The federation combines membership system and cooperative system, and is composed of legal persons from the divisions of peasant credit cooperatives, county corporate champions, county treasury, county committee, the Agricultural Bank, the association of credit unions, the Postal Savings Bank, the Limin Village Bank and county surety companies, etc. The federation raises funds through member investment in share capital and membership fees. The credit cooperatives and related members also contribute funds with a certain proportion. Other sources include individual investments and other funds. Together, these compose of the total capital of the federation. The county fiscal authorities also put in some funds to expand its fund scale and financing power, so as to stand surety for the credit cooperatives. The federation is organized by the general assembly, the board of directors, and the board of supervisors. The general assembly, consisting of all members, holds the highest powers of the federation. The board of directors is the executive body of the general assembly, composed of 9 directors elected by the general assembly. The board of supervisors is the supervisory body of the general assembly, composed of 5 members. The federation is operating according to the following principles. The members join out of willingness and are free to withdraw. The management and decisions should be democratic. The operation and management is autonomous. The members participate into economic operation and share the benefits as well as the risks. The federation has four major missions and competences. First, it offers comprehensive services. Through various ways the federation provides consulting services and information exchanges in production, technology, market, agricultural product promotion, presentation, exhibition and sale information, to promote the member’s development along with the credit cooperatives. Members are organized to participate in technical and career trainings, to enhance production, and to increase economic capacity and management skill. Second, the federation offers loan services. They are divided into two kinds: the first one is to allocate the surplus and shortage among the credit cooperatives, and to take care of the settlement on their behalf, in accordance with self-discipline of the industry. The second is cooperation between banks and cooperatives. One way is for the credit unions or village banks to entrust the credit cooperatives with loans to peasants. Peasant credit cooperatives thus become the new clients of rural finance, and they in turn serve their members, transforming the former one-to-one service 239

of the bank to the peasant into the bank to the credit cooperative. The previous loan retailing is transformed into loan wholesale, reducing the transaction costs and information cost. Another way is for the credit cooperatives to deposit the share capital of members into the credit unions or village banks as guarantee fund. The banks set credit lines according to the volume of the fund. Should there be cases of bad debt, the fund will have to bear the risk, thereby forming internal constraint and credit mechanisms within peasant credit cooperatives. Third, the federation offers operation services. It coordinates the cooperation and the complementary exchanges of resources among members, and organizes production and operation according to market demands and supplies. It organizes the members to purchase the production means they need and sell agricultural products. Another function is to coordinates the agricultural production by order. It also introduces and promotes new technologies, new species and offers technological exchange services. The federation deals with external parties and manages the business. The earnings are redistributed in proportion to the member’s investment contribution. Fourth, the federation takes charge of supervision and management. The supervisory board supervises the financial conditions of the credit cooperatives and the issuing of loans. It also formulates self-disciplinary conventions to ensure sound operations. The board directs the credit cooperatives to enhance their efficiency in using funds, increase fund accumulation and take protective measures against risks. 8.4  Comparison of the Performances of Peasant Credit Cooperative, Rural Credit Union and Village-Township Bank Table 8-4-1. Performances of Peasant Credit Cooperatives, Rural Credit Unions and Village-Township Banks in Fengyang County in Supporting the Agrarian Sector (2008)      Items

Establishments Credit Unions

No. of Loan Application

No. of Sum of Loan Households Success Rate Applied for Granted with (10000 RMB) Loans

Sum of Loan Issued (10000 RMB)

Issuing Rate







Village- Township Banks







Peasant Credit Cooperatives








Table to continue Table 8-5-1         Category Establishments

Average Annual Interest Timely Repayment Rate Disqualified Application Rate

Credit Unions




Village-Township Banks







Peasant Credit Cooperatives

From Chart 8-4-1, we see that in year 2008, the success rate and issuing rate of the peasant credit cooperatives in Fengyang were 98% and 97% respectively, surpassing the corresponding indicators of credit unions and village-township banks (72% and 68.69% for the former, and 91.7% and 85.1% for the latter). The disqualified rate was only 2%, lower than the 10.67% of credit unions and the 9.23% of village-township banks. Furthermore, the timely repayment rate was 100%, which indicated no non-performing loan at all. The annual interest rate of peasant credit cooperatives was only 9.4% of the rate of credit unions, and 15.4% of village banks. This category alone helped drastically reducing the loan costs for peasants. On the one hand, it is apparent that the peasant credit cooperatives have done more to support peasants than the credit unions and village-township banks. Considering the lending conditions of these three kinds of establishments, the cooperatives have been more capable to give direct support to the peasants who usually found it hard to obtain loans, so that they could undertake specialized production. On the other hand, it shows that the design of the peasant credit cooperatives as a rural household financial cooperative institution accorded with the principle of incentive compatibility. Under the cultural and moral constraint of the villages, the peasant credit cooperatives have developed positively. Through the analysis we come to the conclusion that the performance of the peasant credit cooperatives in offering support to the agrarian sector has been better than the credit unions and the villagetownship banks. 8.5  Game Analysis of Association of Credit Unions, Village Banks and Credit Cooperatives As the state’s representatives of the exogenous financial institutional arrangements in rural areas, rural credit unions and village-township banks hold the 241

institutional advantage in terms of legal status. However, they do not fully fulfill the responsibilities of giving support to peasants as designated by the state, and even have hindered the smooth and robust development of rural economy. When an activity is observed to have impact on their political and economic interests, their first reaction is to attempt to stop it and to prevent the new peasant finance from obtaining financial resources, so as not to have their interests compromised or even at loss. When peasant credit cooperatives are set up, peasants cease to deposit their extra money into rural credit unions or village-township banks. The surplus still available after satisfying their daily production and consumption needs is put instead into the hands of peasant credit cooperatives as share capital. When they need fund for production and consumption, they will seek credits from the peasant credit cooperatives, instead of turning to rural credit unions or village-township banks for help. Rural credit unions and village-township banks realize the loss, especially in terms of their economic interests, which in turn affect their political interests. Hence, their attitudes towards peasant credit cooperatives are surprisingly unanimous: they do not allow the peasant households who are cooperative members to deposit money in credit unions or village-township banks, nor do they grant loans to these peasants. In short, they try their best to crush down peasant credit cooperatives economically. When the “1+3” model came into effect with the set-up of the federation of peasant credit cooperatives, the rural credit unions and the village-township banks, in their capacity as the agents of agriculture-related bodies, participated directly in the production operation of peasants. Under the “double guarantee” offered by the federation and the surety companies of the government, rural credit unions and village-township banks could provide loans to peasants undertaking specialized production. In this way, their economic interests were protected while they did not have to take any risk. This results in a fundamental change in their attitudes, and they became unprecedentedly active regarding agriculture-related business. Statistics show that on April 29, 2009, when the federation of peasant credit cooperatives was established, within that one day 840 thousand RMB of agriculture-related loans were granted, surpassing the total of all loans credit cooperatives obtained from formal banking sector in 2008.


8.6  Case Study of Peasant Credit Cooperatives in Xiaogang Village 8.6.1  Basic Information of Xiaogang Village Xiaogang Village is situated in the east of Fengyang County, 30 km away from the county capitol, under the jurisdiction of Xiaoxihe Township. Before the “allround production task responsibility” system, it was under the Liyuan Commune, with a production team of 20 households and 115 villagers. In 1993, the Xiaogang production team merged with the neighboring Dayan production team to form the Xiaogang administrative village of 112 households and 486 residents, with 1800 mu of contracted arable land. In March 2008, Xiaogang Village merged with Shima and Yangang in a county-level rural administrative division adjustments. Currently it has 23 villager teams, 849 households and 3823 people, with 8713 mu of contracted arable land. 8.6.2  Trajectory of Xiaogang Village The development in Xiaogang Village has gone through the following phases, according to our research and analysis: (1) Tremendous change overnight (1978-79). Xiaogang Village is remotely located, with unfavorable conditions for production and frequent droughts. Before the “all-round production task responsibility” system, Xiaogang Village was very poor, a so-called typical “three-dependence village.” It needed to purchase staple foods from outside in order to satisfy its needs. The villagers had to depend upon relief to have money to spend. The production was dependent on loans. Practically all villagers had experienced fleeing from famine and begging for food. In the winter of 1978, with the spirit of “daring to be the first in venture,” 18 peasant households signed an agreement of “production contracted to households” with their scarlet red finger prints for authentication, and practiced the “all-round production task responsibility.” The “contract” became the very first declaration of rural reform in China, and foretold the rural reform to come. Xiaogang Village is therefore reputed to be the first village of China’s rural reform. The practice of agricultural “all-round production task responsibility” brought a new life to Xiaogang villagers. Their enthusiasm for production had never been so high. In 1979, the total staple food production for Xiaogang production team amounted to 133 thousand catties, equivalent to the total production between 1955 and 1970; total oil production came to 35 thousand catties, equivalent to the sum of the 243

previous 20 years. In the same year, Xiaogang Village turned over 65 thousand catties of staple foods to the state. For 23 years, it was the very first time the village could turn over surplus food to the state since the agricultural collectivization was enforced in the country. The average net income per capita became 400 RMB, 18 times more than the 22 RMB of 1978. The right choice of Xiaogang villagers enabled them to bid farewell to poverty. Since then there was no more food and clothing shortage issues. (2) The lingering 20 years (1980-1998). With the nation-wide implementation of the “all-round production task responsibility” system, the zeal of peasants for production was greatly mobilized, and food production grew rapidly. Toward the middle and late 1980s, due to the structural excess of food production in the country, many villages responded to the call of the state to seek new development and eagerly developed agricultural industries with distinctive characters as well as village enterprises. While many peasants elsewhere pursued wealth and empowered their villages, most Xiaogang villagers lacked the fervor and courage for the second-time entrepreneurship. For a long time, they had inclined toward staple food production, and missed numerous great opportunities for development in the first 20 years since the Reform. So it is said that “the problem of food and clothing was solved overnight, but they did not for once become well-off in the next 20 years.” In 1979 alone, the average net income growth of Xiaogang Village peasants increased 17 times, over 370 RMB more than 1978. However, from 1980 to 1992, the average net income growth of the Xiaogang peasants was only 100 RMB, adding up to only 500 RMB. In 1998 it was only 1800 RMB, far below the national average level. (3) Rapid development in recent years (1999-present). Along with rural economic development and prosperity, some famous or rich villages emerged one after another in the country, and Xiaogang villagers saw how under-developed they had been and realized the gap between those villages and their own. Since 2006, the central government implemented the strategy of accelerating the process of the socialist new rural reconstruction. This re-invigorated and mobilized Xiaogang villagers for innovative development. They aspired to continue on innovating audaciously, and find effective ways to accelerate the rural development and building a beautiful homeland. Firstly, specialized grape farming industry was cultivated to set a good example. Xiaogang villagers made the land use rights more flexible, and strove to seek new breaking points for developing industries with 244

distinctive characters. In 1999, Xiaogang Village entered in an agreement with Changjiang Village of Zhangjiagang City, Jiangsu Province, to become “sister villages,” so as to enhance exchange and cooperation, in the hope that Xiaogang Village could benefit from the resources of Changjiang Village for further development. In 2001, Changjiang Village contracted 80 mu of land in Xiaogang to invest in grape vineyard cultivation as a demonstration. Xiaogang villagers were therefore able to witness the economic benefits and learn the technology. In recent years, grape plantation has developed fast in Xiaogang Village. Over 90% of the peasant households got involved into grape cultivation, and over 600 mu of farmland are devoted to grape farming, which became a dominating local industry. This alone brought in an average revenue growth of 2000 RMB per capita. Secondly, talents were invited to come to Xiaogang to develop agaricus bisporus (an edible mushroom) farming. As early as 2005, Fengyang adopted the strategy to attract talents, and invited college graduates to start up business in villages, in its attempt to break through such bottlenecks as lack of talents and information for the new rural reconstruction. Xiaogang Village responded positively to the calling, and in 2006, three graduates from Anhui College of Technology came to Xiaogang Village and developed agaricus bisporus mushroom production. The college graduates brought advanced ideas and technology, and endowed the villagers with more confidence and courage to develop new industries for big markets. For 3 years, 13 college graduates were encouraged to come to Xiaogang Village, and they helped 23 peasant households to get involved into entrepreneurial businesses. The scale of agaricus bisporus production has grown from the initial 35 tents to the current 179 tents, with an annual production close to 1.8 million catties and an estimated output value of 4 million RMB. Thirdly, positive measures were adopted to attract investment and develop new industries. Xiaogang Village has noticed and made good use of its branding advantage to attract investment so as to empower itself through industry. Corporations such as Xiaogang Flour of China and other companies manufacturing steel structure, energy-saving electric appliance as well as healthcare equipment, etc. settled in Xiaogang one after another. A new style industrial park was planned and constructed to attract more business investment to Xiaogang. Standardized plants were built in the village and rented to the corporations. The development of corporations in the village could contribute to the fiscal revenues of the village collective, and also facilitate the villagers to work in local plants and increase their wage incomes. Congyu Vegetable Planting Group of 245

Guangzhou has invested in stage one of 2000 mu of vegetable farming and tourism project. GLG Group of Qingdao, whose headquarters is in the USA, has also participated in the project of 2000 mu of stevia farming. Fourthly, cultural tourism was cultivated so that the tertiary industry could take flight. Xiaogang Village is the birthplace of China’s rural reform. It was also selected as a “demonstration site of rural tourism in Anhui Province,” and a “base for patriotic education in Anhui Province.” Many people visit and conduct research in Xiaogang Village, revealing its great potential to develop cultural tourism. Careful planning thus went into diversifying tourism products, such as Xiaogang Village socialist tourism, ecoagricultural tourism and rural tourism, etc. Touristic and recreational highlights such as the “all-round production task responsibility” museum, old-fashioned thatched cottages, and villager cultural square were built for the purpose. To encourage tourists to stay with the peasant households, policies came out to support the development of “happy farmhouse lifestyle” rural tourism, so as to boost income growth of the villagers. In 2008, Xiaogang Village hosted over 50 thousand visitors. 8.6.3  Fund Needs of Peasant Households in Xiaogang Village Table 8-6-1 Survey Chart for Xiaogang Village Peasant Household Fund Needs in 2008


Fund Needed (thousand RMB)

Fund Sources (thousand RMB) Credit Union (InterestBearing)

Loan from Friend/Relatives (Interest-free)



Guan Zhengyin




Mushroom farming, housebuilding

Ma Wujun




Mushroom farming





Guest- transport vehicle purchase





House- building, Sedan purchase


Yan Dekui Yan Jiakui


Currently only 30000 were paid back



Chart to continue Yan Lihua




House- building, son’s wedding


Yan Jiale




House- building

20000 demanded, only 4000 loaned


Guan Yousong 20




50000 loaned on behalf of Wu Xilin


Wen Xiaoqin




Mushroom- farming, house- building

More loan demand refused by credit union


Chen Xingbiao




House- building

Loan not paid off yet


Yan Lixue




House- building

Loan refused by credit union


Gu Naifang




House- building


Yang Xindong 100



Excavator purchase, house- building


Yan Yinchang




House- building

Loan not paid off yet


Yan Debiao




House- building

Loan refused by credit union


Yan Dejiu




Grape- farming, housebuilding


Yan Fuchang




Education, housebuilding


Yan Deyou






Yan Dekuan




Mushroom- farming, house- building


Yan Delong




Harvester purchase, house- building, son’s wedding


Yan Jiahong











From Chart 8-6-1 we see that Xiaogang Village peasants had urgent needs for funds, mostly for specialized farming production. The funds were mainly borrowed from friends and relatives, with a loan total of 798 thousand RMB, surpassing the 710 thousand RMB from credit unions. This shows that, as the main agents of formal finance, the credit unions could hardly satisfy all the fund demands of the peasants. 247

8.6.4  Analysis of Loans by Formal Finance in Xiaogang Village According to statistics of the People’s Bank, up to the end of October 2008, the Xiaogang Village after the merger demanded 125 loans. The balance was 5.6185 million RMB. 112 households were granted credit support. Of the 4.087 million RMB loaned to Xiaogang Village, 917 thousand RMB were used for mushroom production and 1.911 million RMB were entrusted loans (the provincial treasury allocated special non-gratuitous funds to support Xiaogang Village). 1.259 million RMB were used for other loans related to production and consumption etc. In terms of loan modes, self-operational loans by rural credit unions accounted for 66% (3.7074 million RMB); entrusted loans accounted for 34% (1.9111 million RMB). In terms of the use of loans, personal consumption accounted for 639 thousand RMB (11.37%); transportation business accounted for 330 thousand RMB (5.87%); agricultural industry development accounted for 4.1195 million RMB (73.32%); wholesale and retail accounted for 30 thousand RMB (0.53%); processing industry accounted for 500 thousand RMB (8.91 %). As to loan quality, there were 67 non-performing loans with the amount of 4.457 million RMB, accounting for 53.6% and 79.33% respectively. 16.31% of the household micro credits were nonperforming while other non-performing peasant loans accounted for 78.78%. As high as 100% of the entrusted loans were non-performing. As a whole, up to 80% of the loans in Xiaogang Village were non-performing, which was higher than the 53% average non-performing rate for the association of rural credit unions in the county. Of the 36 households who participated in the survey, they obtained a loan total of 1.0155 million RMB from the credit unions, which accounted for only 32% of the 3.13 million RMB fund needs of the households. As the supply fell far below the demand of the population, the peasants borrowed 1.335 million RMB from relatives and friends, which accounted for 42%. The survey also shows most loans were used for mushroom farming, house-building, children’s education, etc. Some households even borrowed to pay back other debts. With such urgent needs for loans, most of the peasants would hope for support from the formal financial establishments, with which they failed to have good communication and contact. As a result, they could not obtain the needed loans. There are several reasons. Firstly, the loans granted by formal finance are basically used for simple reproduction and expanded reproduction. The consumption loans used for education, housebuilding, wedding, funeral and medical treatment would not be considered by the formal financial sector. Secondly, the current entrance barrier of credit unions 248

is high. Many peasants are not familiar with or could meet the qualifications to obtain loans. The villagers usually do not have good projects. And even when some do have, they do not own valuable assets to be used as collateral. Thirdly, the repayment terms of short-term micro credits are not compatible with the incomes cycle of the peasant’s seasonal production. The fixed short-term repayment at a specific time would affect to a certain extent the productive development of peasants. Fourthly, peasants are generally not so risk-tolerant. Credit unions would consider such kind of loans higher risk- bearing. Due to the influence of politics and local governments, local credit unions and the local branches of the People’s Bank usually tend to invest a considerable amount of credits in Xiaogang Village. However, the credit risks thus incurred are obvious. Peasants seem to respond with a weak credit consciousness. The financial institutions therefore would hold a negative attitude towards credit reinvestment. In the following section, we will make a comparison of Xiaogang villagers’ attitude towards the credit unions with that towards the credit cooperatives they had themselves set up, and compare the different outcomes resulted from the two financial institutional arrangements. 8.6.5  The Example of Peasant Credit Cooperatives in Xiaogang Village Xiaogang Village credit cooperative started operation since September 2009 till the present day. Its overall operational conditions are good, but there are still shortcomings needed to be gradually improved. (1) Services and Operating Procedures There are three types of services—deposit, withdrawal, and loan—with simple and convenient operating procedures. 1. Deposit (liquid share capital): each deposit shall not exceed 30 thousand RMB. A valid personal ID and stamp are required to make a deposit at the credit cooperative. Two copies of personal deposit slips are filled out as reference. The credit cooperative shall give the client a personal deposit passbook as well as a deposit receipt. 2. Withdrawal: a valid personal ID and stamp as well as the personal deposit passbook issued by the credit cooperative are required to make a withdrawal. The client has to fill out two copies of personal withdrawal slips as reference, and the credit cooperative gives back the withdrawal receipt and the passbook showing the remaining balance, after the amount withdrawn is deducted. 3. Loan: it is granted to Xiaogang villagers with integrity and capacity to pay 249

back. The loan must be used to meet the needs of proper business operation and production, with a preferred term of no more than 6 months. Loans less than 10 thousand RMB are granted with the permission of 2/3 of the board directors; loans more than 10 thousand RMB should be granted with the permission of 2/3 of the board directors as well as the signature of the board chairman. Borrowers who meet the above qualifications are also required to: ① have a copy of a valid personal ID and stamp; ② sign a loan agreement. Borrowers who are not members of the cooperative need to have a member to stand surety for the agreement; the guarantor must sign a contract guarantee using his or her personal assets in hand as collateral. Borrower who is member of the cooperative can sign a security agreement using his or her share as collateral if the loan amount is lower than the value of the share he or she holds. As for loans exceeding the value of the share one holds, a security agreement must be co-signed by another member or the borrower must use his or her personal assets in hand as collateral. (2) The Outcomes A total of 154 Xiaogang villagers have borrowed from the credit cooperatives with a total share capital of 1.37 million RMB, and the largest loan amounts to 20 thousand RMB. 45% of the borrowers used the loan for housing, 20% for weddings and funerals, 4.8% for buying agricultural machines and equipments, 5.2% for breeding, 5% for agricultural production and operation, 10% for commercial operation, and 10% for other purposes. At present, there is not a single case of overdue loan. The cooperative staff becomes more and more familiar with the standard financial and accounting procedures in the handling of daily depositing services. Their operating skills are increasingly proficient. The procedures become more and more standardized. In addition, the office staff would supervise and cooperate with each other, enabling the “three persons, three stamps” system to function well. Through the actual performance of the credit cooperatives, we see that the cooperative finance founded by Xiaogang villagers has developed well, without a single case of bad debt. The peasants showed creditworthiness in submitting the share capital or in loan activities. When they dealt with the credit unions, however they left a notorious record of non-performing loans. The drastically different outcomes tell us that institutional arrangement has determined the performance in rural finance. It has nothing to do with the integrity of villagers. Fundamentally, if an institutional arrangement goes without an incentive compatible mechanism, its 250

operation costs would inevitably be very high. 8.7  Different Receptions for the Experiments of Peasant Household Cooperative Financial Institution in Fengyang County Ever since the implementation of the rural cooperative financial institution in Fengyang County, it has attracted attention from different sectors of the society. The reactions are different. Overall it is affirmed by the majority of people, regarding it a new model of rural cooperative finance to be encouraged, supported and well supervised. At the same time, quite a few opposing opinions could be heard. The major objections mainly come from the financial supervisory and commerce administration authorities. They argue that as a financial agent, it is illegal. A few scholars think that its scale is too small to be effective or argue from the perspective of fund-raising. Those who hold positive attitudes consider peasants as the subjects of rural financial needs, and their financial preference should be the precondition constraining the institutional arrangement. Peasant credit cooperatives and the federation of the cooperatives are rural cooperative financial organizations initiated, set up and joined by the peasants themselves, with support and guidance from the Fengyang County Committee and county government, following the principles stated in CPC Central Committee’s 17th Third Plenary Session about rural finance as well as mutual aid and cooperation among peasants. It is the optimal solution to mitigate the predicament of institutional supply in rural finance, because it entails an incentive compatible mechanism. The remarkable result with the experiments of Fengyang County peasant credit cooperative organizations in practice can serve as a convincing evidence of the effectiveness of this new model of rural cooperative finance. Ever since the establishment of the Fengyang County peasant credit cooperative organizations, they have been serving important functions: First, the peasant credit cooperative organizations solve the long-term difficulty poor peasant households face in getting loans. The core value of the organizations is to provide financial support for the cooperative members, as most of them can hardly obtain loans from credit unions. With the establishment of the credit cooperatives, the function of mutual funding is realized to a large extent. According to the regulations of the credit cooperatives, members can enjoy the right to use the fund for free for a month. If the fund in need is more than the 251

member’s own share, it can still be made available as long as he or she can find another member to stand surety. The loan interest rates are generally lower than those of formal financial institutions. Second, the organizations enable minimized costs for rural credits. In the past, because of a series of factors including the information asymmetry between credit unions and peasants, high transaction costs, small transaction amounts, and scattered transaction areas, the management costs stayed at a high level. This would not be the case for credit cooperatives: hardly any transaction cost is involved, and even offices are offered by members for free. This high degree of trust and mutual aid is an advantage hard to beat by any formal financial institutions. Third, credit cooperatives are cultivating new clients with good creditworthiness for rural credit unions, as a matter of fact. The present 41 peasant credit cooperatives in Fengyang County have recruited 1811 households as their members. If the peasant households have to face the credit unions one by one, the costs no doubt would be high. Now, within the credit cooperative organizations of their villages, they have formed their own credit alliances and earned their creditworthiness in the process. As a result, the associated organizations they form now become new clients of rural credit. Up to the present, of all fund transactions within the peasant credit cooperatives of Fengyang County, not a single case of breach of contract has ever happened. This shows the peasant household cooperative financial institution can share incentive compatibility with the cooperative financial institution of formal credit unions. Fourth, the arrangement effectively curbs the outflow of rural funds. The problem of rural fund outflow has always put rural finance in dire straits. The solution reveals itself within the Fengyang County peasant credit cooperative organizations. In these organizations, peasants not only act as savings depositors, but also members of the credit cooperatives. The funds can function well within the cooperatives. Since rural household cooperative financial organizations such as peasant credit cooperatives or the federation of peasant credit cooperatives are involved in fund transactions, they are required to obtain related financial permits and register with the industry and commerce administration authorities, in accordance with related legal regulations. As credit cooperative organizations are initiated and organized by peasants, they cannot expect to fulfill the qualifications of acting as a financial agent as specified by the regulations, let alone getting legal registration. 252

As a result, the financial supervisory and commerce administration authorities consider them illegal. In fact, the CPC Central Committee’s Resolutions Regarding Certain Issues in Pushing for Development in Rural Reform has clearly specified that the “operations of credit cooperation by qualified specialized peasant credit cooperatives are to be permitted. Informal lending shall be regulated and guided to ensure a sound development. The construction of rural credit system should be accelerated. A market-oriented rural credit surety mechanism shall be established with support from the government and multilateral participation from different sectors.” In other words, if the government enhances its role in guidance and supervision while the peasant household credit cooperative organizations strictly discipline themselves, under a market-oriented rural credit surety mechanism with multilateral participation, the rural household cooperative finance is in line with the spirit stated in the document. In addition, those viewpoints judging rural cooperative finance to be ineffective just because of the small scale of initial funds of the cooperative organizations are being unfair. In fact, commercial finance chooses to retreat from rural areas exactly because of its scale economy as the transaction costs are higher in villages than in cities. For those who focus only on the part of fund savings involved during the operation of cooperative financial organizations, without carefully studying the mutual funding happening after and during the process of savings, they could come to a wrong conclusion by seeing the practice as a new round of informal and unregulated fund-raising in rural areas. The assumption that such a practice could disturb financial order is furthermore a biased and lopsided viewpoint towards cooperative finance.


Chapter 9  Conclusion and Policy Orientation

9.1  Conclusion Rural financial issues are indeed complicated and entangled. Through the unique approach of the household contract responsibility system, we analyze the demand of rural households and the institutional supply, and study the performance of institutional supply. We can thus draw the following general conclusion. 9.1.1  The Solution for Rural Financial Problems Lies in Institutional Innovation The present rural finance in China is constituted by an institution based mainly on the exogenous system, including commercial finance represented by the Agricultural Bank, policy-supported finance represented by the Agricultural Development Bank, and cooperative finance represented by the association of rural credit unions. Upon the basis more efforts have been made to expand the supply of the exogenous financial institution through market-oriented measures, such as the reform of cooperative finance, the founding of village-township banks, and the permissions granted to specialized loan companies. But these arrangements take mainly into consideration the exogenous institution. Their costs of institutional supply and operation are huge. Due to its commercialized institutional arrangements, the Agricultural Bank of China has retreated from rural areas to reduce transaction costs. Its political objective function of servicing the san nong—an integral part of its institutional design—is close to zero. The policysupported banking institutional arrangements face the double dilemma of losses in operation and the shutdown on rural credit support, because of its concentration on specialized products. Rural credit unions are endowed with the double-objective function of pursuing commercial profits as well as fulfilling their peasantssupporting policies, and this paradoxical institutional arrangement has resulted in a predicament of reform. The village-township banks and loan companies replicate the founding principles of formal banking systems. As a result their commercial costs are high. A sustainable operation then becomes questionable, and they are even in danger to be out of business. Overall, exogenous institutional arrangements are ineffective in regard to the specific objective function of both servicing the san nong and gaining commercial profits, and their institutional operations are rather 255

inefficient. On the one hand, the exogenous rural financial institutional arrangement continues to supply and constantly adjusts itself; on the other hand, the endogenous institutional arrangements such as rural cooperative finance, fund unions, micro credit organizations, community banks, etc. can hardly come about. The institutional supply in China’s finance therefore becomes one-dimensional. This tendency has caused a structural imbalance out of shortage in the institution. Improvement on performance cannot be brought about no matter how much the exogenous system strives to improve upon itself. The problem is—the more ineffective it becomes, the more the exogenous institutional supply is augmented. The impasse of an institution that puts too much emphasis on quantity is the current situation of rural financial reform in China. Why would there be such a phenomenon? At the center of the problem are the financial supervisory authorities’ preferences in monopolizing resources, and the consequential biased and distrusting attitude they hold towards informal financial institution. In China, for a long time financial resources have been controlled by the government under the institution of planned economy. In the process of transforming toward market economy, the reform of the financial system has been done in a passive way, or rather, the reform is under strict control. The short-lived rural fund unions could be cited as a typical example. Moreover, the authorities have always been suspicious about the endogenous rural financial institution: they do not believe that peasants could handle financial issues well, and they either reject or suppress unregulated finance in rural communities. Informal finance in rural areas, branded as “usury” or illegal fund-raising, are constantly distorted or repressed. Only the formal financial system is allowed to thrive. At the same time, to protect the interests of formal finance and to prevent informal financial development from affecting the monopoly of formal finance, which in turn would affect the monopolistic status of the financial supervisory authorities, policy-makers adopt the measures of controlling, disrupting, and suppressing the development of informal finance. For a long time informal finance has been discriminated politically. Its activities are strictly controlled and many often banned under the name of illegal “fund-raising.” These are the deep-seated factors preventing rural informal finance in China from further development and prosperity. What is the solution for rural financial problems? Our study shows that the answer to this question is institutional innovation, since the shortage of the 256

endogenous institution has constrained the sustainable development of rural finance. Hence, there should be informal financial institutional arrangement and informal rural financial organizations should be given their legal status. Once informal finance is connected with formal finance, a vertically and horizontally well-structured institution could be constructed, supplementing each other to serve rural finance with advantages from both sides. In the array of informal financial institution, the rural household cooperative finance is at present the foremost institutional innovation. 9.1.2  Rural Financial Institutional Arrangement Must Be Compatible with the Basic Rural Economic Institution To be in line with the three representative financial theories—the subsidy paradigm, the market paradigm and the imperfect market paradigm—there have been three kinds of institutional arrangement in China’s rural finance: policyoriented finance, commercial finance and cooperative finance, which have emerged one after another. Although they are able to satisfy the rural financial demands to a certain extent, the asymmetry of demand and supply in rural finance has become an increasingly serious problem. A central viewpoint for new institutional economics is that any institutional arrangement without an incentive compatible mechanism is invalid. Our research shows that the institutional arrangement of rural finance in China, or to be more precise, the current exogenous institutional arrangements are incentive-incompatible. Given this condition, to expand the volume of institutional supply in an attempt to meet the demand of rural finance would only increase its operational costs, causing institutional malfunction in both performance and efficiency. Through extensive research, we are convinced that rural financial institutional arrangement must start with the right logical point of departure—the basic rural economic institution, which, currently in China, means the household contract responsibility system. The system is in essence an endogenous informal institution, an incentive compatible institution, therefore gaining the support and recognition of millions of peasants. The success of this institutional arrangement says much about how compatible it is with the regularities and characteristics of the current rural economy. In other words, the household contract system answers for the demands characterized by the peasant economy in China. Now that China’s rural economic institution is based on the household contract system, any rural economic institution 257

has to adapt itself to the household contract system—this is what we call the institutional compatibility. In view of the household contract system, the financial institutional arrangement that matches it, in terms of incentive compatibility, is the informal financial institution endogenous of rural economy. Both of them take as basic economic unit peasant households and fulfill the objective function of the family’s needs. The transaction costs are minimized and therefore its institutional operations are sustainable. Our study shows that the household contract system could adapt to the nature and regularities of China’s current rural economy. It is an endogenous institutional arrangement with incentive compatibility. The present rural financial institution is a unitary exogenous system regulated by the government. Due to the shortage of endogenous institution, as well as the incompatibility between them, the current rural financial institution lacks an endogenous incentive mechanism and does not match with the household contract system. As a result, we record a poor performance of its institutional supply. 9.1.3  Rural Financial Institutional Supply Must Adapt to the Financial Preferences of Peasant Households Peasant households are the subjects of rural financial demands. Their financial preferences should be the precondition determining the financial institutional arrangements. In the production environment of China’s peasant economy, for a long time the family has been the basic unit of production and life for peasants. Rural finance therefore is characterized with peasant economy and the family. Family survival and family development are the decisive factors for peasants’ financial preferences. Peasants put survival as their first priority, followed by development. The financial demands for survival are inelastic. Even though a peasant household may be short of the ability for repayment, it has to make the credit demand its first priority. The credit costs therefore lack in elasticity. This explains for the long-term existence of usurious loans in rural communities. Therefore, to provide for suitable credit products the institutional arrangement has to be endogenous, information-symmetric, and equipped with long-lasting constraint mechanisms. Exogenous institutional arrangements have to take the form of policy-supported financial supply. Commercial forms of supply cannot work. On the precondition that survival is guaranteed, the credits for the development of production—mainly for expanded reproduction—becomes the major demands for 258

peasants. Due to their production objective for profits and risk-averse tendency, the credit costs show elasticity—here the costs include interest, time, psychological factors, and so on. Peasant households could resort to trickery in obtaining credit products. Because of the control imposed on the rural financial institution, financial products are in shortage. As a result, commercial finance becomes the best product for the adverse selection of rural finance. But this institution is not connected with an endogenous one, thus leading to high operational costs. Although the cooperative financial institution has been arranged in rural finance, it does not possess the advantage of cooperative finance as it is deprived of the endogenous attributes. For a long time, rural finance in China is inclined towards governmentsupplied institutional arrangements. The endogenous financial institution is prejudiced against and measures are taken to repress their development, resulting in a severe shortage of the endogenous institution. From the beginning, this institutional design does not take into consideration the financial preferences of peasant households, and proceeds without the active participation of peasants. It does not have an incentive mechanism concerning the financial behavior of rural households. It is not surprising that the efficiency of the institutional supply is low. Our research reveals the inherent strength of the rural cooperative financial institution, showing its numerous advantages such as information symmetry, low transaction costs, fewer opportunities for adverse selection, etc. Most importantly, its institution operation involves the direct participation of peasants and adapts to the financial preferences of rural households. It possesses incentive compatible mechanisms, and therefore is the best solution to relieve the deadlock of institutional supply in rural finance 9.1.4  The Optimal Performance of the Peasant Cooperative Financial Institutional Arrangements Lies in the Coupling of the Endogenous and Exogenous Institutions The sustainable development of rural finance is made possible only through the establishment of an institution encompassing an endogenous institution based on a rural cooperative financial institution that is compatible with the exogenous institution. In spite of the inherent advantages of educational cost in the endogenous financial institutional arrangements, the constraints of the exterior environment and the lack of commercialized credit advantages prevent its formation of larger 259

scale credits. With the elevation of productivity and the development of modern agriculture, rural households find it increasingly hard to meet their credit demands. For the reason, cooperative finance alone cannot properly handle larger loans, especially those loans to meet the larger scale credit demands of specialized production cooperatives. The exogenous financial institution finds itself in a similar situation when striving to meet the rural credit demands. Its advantages are lost burdened with high transaction costs. Commercial credits fail to function well. When specialized rural production cooperatives are set up, the new entity is not included in the credit domain of commercial finance. As the cooperatives start credit cooperation upon the basis of their production cooperation, its internal financing has in effect competed with the exogenous financial arrangements. Not only do the conflicts of the two institutions restrain them from functioning to their advantages, they also waste the resources of the existing institutions. The conflicts do not come from the institutions themselves, but from the current financial system. Since the endogenous and exogenous rural financial institutions have their advantages and disadvantages, and they could well complement each other to the advantage of the institution, we have to ask why we cannot link up the two. The case study in Fengyang County of Anhui Province gives evidence that the coupling of the two institutions allows them to contribute their strong points, and unify their interests. The joint advantages are desirable. The transaction costs are greatly reduced through the endogenous institution while the creditworthiness can be augmented through the exogenous counterpart. A scale economy of credits can also be achieved through the exogenous institution. In a word, the coupling of the two institutions will realize the goal of effective institutional operations. 9.2  Policy Orientation 9.2.1  Peasant Household Cooperative Financial Laws Must Be Formulated and Implemented In 2007, the Law Governing Specialized Peasant Cooperatives, the first law in China encouraging and permitting peasants to establish cooperative organizations, was promulgated. Regretfully, finance is not included in the regulations. Apart from production cooperation, an important cooperative content would be funding cooperation. Without funding cooperation, production cooperation cannot generate 260

the effects of economies of scale, and the willingness for undertaking expanded reproductions would be reduced. This issue has been raised and contested by many scholars in China. The fundamental problem is still the lack of confidence in peasants, and the preference of financial supervisory authorities to monopolize financial resources. Because of this fatal flaw in the cooperative law, the anticipated benefits for rural financial development have not come to pass after its promulgation. After the establishment of the cooperative organizations, the problem of fund shortage seems even more prominent, and financial issues have become an obstacle that cannot be bypassed for rural economic development. As a matter of fact, in many places peasants have initiated fund cooperative organizations in various forms. But their operational costs are still high as the government has not yet given them permissions. It is therefore crucial to issue a law specifically made to encourage, support and regulate rural cooperative finance. (1) Confirm the legitimacy of the new “1+1” cooperative financial institution. The so-called “1+1” cooperative financial system designates the founding of a credit cooperative on top of the existing specialized rural production cooperative, and the two-in-one cooperative coupling is called the “1+1” model. To be more precise, the key is for the specialized production cooperative organizations to start credit cooperative businesses, so as to facilitate an organic coupling between production and capital, to make the latter serve the former, and to expand cooperative scales and elevate production effects. This type of cooperative financial organization is different from traditional informal finance. It is not simply a financial organization, for it links the production factor with the capital factor, and avoids the risk of insolvency—the risk that has often plagued traditional informal finance. At the same time, as it sets production as its prerequisite, this type of financial organization could develop sustainably. Since the promulgation of the cooperative law in 2006, rural cooperative organizations in China have thrived, and these cooperatives mainly focus on agricultural production. However, one common problem they are confronted with is still the credit issue. With the support of the local government, the production cooperatives in Fengyang County of Anhui Province are allowed to start credit cooperation; in other words, it concerns the legitimation of the “1+1” model. Not only are the fund shortage problems greatly relieved, but it also makes possible further development of these cooperative economic organizations. These practices demonstrate the necessity to accelerate the legitimation and 261

advancement of the “1+1” model, in order to push for rural financial innovation and the sustainable development of rural economy. (2) Confirm the legitimacy of the new comprehensive cooperative financial institutions. The basic form of the “1+1” model for rural cooperative finance is to link up the rural endogenous financial institution with production cooperative organizations. This formation stands for the vitality of the rural financial institution. That is to say, the rural cooperative financial institution is the foundation for the rural financial institution, without which the exogenous and endogenous institutions of rural finance cannot co-exist with compatibility. The innovation of the rural financial institution is a system engineering project. The establishment of the rural cooperative finance cannot claim the entirety of the innovations of the rural financial institution. For the better functioning to the advantage of the institutional innovation of rural cooperative finance, comprehensive cooperative organizations must be constituted upon the foundation of the rural cooperative financial institution. The organization is established as an innovative entity combining the rural cooperative financial institution and the formal financial institution, making an institutional connection of the endogenous and exogenous financial institutions. This joint-institutional model has been experimented and proved valid in Fengyang County of Anhui Province. The elaboration of this model is the innovation of this research. From the case studies of experiments in Fengyang, it is observed that this institutional innovation is even more difficult than the institutional arrangements of rural cooperative finance. The crucial factor for this is the biased consciousness and crowding-out attitude that formal financial organizations have towards their informal counterparts. They would even blame informal financial organizations for disturbing the order of financial market. Nevertheless, through numerous negotiations and repeated games of strategy, the advantages of this institutional model were allowed to present themselves. The participating parties gained satisfactory benefits. Most importantly, both the rural cooperative finance and the participating formal financial authorities have created a new interest-discovery mechanism through cooperation. In order to more effectively push for rural financial institutional innovation, the legitimacy of the comprehensive cooperative financial organizations must be confirmed. Formal rural financial organizations such as the Agricultural Bank, rural credit unions, village-township banks, etc., should be encouraged to support and 262

work with rural credit cooperatives and the corporate champions in agricultural industries. Through diversified cooperation, they could supplement each other in their respective strengths in information and transaction costs, and form a coupling of interests. As we summarize the discoveries made through the experiments on this institutional model, we find that not only is it necessary to legitimize this institutional arrangement, but governments of all levels should promote it. In terms of the institutional change and supply form, this institutional innovation belongs to the category of exogenously imposed institutional change, which makes it different from the peasant cooperative financial system. (3) Formulate support policies. Effective policy support must be offered to rural cooperative finance and comprehensive cooperative financial institutional arrangements. These policies should be formulated in the light of related measures the government adopts to support rural credit unions, village-township banks, etc. The main contents include: ① Exemptions of tax and related levy: startup cooperative financial organizations should be exempted from administrative expenses for related authorities, such as business registration fee, barcode certification fee for the administration of quality and technology supervision, etc. ② Interest subsidies: a certain amount of interest subsidies should be given to rural cooperative financial organizations when they loan from formal financial institutions, as a way to support cooperative economic organizations in developing production and to encourage them in expanding operation scales. ③ Rewards: to encourage the sound development of rural cooperative financial organizations, the government could conduct performance reviews and give a certain reward capital for those organizations with sound development, standardized management and outstanding performance. Both the rural cooperative finance and comprehensive rural cooperative financial organizations are generated out of the needs for production development from the rural households at grassroots level. They are the most effective ways to directly support and benefit the peasants. To support the development of these financial organizations is to support the production development of peasants, to accomplish a sustainable development of rural economy, and to accomplish the mission of new rural reconstruction.


9.2.2  Cultivation and Construction of Cooperative Culture in Rural Communities The rural cooperative financial institution is in essence an endogenous institution, and whether this institutional arrangement could be successful or not depends on the cooperative attitude and behavior of participating peasants. Wen Tiejun considers it crucial to cultivate cooperative culture for the ongoing development of rural cooperative finance, and reiterates the importance of rural culture and the construction of cooperative culture in numerous essays and lectures. The cooperative culture in rural community is not a foreign product; it originates from the local rural culture which encompasses the contents of credit culture. Nevertheless, it serves only as the foundation for building cooperative finance. With the expansion of cooperative organizations and the multiplication of cooperative contents, the construction of cooperative culture becomes even more important. Cooperative finance might face a premature termination due to the lack of a sound cooperative culture, and the conflicts between a few peasants regarding cooperative issues might compromise the cooperative financial sector and result in financial risks. Local governments should cultivate and promote a good cooperative culture by encouraging and commending excellent examples of cooperative culture. Organizations violating cooperative culture should be dealt with in a timely manner, so as to create favorable conditions for the sound development of rural cooperative finance. 9.2.3  Social Insurance System for Peasants Must Be Constituted (1) Medical insurance. We have analyzed earlier the household economy and the financial behaviors of peasant households, and observed that a considerable amount of peasant households’ financial needs for consumption was used for medical expenses. According to statistics of the 2006 survey on ten thousands of rural households in Fengyang County, the households used their family saving mostly on house-building, education, medical care (providing for the elderly), purchasing agricultural materials, etc. The credits for consumption, so to speak, occupy a dominant position in a peasant household’s financial needs. Apart from the expenses on housing and education, medical care (providing for the elderly) becomes an important risk expenditure for peasant households. At present, housing issues vary with the differences of income levels. The saying, “western mansions for the wealthy, and thatched cottages for the poor” depicts the lifestyle of peasant 264

households. This is to say that housing consumption has elasticity. Regarding education, the costs have been greatly reduced ever since the state’s policy of 9-year obligatory education was put into practice. General education no longer accounts for the credit demands, while advanced education is still a saving objective for peasant households. Medical issues, on the contrary, are very complicated. In 2006, the new cooperative medical system was implemented in rural areas of China. The system did to a certain extent relieve the peasants from overly expensive medical services. However, the variety of medical services covered and the proportion of expenses that could be claimed have been far lower than the actual needs of peasants. It is still a universal phenomenon that the peasants fall into poverty or adversity because of illness. The formal financial institutional arrangements tend to restrict the credits for consumptions in medical consultation and healthcare, even though this type of expenses of rural households belongs to the category of inelastic consumption with little elasticity. It leads to the adverse selection in formal financial credits. The solution for this problem is to construct a social security system that offers all-round coverage and secondary assistance to target groups, so as to prevent the peasants from excessive saving for risk later in life and adverse selection. (2) Endowment insurance. The endowment insurances for peasant families are closely connected with medical insurances. Providing for the elderly in Chinese peasant families would be very different from what it is like in foreign countries: due to the lack of endowment insurances in rural areas, most peasant families hold expectations to “raise a son for old age” and children are relied on to provide for their aging parents. Providing for the elderly in rural families becomes a poignant issue with the implementation of the family planning policy and the flagging of the traditional ethics to care for the elderly. It has become common for peasant households to “save money for old age.” As old age is often associated with medical treatment, the production credits of peasant households would be repressed if this problem could not be effectively resolved. The credit demands for expanded reproduction would be replaced by saving for the risks in old age, which evokes the fear of seeking credit. Saving habits having been formed in Chinese rural communities from ancient times, and it has something to do with the lack of social security system in rural areas. This is contrary to the saving and consumption behavior in rural areas in European countries and the United States, where consumption has been a risk-free credit demand, due to the existence of a sound 265

social security system. Furthermore, with the elevation of social security levels, the desire to demand the dual credit for consumption and production continues to grow. Hence, the establishment of an endowment insurance system for peasant households in China will not only resolve the issues of weak credit demands in rural areas and inappropriate credit structure, but also promote sustainable rural financial development. 9.2.4  Rural Financial System Must Be Optimized and Restructured In this book, we combine studies of the current conditions and issues of rural finance with case studies and experiments, and offer a proposal to improve and restructure the rural financial system. Our concept is to take the fulfillment of the peasant household’s needs as the objective function, to take the institutional arrangement as the logical starting point, and to provide a new perspective for resource allocation in rural finance. Overall, we propose to establish a multidimensional financial system with coexisting and compatible endogenous and exogenous institutions, based on rural household cooperative finance, with mainly medium and large-sized formal financial institutions, supplemented with smallsized and diversified semi-formal financial organizations. (1) Institutionalization of peasant household cooperative finance. The legitimation of rural cooperative finance has been discussed earlier, but the institutionalization mentioned here is a different concept than that of legitimation. Legitimation means the status of cooperative finance is secured whereas institutionalization refers to the universal implementation of peasant cooperative finance in the vast rural areas, like the household contract system. Only with its institutionalization can peasant cooperative finance function well. In China’s realities, the all-round and extensive promotion of any system cannot do without governmental support; therefore, what is implied in the issue of institutionalization is also the problem of how the government promotes the institution. Our experiments in Fengyang also show that it is not sufficient for an institution from the civil society to gain recognition from the government. The government has to provide guarantee for the normalization and long-term effectiveness of the institution, so as to push for the sound development of peasant cooperative finance. (2) Commercialization of formal cooperative finance. As the formal cooperative finance in China, rural credit unions have been through numerous institutional changes, and find it hard to return to the path of cooperative finance 266

in a real sense. Scholars in China have been debating on this issue, and they cannot agree upon whether the “three-nature” (populous, democratic, flexible) cooperative finance should be rebuilt, or the institution should be optimized. We would say the current reality only permits rural credit unions to follow the path of commercialization. In their actual operation, the tendencies of the rural credit unions to move away from the agrarian sector and toward the urban sector become more and more obvious. In management, they duplicate the commercialized management model and prefer business and corporate credit clients, offering a smaller ratio of credits to the peasants. Compared with commercial banks, the previous credit advantages of rural credit unions with rural communities as their main business areas and the peasants as main clients are losing ground. The credit unions cannot be restored to the cooperative financial institution, whether in terms of its current organizational form or management system. For this reason, it is better to adopt their present path preferences and transform into commercial financial institution—in fact, many local rural credit unions have already done so. Compared with commercial agricultural banks, the commercialized rural credit unions have to hold on to their base of the vast rural areas in order to compete with various commercial financial establishments. They have to incubate new types of peasants (undertaking various farming and breeding activities of expanded scales) and support the secondary and tertiary industries in rural areas. Only by so doing can rural credit unions expand their commercial market and walk out of their dilemma of institutional changes. (3) Diversification of commercial financial organizations. In their Towards the Diversified and Competitive Rural Financial Market (2006), Zhang Xiaoshan and Hu Annai write, “Only by adopting market-oriented strategy and establishing a competitive market, can we gradually improve the operating conditions of rural finance, create good credit and institutional environments to invigorate rural finance for a benign and sound development. This way we can realistically solve the fund shortage problems plaguing agriculture and the peasants, to achieve the definitive goal of the harmonious development of social economy.” And they have given the following specific suggestions: ① Diversified financial establishments, including banks, insurance companies, surety companies, etc., should be cultivated, and based mainly on commercial finance, supplemented with appropriate policy-supported cooperative finance. ② Lower the entrance barrier for establishments and promote small-sized community financial organizations. Cultivate a competitive financial 267

market. ③ Ease the entrance requirements for financial products, and explore diversified financial products and services, etc. I cannot agree more with the above suggestions. What I would like to add and emphasize, is that we must develop peasant cooperative finance, under the circumstances of an immature market, so that the financial market will grow through the development of cooperative finance. At the same time, micro financial organizations should be encouraged and cultivated to meet the demands of the rural financial market at its initial stage. (4) The operation of policy-oriented finance should benefit the peasants. Currently the policy-oriented finance in rural China is commissioned mainly to the Agricultural Development Bank. In accordance with the central government’s requests, the Bank undertakes largely the purchase of staple foods, edible oil and cotton, and serves the corporate champions in related sectors. This policysupported banking does not have direct credit relations with peasants, and does not provide financial products to support peasant households, whether in the domain of daily life or production. It should be noted that in terms of its operation, the Bank totally relies on the support of the central government policy. In a way it has become a “cashier” of the central government’s treasury. After the complete commercialization of the staple foods, edible oil and cotton industries, the functioning of the Bank has been weakened, and is confronted with challenges for its sustainable operation. Furthermore, due to the under-development of the rural financial market and the shortage of rural credit products, the support from policy-oriented finance is in urgent need. Hence, the responsibilities of policysupported finance have to be adjusted, and its businesses expanded. In addition to investing in public goods programs such as rural infrastructure construction, the Bank should also include rural cooperative financial organizations as targets of its support, so that these organizations may grow and thrive. Only in this way can the rural financial market continue to grow, the rural production development can be promoted, and the mission of new rural reconstruction accomplished. (5) Agricultural insurance policy should be public-welfare oriented. In a broader sense, rural finance should include a variety of forms such as credit, insurance, surety, fund, etc. But the current rural financial institutional arrangement in China is incomplete, and the organizations are not well developed. The development of rural insurance particularly lags behind, causing a shortage of effective supply. These unfavorable conditions are not only disadvantageous for 268

rural economic development, but also affect directly the sound development of the rural financial market. Ever since the implementation of the household contract system in China, peasant households become all the more vulnerable to risks, under the condition of agricultural production contracted to individual households. The issues concerning agricultural security and the economy of scale in agricultural operation become increasingly pronounced. For this reason, it is important to come up with the Law Governing Agricultural Insurance and supplementary measures as soon as possible, in order to accelerate the establishment of an agricultural insurance system. We should facilitate a cooperative relationship between these insurance agents and the rural cooperative financial organizations. With this we can come to a good solution regarding the scale and effectiveness of agricultural insurance. Furthermore it will reduce the credit risks of the peasant household cooperative finance and therefore provide a strong and much needed guarantee for a sound development of rural economy.


Appendixes Appendix 1  Preliminary Statistical Results of the Survey on Fengyang County Peasants’ Needs 1. Production and Employment B02.

Where were the seeds your household used purchased? 1. County capitol  2. Township  3. In the village  7. Others Statistical result: County capitol: 14.1%   Rural township: 70.8% In the village: 14.2%    Others: 0.8%


From which shops were the seeds your household used purchased? 1. Seed companies  2. Supply/Sale cooperatives  3. Agro-technical stations 4. Private  5. Others Statistical result: Seed companies: 22.7%   Supply/Sale cooperatives: 7.9% Agro-technical stations: 29.6%  Private sources: 39.7%  Others: 0.2%


Has your household ever bought fake fertilizers, seeds or pesticides? 1. Bought fake fertilizers  2. Bought poor quality seeds  3. Bought fake pesticides  4. Bought other fake/poor quality agro-material  5. Has not Statistical result: Bought fake fertilizers: 13.8% Bought poor quality seeds: 16.9% Bought fake pesticides: 14.8%   Bought other fake/poor quality agro-material: 5.5%


How did you handle it after buying fake / poor quality agro-material? 1. Return  2. Exchange  3. Complain/Report/Go to court  4. Blame it on luck 5. Get refund from the seller Statistical result: Return: 2.1%  Exchange: 5.3%  Complain/Report/Go to court: 0.8%  Blame it on luck: 85.7%  Get refund from the seller: 6.1%


What kind of assistance do you desire from the government in this regard? 1. Improve inspection, eliminate/reduce fake/poor quality goods from the market 2. Strictly control distributors’ entrance into the agro-material sale market


3. Help peasants identify fake goods 4. Sustain justice when fake goods appear, help obtain compensation Statistical result: Improve inspection, eliminate/reduce fake/poor quality goods from the market: 58.4% Strictly control distributors’ entrance into the agro-material sale market: 8.07% Help peasants identify fake goods: 14.98% Sustain justice when fake goods appear, help obtain compensation: 11.06%

B09. Do you think in the purchase of agro-material, neighbors and relatives can be grouped to buy directly in the county or the factory? 1. Yes it can  2. No it cannot Statistical result: Can be grouped: 69.91%

B12b. Who provides you with the related technical skill? 1. County agro-technician  2. Agro-technician in rural townships 3. Village agro-technician  4. School teacher  5. Others Statistical result: County agro-technician: 19.2% Agro-technician in rural townships: 19.2% Village agro-technician: 38.5%  School teacher: 11.5% 5. Others: 11.5%

B13. In the past three years, have your household encountered any relatively major natural disasters? 1. Drought  2. Flood  3. Hail  4. Pests  5. Others Statistical result: Drought: 34.1%  Flood: 58.3%  Hail: 2.5%  Pest: 10.1% Others: 0.3%

B14. In the last two years, with regard to farming and aquaculture, were there losses made due to cost fluctuation? 1. Yes  2. No Statistical Result: There were losses made due to cost fluctuation: 56.1%

B15. In order to reduce losses made due to market risk, some people proposed the following measures. Which ones do you think are suitable to be promoted in your village? 272

1. Government to provide information on supply/sale 2. Government to help with making orders 3. Villagers to set up associations to unify purchase of agro-material and distribution of products Statistical result: Government to provide information on supply/sale: 29.9% Government to help with making orders: 26.3% Villagers to set up associations to unify purchase of agro-material and distribution of products: 37.7%


Do you think the farmland in your household needs to be adjusted? 1. Yes it does  2. No need Statistical result: It needs adjustments: 78.2%


If the village conducts land adjustment, will you support it? 1. Support  2. Not support Statistical result: Support adjustment: 85.79%

B17a. Why do you support land adjustment? 1. Land is dispersed  2. Allocation of good land and poor land is uneven 3. Others Statistical result: land is dispersed: 77.1% allocation of good and poor land is uneven: 15.6% Others: 7.2%

B18. Based on local conditions, what measures do you think the government can take to provide employment opportunities to villagers? 1. Attract merchants and investments to establish enterprises 2. Create better investment conditions to encourage private entrepreneurs 3. Provide technical training to the labor force, raise their career competence 4. Others Statistical result: Attract merchants and investments to establish enterprises: 39.3% Create better investment conditions to encourage private


entrepreneurs: 24.4% Provide technical training to the labor force, raise their career competence: 42.7% Others: 5.0%


Does your household have members who leave hometown to work? Yes  2. No Statistical Result: Household has members who leave hometown to work: 54.76%

B19b. If yes, then what difficulties they might encounter when they leave home to work? 1. Employment information  2. Lack of technical skill / technical capability 3. Delayed pay  4. No security  5. Need to return in busy farming seasons 6. Children are left home away from parents 7. Children have difficulty going to school in town  8. Others Statistical results: Employment information: 6.5% Lack of technical skill / technical capability: 36.9%  Delayed pay: 16.3% No security: 19.2%  Need to return in busy farming seasons: 21.&% Children are left home away from parents: 12.6% Children have difficulty going to school in town: 4.8% Others: 7.5% Apparent Price Increase on Agro-material in the Past Three Years 2004



Compound Fertilizer (left axis)




Carbamide (left axis)







Diesel (right axis)


II. Life C1.

The water used in the daily life of your household is 1. Tap water  2. Pressured well water  3. Public well  4. River water 5. Pond water Statistical result: Tap water: 2.77% Pressured well water: 77.56% Public-used well: 17.45%  River water: 0.6% Pond water: 1.44%


Does the drinking water have strange taste? 1. Bitter  2. Astringent  3. Salty  4. Muddy  5. No strange taste Statistical result: Bitter: 0.69%  Astringent: 8.31%  Salty: 12.13% Muddy: 7.64%  No strange taste: 69.8%

C2b. Are there people in the village suffering from various kinds of lithiasis? How many people have the disease? 1. No  2. Yes, but not many 3. Yes, around half of the families have lithiasis patients 4. Yes, most families have patients Statistical result: No: 28.38%  Yes, not many: 57.66% 3. Yes, around half of the families have lithiasis patients: 6.5%

4. Yes, most families have patients: 7.31%



What kind of fuel does your household use for cooking? 1. Wood  2. Biogas  3. Coal  4. Electricity  5. Liquified natural gas Statistical result: Wood: 82.6%  Biogas: 1.7%  Coal: 24.7% Electricity: 16.5%  Liquified natural gas: 14.5%


The toilet in your household is 1. Open air toilet  2. Open air dunghill  3. Toilet with roof  4. Flush toilet 5. Others Statistical Result: Open air toilet: 54.45%  Open air dunghill: 3.95% Toilet with roof: 40.72%  Flush toilet: 0.46%


How do members of your household bathe usually? 1. Household has shower/bathtub  2. Bathe at home with wood basin 3. Go to public bath to bathe  5. Others Statistical result: Household has shower/bathtub: 5.41% Bathe at home with wood basin: 90.48% Go to public bath to bathe: 3.29%


How is the garbage in your household disposed of? 1. Simply thrown away  2. Burnt if possible  3. Compost for land 4. The village has garbage station, with staff responsible for disposing Statistical result: Simply thrown away: 43%  Burnt if possible: 21% Compost for land: 42.5%  The village has garbage station: 3.1%

C6b. Do you think that every village should build garbage station, with dedicated staff responsible for the disposal? 1. Yes  2. No Statistical Result: Yes: 61.63%  No: 37.66%

C7. Is there an overall plan for building houses in this village? Are houses built according to the plan? 1. Yes there is a plan, houses built to plan 2. There is a plan but houses are not built to plan 3. No plan  4. Don’t know


Statistical result: No plan 66.02%

C8. Are there industries in or around the village? Is there any unfavorable impact on the living environment? 1. No industries 2. There are industries, no major impact on the living environment 3. There are industries with major impact on the living environment Statistical result: No industries:75.23% There are industries, no major impact on the living environment: 10.14% There are industries with major impact on the living environment: 14.59%


Is it convenient to buy goods for daily use? 1. Convenient  2. Not convenient Statistical result: Convenient: 79.68% Not convenient: 20.19%

III. Cultural Activities and Public Order D01.

What are your pastimes in your leisure hours? 1. Watch television  2. Play mahjong  3. Chat 4. Read newspaper/ magazines  5. Others Statistical result: Watch television: 68.1%  Play mahjong: 24.4% Chat: 30.6%  Read newspaper/ magazines: 4.1%  Others: 5.3%


What television programs do you watch most frequently? 1. TV series, movies  2. Opera  3. Variety entertainment shows  4. News 5. Sports  6. Agro-technique  7. Economic information  8. Others Statistical result: TV series, movies: 55.6%  Opera: 8.6% Variety entertainment shows: 15.8%  News: 58.2% Sports: 2.5%  Agro-technique: 7.3% Economic information: 6.7%  Others: 2.1%

D04. Is there broadcast in your village? 1. Yes  2. No


Statistical result: There is broadcast: 35.3%  No broadcast: 64.57%

D04b. What is the main content of the broadcast in your village? 1. Notice  2. News  3. Agro-technique  4. Entertainment program 5. Others Statistical result: Notice: 79.97%  News: 11.07%  Agro-technique: 3.75% Entertainment program: 1.58%  Others: 0.59%


Do you wish to have a group-based cultural life? Yes  2. No Statistical result: Wish: 78.58%  Do not wish: 21.35%

D06. Do you feel there is a need to for an art team, theatrical troupe, and film screening? 1. There is a need  2. No such need Statistical result: There is a need: 66.12%  No such need: 33.79%

D06b. If the village establishes art team and theatrical troupe, will you participate? 1. Will participate  2. Will not participate Statistical result: Will participate: 60.86%  Will not participate: 39.12%

D07. Do you feel the village needs women’s associations or seniors’ associations? 1. Yes it does  2. No need Statistical result: Yes it needs: 73.18%  No need: 26.8%

D07b. If someone organizes women’s associations or seniors’ associations, will you actively participate? 1. Will participate  2. Will not participate Statistical result: Will participate: 69.39%  Will not participate: 30.51%


D08. If someone in the village organizes a professional association or cooperative, will you participate? 1. Will participate  2. Will not participate Statistical result: Will participate: 71.17%  Will not participate: 28.6%


Are there minor theft cases in the village? 1. A lot  2. Yes, but not many  3. Occasionally  4. No  5. Others Statistical result: A lot: 16.06%  Yes, not many: 47.21% Occasionally: 23.02%  4. No: 13.49%

D11. Does this village have a joint security defense team (or similar organizations)? 1. Yes  2. No Statistical result: there is a joint security defense team: 10.73%  No: 88.61%

D12. Do the people’s militia organizations in your village have frequent activities? 1. Frequent activities  2. Infrequent activities  3. No activities in fact 4. Others Statistical result: Frequent activities: 2.84%  Infrequent activities: 25.17% No activities in fact: 69.29%

IV. Education and Medicare E3.

Are there any children of school age who have not attended schools? 1. Yes there are  2. No Statistical result: There are children of school age not attending schools: 36.75% No: 62.68%

E4. What do you understand to be the reasons for the children not attending schools? 1. Cannot afford tuition  2. Household lacks labor  3. Children not interested in learning  4. Learning not useful  5. Others


Statistical result: Cannot afford tuition: 55.1%  Household lacks labor: 11.4% Children not interested in learning: 39.6% Learning not useful: 2.8%


Are there children in the village slacking in school because of internet? 1. Yes  5. No  7. Don’t know Statistical result: Yes: 36.4%    No: 44.59%    Don’t know: 18.93%


Did you join the new cooperative medical care program or not? 1. Yes  5. No, did not join Statistical result: Yes: 87.05%    No: 12.92%

E8. What problems shown below do you think are found in the new cooperative medical care program? 1. Advertising not in place  2. Claiming procedure complicated  3. Threshold too high  4. Difficult to change hospitals  5. No regulated prescription in hospitals  6. Price of medication high in hospitals  7. Others Statistical result: Advertising not in place: 12.41% Claiming procedure complicated: 50.74% Threshold too high: 38.82% Difficult to change hospitals: 9.84% No regulated prescription in hospitals: 17.83% Price of drugs high in hospitals: 43.42% Others: 7.41%

V. Rural Finance F1.

Where is the savings in your household deposited? 1. Post Office  2. Credit Union  3. Bank of Agriculture  4. At home 5. No savings  6. Others Statistical result: Post Office: 2.11%  Credit Union: 25.72% Bank of Agriculture: 6.2%   At home: 5.96% No savings: 59.7%  Others: 0.08%


Why do you deposit the money there? 1. Safety 2. Convenience  3. High interest  4. Good service  5. Others


Statistical result: Post Office: Safe: 54.2%  Convenient: 49.5% High interest: 2.8%  Good service 1.9%  Others: 2.8% Credit union: Safe: 70.8%  Convenient: 43.7% High interest: 0.5%  Good service 1.9%  Others: 0.6% Bank of Agriculture: Safe: 67.8%  Convenient: 47.1% High interest: 1.0%  Good service 4.1%  Others:2.2% At home: Safe: 20.2%  Convenient: 59.3% High interest: 0.3%  Others: 7.9%

F3. What do you do when you are in need of money? What channels are there for borrowing? What is the priority? 1. Bank / credit union loans  2. Borrow from relatives and friends 3. Personal loan  4. Pawn shop  5. Others Statistical result: Bank/credit union loans: 19.38% Borrow from relatives and friends: 69.94%  Personal loan: 10.08% Pawn shop: 0.41%


Have you ever borrowed from usury? 1. Yes

2. No

Statistical result: Have borrowed from usury: 20.88%  No: 78.95%

F7. If the rural households in the village put their money together to form a mutual-aid financial organization to satisfy funding demands, are you willing to do this? 1. Willing  2. Not willing  3. Have to wait and see  4. Others 5. Don’t know Statistical result: Willing: 38.03%  Not willing: 37.56% Have to wait and see: 15.49%  Don’t know: 8.18%


What can be done if some rural households do not repay? 1. Get the guarantor  2. Find a revered person to arbitrate  3. Go to court 4. Take their belongings as compensation  5. Others 6. Don’t know Statistical result: Get the guarantor: 37.0% Find a revered person to arbitrate: 17.6% Go to court: 14.4%  Take their belongings as compensation 4.9%


Others: 8.5%  Don’t know: 17.6%

VI. Peasants’ Investment Willingness G1.

Is it necessary to build roads locally? 1. Very necessary  2. Necessary  3. Not too necessary  4. Not necessary 5. Can’t say Statistical result: Very necessary: 48.87%  Necessary: 46.79% Not too necessary: 2.16%  Not necessary: 1.43% Can’t say: 0.6%


Is it necessary to drill wells locally? 1. Very necessary  2. Necessary  3. Not too necessary  4. Not necessary 5. Can’t say Statistical result: Very necessary: 11.66%  Necessary: 44.22% Not too necessary: 21.32%  Not necessary: 21.44% Can’t say: 1.04%


Is it necessary to build drainage locally? 1. Very necessary  2. Necessary  3. Not too necessary  4. Not necessary 5. Can’t say Statistical result: Very necessary: 18.75%  Necessary: 53.5% Not too necessary: 13.29%  Not necessary: 11.87% Can’t say: 1.89%


Is it necessary to build biogas pool locally? 1. Very necessary  2. Necessary  3. Not too necessar  4. Not necessary 5. Can’t say Statistical result: Very necessary: 9.04%  Necessary: 34.91% Not too necessary: 27.76%  Not necessary: 23.94% Can’t say: 3.56%


Is it necessary to change the water supply locally? 1. Very necessary  2. Necessary  3. Not too necessary  4. Not necessary 5. Can’t say


Statistical result: Very necessary: 15.8%  Necessary: 45.54% Not too necessary: 18.23%  Not necessary: 17.58% Can’t say: 2.14%


Is it necessary to upgrade the toilets locally? 1. Very necessary  2. Necessary  3. Not too necessary  4. Not necessary 5. Can’t say Statistical result: Very necessary: 15.63%  Necessary: 47.4% Not too necessary: 17.99%  Not necessary: 15.93% Can’t say: 2.15%

VII. Democratic Management H01.

Have you participated in the election of village cadres? 1. Participated  2. Not participated Statistical result: Participated in village election: 59.74% Have not participated: 40.2%

H02. Were there other people present when you fill in the ballot? 1. Yes  5. No Statistical result: Someone present: 36.43%

No one present: 63.3%

H03. Did other people know whom you picked? 1. Yes  2. No Statistical result: Yes: 29.36%  No one knew: 70.31%


Was the election results announced on the spot? 1. Yes  2. No Statistical result: Yes: 67.53%  No: 32.1%


The supervision condition when ballots were read out? 1. Supervised by villagers’ representatives 2. Supervised by party member representatives 3. Supervised by senior leaders  4. Not supervised  5. Others


Statistical result: Supervised by villagers’ representatives: 47.3% Supervised by party member representatives: 21.0%  Supervised by senior leaders: 27.3% Not supervised: 11.0%  Others: 6.8%

H06. What are the channels through which you know about financial conditions of the village? 1. Village affairs notice board in the village 2. Announcement in villagers’ general assembly 3. Presented by village cadres from door to door  4. No knowledge  5. Others Statistical results: Village affairs notice board in the village: 19.8% Announcement in villagers’  general assembly: 2.0% Presented by village cadres from door to door: 1.2% No knowledge: 74.9%  Others: 2.1%

H07: If you want to know the situation of revenue and expenditure of a certain funds in the village, can you go and check the original documents? 1. Can  2. Cannot  3. Have not tried  4. No concern  5. Others Statistical result: Can: 9.27%  Cannot: 31.54%  Have not tried: 37.68% No concern: 21.1%

H09. If people in the village have opinions on village management what can be done? 1. Seek out the village cadre and speak directly 2. Reflect to rural township government 3. Reflect to county government 4. Reflect to provincial government 5. Call villagers’ general assembly 6. Reflect directly to central government through petition  7. Others Statistical result: Seek out the village cadre and speak directly: 36.7% Reflect to rural township government: 18.7% Reflect to county government: 9.0% Reflect to provincial government : 1.6% Call villagers’ general assembly: 2.8% Reflect directly to central government through petition: 1.3% Others: 29.9%


H11. How do you do a good job as village cadre? 1. Frequently call villagers’ general assembly to hear opinions from the villagers 2. Establish good relation with the rural township  3. Initiate wealth creation 4. Others Statistical result: Frequently call villagers’ general assembly to hear opinions from the villagers: 49.8% Establish good relation with the rural township: 14.0% Initiate wealth creation: 46.9%


Do you know the benchmarks for dissemination? 1. Yes  2. No  3. Others Statistical result: Yes: 18.04%  No: 81.47%

H15. How are the programs such as building roads and drainage for the village determined? 1. Villagers discussed together  2. Party members discussed and decided 3. Cadres decided on their own  4. Others  5. Don’t know Statistical result: Villagers discuss together: 30.49% Party members discuss and decide: 5.54% Cadres decide on their own: 38.33%  Don’t know: 22.97%

H16. Does anyone ask for your opinion for village affairs such as building roads and drainage? 1. Village cadre will ask  2. No one asks  3. Never pay attention  4. Others Statistical result: Village cadre will ask: 30.94%  No one asks: 54.64% Never pay attention: 12.79%

VIII. Village Culture K06.

Is there anyone not supporting their elderly in this village? Yes, very common  2. Yes, but not many  3. No  4. Don’t know Statistical result: Yes, very common: 2.91%  Yes, not many: 38.97%  No: 48.77%

K08. You consider banquets and giving presents among relatives and friends for weddings and funerals: 285

1. A necessary courtesy of giving and receiving 2. Everyone does it, so cannot do otherwise and must follow the trend 3. Absolutely unnecessary, a pure waste 4. Okay to have but should not be too lavish  5. Cannot say  6. Others Statistical result: A necessary courtesy of giving and receiving: 32.9% Everyone does it, so cannot do and must follow the trend: 43.6% Absolutely unnecessary, a pure waste: 7.9% Okay to have but should not be too lavish: 10.6% Cannot say: 3.8%


What do you think of the custom of burial? 1. Follow the local custom  2. Waste of farmland, but no need to reform 3. Should reform  4. Absolutely justified and should be the way 5. Can’t say Statistical result: Follow the local custom: 37.0% Waste of farmland, but no need to reform: 9.7% Should reform: 10.0% Absolutely justified and should be the way: 20.4% Can’t say: 10.5%

K11: What is the situation of the “five basic support” households in your village? 1. Self-labor, self-supporting  2. Supported in relatives’ households 3. Senior homes in the village  4. Others  5. Not clear Statistical result: Self-labor, self-supporting: 39.3% Supported in relatives’ households: 4.5% Senior homes in the village: 12.2% Others: 17.4%  Not clear: 15.5%


What do you find to be most unsatisfactory in your village? 1. Dirty and unorganized  2. Poor public order  3. Poverty 4. Roads not good  5. No collective life  6. Others Statistical result: Dirty and unorganized: 23% Poor law and order: 15% Poverty: 34%  Roads not good: 55%  No collective life: 4% Others: 8%


Appendix 2  Fengyang County Peasant Credit Cooperative Pilot Experiment Proposal and Management Measures Fengyang Country Peasant Credit Cooperative Pilot Experiment Proposal This program is formulated to actively explore and resolve the problem of fund supply bottleneck during the process of the rural socio-economic development, accelerate the pace in the new rural reconstruction, strengthen peasants’ capability of self-service, self-management and self-development, and facilitate the increase in agricultural production and peasant income, in accordance with the central government’s Document No. 1 in 2008 as well as the spirit of the provincial party committee and provincial government’s document Viewpoints Regarding the Thorough Implementation of Scientific Concept of Development in Facilitating Good and Fast Development of County Economy (Anhui Issued [2008] No. 9 ), incorporating the reality of our county. I. Amply Recognizing the Significant Meaning of Pushing Forward the Tasks of the Peasant Credit Cooperative Pilot Experiments In the thirty years since the Reform, the socio-economic development in rural areas has achieved an earth-shattering transformation. However, during the development process, the problems of inadequate fund, technical skill, human resource and management and so on have never been effectively resolved. In particular, inadequate funds and insufficient investment have become the main constraining bottleneck in rural socio- economic development. The central government’s Document No. 1 in 2008 clearly pointed out: there is a need to actively develop specialized peasant cooperatives, accelerate reform and innovation of the rural financial system, actively cultivate micro credit organizations, and introduce all kinds of financial institutions to operate in rural areas. The provincial party committee’s Document No. 9 also requested active exploration on developing micro credit organizations and rural mutual-aid funding organizations. As the birthplace of rural reform, our county as the point to launch the peasant credit cooperative pilot experiments, will not only innovate rural finance, activate capital 287

in the private sector, resolve the problem of inadequate fund supply during the rural socio-economic development, but will also have special meaning in raising the peasants’ sense of cooperative, sense of credit and sense of collectivity, strengthening their capability of self-development, self- enrichment in building the new rural areas. All rural townships and relating county-direct units should give the experiments high level attention, promote the spirit of “all-round production task responsibility,” seriously organize and implement, fully support the establishment and development of the peasant credit cooperatives. II. Task Objectives Through the establishment of the peasant credit cooperatives, the share capital of members is absorbed, surplus and deficiency of funds among members are regulated, fund investments in agriculture are increased, contradictions arising from tight supply of funds for rural production is relieved, and services for agricultural industries are provided. 1. Direction of development: upholding the peasant as the principal subject, achieve a populous nature of organization, democratic nature of governance, and flexible nature of operation. 2. Principle of the cooperatives: upholding government guidance; upholding operation and management by the people, for the utility and benefit of the people; upholding the villages or members within cooperatives as the domain of activities; upholding voluntary membership into the cooperative, freedom to withdraw from the cooperative, self-democratic management and self-risk control. 3. Cooperative guidelines and fund management approach: to be formulated by the general assembly based on state policies and legal regulations. III. Source of Funds, Terms for Pilot Experiments and Task Steps 1. Source of Funds i. Share capital of cooperative members ( on principle the share capital for members of the peasant credit cooperative should be no less than 100 RMB per share, each member shall deposit no less 288

than 3 shares. Concrete terms to be determined by the guidelines adopted in the general assembly of members); ii. Funds loaned by the financial sector; iii. Idle funds deposited by cooperative members; iv. Funds donated and contributed by various people in the society; v. Common accumulations; vi. Members may use housing of small property rights and rural land contract operation rights to obtain share financing; vii. Members may use other legal properties as mortgage to obtain share financing. 2. Terms for Pilot Experiments i. Cooperatives that are already established; ii. Number of people entering should be more than 10; iii. The elected cooperative president should be upright in dealings, happy to contribute, trusted by the people, willing to undertake tasks for the people, having a certain degree of integrity and management capability. On the basis of the above terms, all rural townships should, in accordance with local conditions in establishing cooperatives as well as characteristics of local industries, launch the task on peasant credit cooperatives pilot experiments. Each rural township should task out at least two pilot experiments. After the experiments have succeeded, their experience shall be summarized and a comprehensive promotion shall be carried out. 3. Task Steps Stage one: on the basis of in-depth survey and research, as well as comprehensive understanding of local conditions among the villages and peasants, pilot experiment villages or cooperatives are confirmed. All kinds of measures to publicize and promote the significant launching of the pilot experiments for peasant credit cooperatives shall be optimized. The awareness among peasants shall be raised and a positive view regarding joining the cooperatives initiated. An operating model In line with practicality for the pilot experiments shall be set up. Stage two: Provide business operation training to cooperative members in pilot 289

experiment villages, teams or cooperatives. Confirm the initiator and share capital, call members’ general assembly to pass the guidelines and important regulations, elect the boards of directors and supervisors, announce the operation model for the peasant credit cooperatives, register, and confirm office location. Stage three: Receive share capital from cooperative members and operation starts officially. IV. Set up Safeguarding Mechanism 1. Setting up organization, strengthen leadership. The county will set up a task force for the peasant credit cooperative pilot experiment program. The chief leader of the county party committee and county government shall be the director. The leader of the county government branch management shall be the deputy director. The respective key persons of the county party committee office, county government office, financial bureau, agricultural party committee, audit bureau, civil affairs bureau, industry and commerce administration, development and reform commission, county branch of the People’s Bank and other related authorities shall be members. The task force shall set up an office located in the county agricultural committee, to be responsible for actual management of day to day tasks. At the same time, personnel from the task force member units are selected to establish an assessment task force, responsible for performing regular assessment and oversight on the operation of funds for the pilot experiment units. The respective rural township should handle the task of pilot experiments with high priority, and should set up organizations, appoint dedicated personnel responsible for executing tasks for the pilot experiments. 2. Policy Support, orderly progress. First, exempt peasant credit cooperatives from taxation. Second, allow peasant credit cooperatives to self-determine the rate to be charged on use of funds, to the extent permitted by state financial policy regulations. Third, the financial sector shall grant credit affirmation to peasant credit cooperatives assessed as operating well. Fourth, peasant credit cooperatives shall be allowed to stand surety to cooperative members and demand financing services on behalf of cooperative members from financial institutions. Fifth, permit members to use registered housing of small property rights and land contract operation rights to subscribe for 290

shares or to obtain financing from financial institutions as share funds for joining the cooperatives. Sixth, civil affairs as well as industry and commerce authorities should simplify procedures, and handle registration of the cooperatives on a timely basis. Seventh, financial institutions should open accounts for the peasant credit cooperatives, and provide them with corresponding loan support. Eighth, county finance should give each peasant credit cooperative pilot experiment a subsidy of 3,000 RMB. Ninth, permit and encourage funds from other sectors of the society to support development of the peasant credit cooperatives. 3. Perfect system, standardize management. The Peasant credit cooperative pilot experiment is a new task. Respective rural townships and related authorities should strengthen the efforts on promotion, advice and training. On the basis of upholding adequate respect to peasants’ preferences, peasant credit cooperatives should be assisted to design fund management measures, perfect various regulating systems, in order to safeguard the sound development of peasant credit cooperatives, the safe operation of cooperative funds, and their optimal efficacy. 4. Audit and assessment, reward merit and penalize poor performance. The county task force shall on a timely basis perform monitoring and inspection on the respective rural townships’ peasant credit pilot experiments, perform audit and assessment on the cooperatives based on synthesizing benchmarks of various regulation systems, safety of fund, turnover rate, profit rate, community effectiveness and so on, to uncover and resolve problems that appear in the experiments on a timely basis. For those cooperatives and pilot experiment townships that have better fund operations and obvious fund growth, the county party committee and county government shall commend with proclamation, adopting the “award for compensation” way as reward. For financial institutions that assist the development of peasant credit cooperatives as well as provide loan support, the county financial authorities shall provide them with subsidized interest (the concrete measures for subsidizing interest will be established separately) as well as allocating rewards based on result of their loan business. Those with ill management in which funds are not utilized to efficacy shall be reprimanded and given a deadline for rectification. Those found to have violated against regulations and codes shall be prosecuted pursuant to law, as well as banned from operation. 291

Fengyang County Peasant Credit Cooperative Management Measures (Provisional) Chapter One General Provisions Article 1    To strengthen oversight and management of the peasant credit cooperatives, standardize their organization and actions, safeguard the legal, stable and safe operation of the cooperatives, in accordance with the CPC Central Committee (2008) Document No. 1, the Law on Specialized Peasant Cooperatives and related regulations, the measures are specifically formulated. Article 2    Peasant credit cooperatives fulfill requirements specified in the Law on Specialized Peasant Cooperatives regarding establishment and guidelines. In addition it clearly conveys: the powers of the members’ general assembly, members’ right and obligations, responsibilities of the chief director and chief supervisor, measures for share deposit and loan obtainment, financial accounting system and so on. Article 3    Peasant credit cooperatives shall uphold security, service to the people, convenience, voluntary membership, freedom to withdraw, principles of democratic management, democratic supervision, risk control and so on. Article 4    In order to safeguard the legal and normal operations of the peasant credit cooperatives, the cooperatives have to register with the industrial and commerce or civil affairs authorities. Number of enrolled members should be no less than ten. Registered funds will be paid-in capital. Total share capital should be no less than 30,000 RMB. Article 5    The peasant credit cooperatives’ launch of operational activities in accordance with the law is protected by law. No units or individuals can interfere. They enjoy the right of sharing, using, profiting and handling the legal entity asset made up from members’ share funds, accumulations and other assets legally obtained. Article 6    Peasant credit cooperative members’ shared funds come from legal sources and shall pay shared capital in accordance with the Fengyang County Peasant Credit Cooperative Pilot Experiment Proposal. Chapter Two Management of Share Right Article 7    Members of the peasant credit cooperatives should comply with the following conditions: 292

i. ii. iii.

Possess complete capability on civil actions; Share funds are self-owned funds coming from legal sources. Honest and trustworthy, with good reputation;

Article 8    Share funds of members of the peasant credit cooperatives shall mainly be paid in cash. The number of shares held shall not be restricted. Share in the form of legal assets or other means shall be respectively determined by members’ general assembly. Peasant credit cooperatives should present members with share certificates in their names, as proof of shareholding by the members. Article 9    Members of peasant credit cooperative attending the general assembly shall, in deciding major items by vote, practice the system of one person one vote. The voted decision shall not be constrained by the share fund amount held by a member. Article 10    Members may personally use share funds in the cooperative to stand surety to other members. The amount of the given surety should not exceed the amount of the cooperative share funds held. Cooperative members who stand surety for other members and whose surety amount reaches that of share funds held cannot demand loans from the cooperative unless the loans they stand stands surety for are paid back. They may demand other members who have not demand loans or stand surety for other members to give surety for their loan demands. Article 11    The share funds and accumulations of the peasant credit cooperative can be transferred, inherited and given as gift. However, the shared funds and accumulations held by the directors and supervisors cannot be transferred or given as gift during their tenure. Article 12    With simultaneous fulfillment of the following terms, the member can apply to disinvest.

i. The member should have invested for over a year when submitting application to disinvest; ii. In case the peasant credit cooperative suffers a loss in the year, the disinvestment will be based on current value; in case of profit, it will be redeemed based on initially invested share fund plus proportionate share of surplus. 293

Article 13    Upon termination of membership, the peasant credit cooperative should, in accordance with the method, time frame and procedure set out in the guidelines, return the member’s share capital and share accumulation on a timely basis. Contracts signed by the member with the peasant credit cooperative before termination of membership shall be honored. In the year of membership termination, the member shall not enjoy sharing of surplus for the year. Chapter Three Management of Credit Article 14    Peasant credit cooperatives shall deposit funds into the Limin Bank and rural credit unions, to serve as guaranteed capital. The Limin Bank and rural credit unions shall take the share capital of the peasant credit cooperative and grant credit facility, guarantee as well as loan. At the same time, the Bank and rural credit unions can authorize the cooperative to perform lending to members. Article 15    Loan and deposit service: are provided only to members who join the cooperative. Loans and deposits with non-members are strictly forbidden. Article 16   Peasant credit cooperatives should strictly perform risk control on loans.

i. Longest term for loan is one year; ii. Amount of loan to a member should in general not exceed the share fund invested personally by the member. Where it exceeds the member’s invested share fund, joint- guarantee should be practiced. The amount of joint-guaranteed loan should not exceed the total invested share funds of the joint-guarantee members. iii. Capital adequacy ratio should not be lower than 8%.

Article 17    Members applying for loans should adhere to an appointment process, completing a loan application form to include the borrower’s basic circumstances, usage of loan, amount, term, guarantee situation and so on. Article 18    The board of directors should, based on the member’s application, set up a 3-person credit assessment team, to perform credit assessment and audit on the member’s credit history, guarantee history, repayment situation of personal loan and credit situation of the guarantor. 294

Article 19    Members fulfilling the following conditions simultaneously can demand unsecured loans.

i. Amount of loan should not exceed personal share fund and guarantors’ share fund; ii. No unfavorable loan history with the cooperative; iii. No unfavorable credit assessment history; iv. No unfavorable history of loan guarantee; v. The guarantor personally does not have loans and has not stand surety for other members.

Article 20    Where loan amount does not exceed the member’s share fund, the loan procedures will be handled by the business officer, and reported to the chief director for audit and approval. Where loan amount exceeds the member’s share fund, the board of directors shall collectively consider and decide. Article 21    The board of directors shall be responsible for organizing loan monitoring. In principle loan monitoring should take place simultaneously. Where it cannot be conducted simultaneously, it should come out with an opinion within three days. Article 22    Interest rates on loans and deposits as well as interest rate adjustments will float within the interest rate scope stipulated by state policy. The board of directors shall formulate the concrete floating measures. After this is approved by the general assembly, the board of directors should strictly adhere to it during loan and deposit processes. Article 23    Upon loan maturity and where it fulfills the terms for extension, the procedure for extension should be handled on a timely basis. The maximum extension should not be more than half a year. Article 24    Where loans are overdue, the business officer and guarantor shall be responsible for collection. For those who maliciously refuse repayment upon maturity, the guarantor shall take on the related responsibility, and where necessary take legal actions.


Chapter 4  Monitoring and Management Article 25    The peasant credit cooperative shall adopt the State’s financial system and accounting standard under the guidance of supervisory authorities, in accordance with the Fengyang County Peasant credit Cooperative Accounting Standard, and design the accounting subject and conduct accounting review. Article 26    The peasant credit cooperative shall practice internal audit and monitoring. The board of directors shall be responsible for conducting internal audit for the cooperative, and shall conduct specialized audits and termination audit on the chief director. Audit result should be reported to the general assembly. The general assembly may also engage an intermediary institution to conduct audit on the cooperative. Article 27    The Peasant credit cooperative should conduct annual inspection in accordance with regulations, and accept the community’s monitoring and oversight. Article 28    The following affairs of the peasant credit cooperative should be disclosed to members. The contents to be disclosed are: members’ share funds, loans, investments, financing, profits and other items that members considered necessary to disclose. Article 29    The monitoring and management institution shall, based on situations of the peasant credit cooperative’s share funds, loans, investment, financing and profit, adopt different monitory measures, to be separately stipulated by the monitoring institution. Article 30    Where the peasant credit cooperative violates relevant laws and legal regulations, the monitoring institution should reprimand and demand rectification. For actions of directors and staff that violate laws and regulations, the monitoring institution may demand the peasant credit cooperative to take disciplinary actions. Where it constitutes a criminal case, it shall be transferred to the judiciary authorities to pursue legal responsibility pursuant to law. Chapter 5  Merger, Split, Dissolution and Liquidation Article 31    Where peasant credit cooperatives merge, split or dissolve, it should be reported to the office of the county peasant credit cooperative task force 296

to inspect and confirm. Article 32    Merger of peasant credit cooperatives should be announced to debtors within ten days of the merger resolution. The loans and debt obligations of the merged parties should continue as is after the merger, or should be taken on by the newly established institution. Article 33    For the split of peasant credit cooperatives, the asset should be divided accordingly, and should be announced to debtors within ten days of the split resolution. The debt obligation and related responsibility before the split should be taken on by the institutions after the split. Exceptions are where a written agreement with separate provision has been reached on repayment of debt obligations with the debtor before the split. Article 34    Where peasant credit cooperatives are dissolved due to the following reasons:

i. ii. iii. iv.

Events occur that require dissolution as stipulated in the guidelines; Resolution made by the general assembly to dissolve; Merger or split requiring dissolution; Suspension or revoking of operating license by law.

Within 15    days of the occurrence of the dissolution event, the general assembly shall appoint members to form a liquidation team and start dissolution liquidation. Where a liquidation team cannot be formed within the appointed date, members and debtors may apply to the people’s court to conduct liquidation. Article 35    The liquidation team will take over management of the peasant credit cooperative from the day that it is formed, and will be authorized by the general assembly to be responsible for handling liquidation related unfinished business, clearing debt obligations, allocating remaining asset after debt clearance, representing the peasant credit cooperative to participate in legal suits, arbitration or other legal matters. Article 36    Peasant credit cooperatives that terminate due to dissolution or license withdrawal should de-register with authorities of industry and commerce as well as civil affairs on a timely basis, and make announcement on such.


Chapter six    Supplementary Regulations Article 37    Monitoring institution: Fengyang County Agricultural Committee. Article 38    The County Agricultural Committee shall be responsible for interpretation of the measures. Article 39    The measures shall be implemented from the date of release. July 18th, 2008


Appendix 3  Fengyang County Federation of Peasant Credit Cooperatives Set-up Proposal, Guidelines and Organization Structure Layout Fengyang County Federation of Peasant Credit Cooperatives Set-up Proposal 1. Guiding Concepts on Setting up the Federation To seriously and thoroughly implement the core thoughts of the 17th CPC Central Committee’s the Third Plenary Session of as well as the spirit of the September 30th speech by Party Secretary Hu Jintao on his inspection trip to Xiaogang Village of Fengyang County. To implement the scientific concept of development and continuously deepen integrated rural reform and innovation, develop peasant credit cooperatives into organizations with adequate capital, safe operation, shared information, well functioning and flawless service. To raise the organizing extent of our county’s peasants, and the community service capability of peasant credit cooperatives on all fronts. To facilitate peasants’ participation on all-fronts in market competition, the ability to adapt to development of socialist market economy. To facilitate a good and fast socialist new rural reconstruction in our county. 2. The Set-up Model and Operation Principles of the Federation i. The federation is made up of all members (suggested name list attached). The general assembly holds the highest powers of the federation. ii. The federation shall adopt membership system, made up of legal persons of peasant credit cooperatives willing to join, legal persons of leading agro-industrial enterprises in the provincial and city levels of our county, as well as legal persons of county-direct units relevant to agriculture. iii. Voluntary participation, freedom to withdraw. The withdrawal of membership shall be handled in accordance with procedures stipulated in the guidelines. iv. Democratic decision-making, democratic management. Members participating in the general assembly enjoy the right to vote, right 299

to elect and right to be elected. The system of “one person one vote” shall be adopted. v. Self-serve, self-manage. There is no subordination relationship between the federation and the peasant credit cooperatives or the enterprise (company) members. The peasant credit cooperatives and the enterprises (company) are still legal entity institutions with autonomous operations, self-service and self-manage. The federation shall not interfere with member units’ operations and their own management activities. vi. Economic participation, share of profit and shared responsibility of risk. Members pay membership fees and risk premiums in accordance with the measures as stipulated in the guidelines. vii. The federation’s general assembly sets a number of honorary presidents, to be taken on by country leaders. viii. The federation sets a board of directors, accountable to the general assembly, to be made up of 26 people: 1 president, 3 vice presidents, 22 executive directors. The term of service is 5 years; re-election for another term is possible. Functions and powers of the board is stipulated in the guidelines. The board of directors shall set up a secretariat with a chief secretary to manage daily tasks. ix. The board of supervisors is the supervising entity of the federation, to be formed by 5 people: 1 chief supervisor, 1 deputy chief supervisor 1, 3 supervisors. Functions and powers of the board is stipulated in the guidelines. 3. Fund Raising for the Federation i. The federation takes membership fees and risk guarantee fund for payment and collection of funds. Each member pays an annual fee of 1,000 RMB to be used on operation expenses. Each member pays risk guarantee expenses of 2,000 RMB, to be used on members’ own loan guarantee and operation risk fund. The risk guarantee fund belongs to fund-paying members. In situations where loan guarantees or operation risks are not involved, the federation cannot use the funds. 300

ii. Finance to support the fund, mostly to provide loan guarantee to the credit cooperatives. iii. Accept donations from third parties, allocate in accordance to agreements with donors. 4. Main Functions of the Federation Provide services such as information, loan service, business training, operation, management and arbitration in accordance with the law. Concrete provisions are as follow: i. Information service. Through many different means, from time to time the federation provides information to members on production, technical skill, market, information on agricultural products, presentation and sale fairs, enquiry service and information exchange. The federation facilitates the implementation among member units of common sharing of information and cooperative development. ii. Loan service. First, in accordance with self-regulation agreement in the industry, the federation helps the credit cooperatives adjust their funds; second, the supporting fund of the financial sector provides loan guarantee to members; third, the federation organizes the credit cooperatives to conduct credit assessment on members, coordinates with the financial sector to conduct credit assessment on the credit cooperatives. iii. Business training. The federation organizes members to participate in technical skill and career trainings, enhances the development of production, and strengthens economic capability and management level. iv. Service operation. The federation coordinates the cooperative relationship among members, implements mutual complementing of resources. The federation organizes members to purchase required production material and agro-products based on supply/ demand of the market. The federation organizes implementation of agricultural projects and promotion of new techniques and new species, conducts technical exchange services, directs various member units to raise fund usage effectiveness, increases accumulation and guards against risk. 301

v. Manage and coordinate services. Based on resolutions in general assembly, the board of directors shall execute control over financial conditions of the credit cooperatives, the dissemination and usage of loans and so on, as well as formulate industry self-disciplinary agreement to ensure the sound operation. 5. Design and Function of the Federation The board of directors shall set up 5 departments and their functions are as follows (provisional): i. Secretariat: authorized by the president to take charge of daily tasks. ii. Information and training service department: through many different means, the department provides from time to time information to members on production, skills, market, and agricultural project information. It organizes members to participate in skill and management trainings, and raises the level of production development and operation management. iii. Project service department: the department organizes the implementation of agricultural projects and project assessment. It organizes members to purchase market required production material and agricultural products and implements of agriculture by order. It organizes the implementation of the introduction and promotion of new technical skills and new species and conduct services on technical skill exchanges. iv. Financial service department: first, in accordance with selfregulation agreement, the department assists the credit cooperatives to adjust funds; second, to provide project loan guarantee service to members; third, to organize various credit cooperatives to assess the credit of their members, and to coordinate with the financial sector to assess credit of the credit cooperatives. v. Management and coordination service department: in accordance with the general assembly’s resolutions, the board of supervisors executes the supervision over financial conditions as well as dissemination and usage of loans in the credit cooperatives. The department coordinates with various member units to formulate industry self-disciplinary agreements, directs various member units 302

to raise the effectiveness of fund usage, increases accumulation, safeguards against risk and ensures sound operation. 6. Proposed Support Polices for the Federation First, exempt the federation from taxation. Second, allow the federation to determine autonomously the rate to be charged on use of funds, to the extent as permitted by the state’s financial policy regulations. Third, allow the federation to give guarantee to members, in order to provide guarantee service to their members for financing. Fourth, related authorities should simplify procedures and handle the registration of the federation on a timely basis. Fifth, financial institutions should open accounts for the federation, and provide it with corresponding loan support. Sixth, the loans from financial institutions to various peasant credit cooperatives and the federation shall be guaranteed by the county surety companies. The country government shall grant a corresponding reward to the financial institutions in accordance with the loan amount. 7. Execution Steps i. Initiate campaign; members complete registration forms. ii. Draft and revise the federation guidelines to be passed in the general assembly. iii. Complete necessary registration procedures at the civil affairs bureau. iv. Confirm location of the federation office v. Convene the federation inauguration meeting, pass the guidelines, elect the board of directors, chief director, board of supervisors, chief supervisor, secretary-general and so on. vi. The federation begins to operate. The Guidelines of the Fengyang County Federation of Peasant Credit Cooperatives Chapter I  General Provisions Article 1    To safeguard the legal rights of members, increase the income of members, facilitate development of this federation, the guidelines are formulated in accordance with the Law on Specialized Peasant Cooperatives of the People’s Republic of China, Provisional Regulations on the Management of Peasant Credit 303

Cooperatives and related laws, regulations and policies. Article 2    This federation was initiated by various peasant credit cooperatives and related legal person institutions, with inauguration meeting convened on _______________________. Name of the federation: _____________________ Cooperative Federation, Total Fund Capital of Members _____________ RMB, of which: Legal Representative of the Federation: Location of the Association: Postal Code: Article 3    The federation’s mission is to serve the members, to pursue common interest of all members with voluntary membership, freedom to withdraw, democratic decision-making and democratic management. Self-operation, selfmanagement, economic participation, sharing of benefit and joint responsibility for risk are practiced. Surplus is returned in accordance with proportion of contribution. Article 4    The federation’s service targets are chiefly its members. It aims to provide members with services, in accordance with law, on purchase of agricultural production material, sale and processing of agricultural products, transportation, as well as relevant skills, information and credit. The main business scope is as follow: i. Provide information services and realize the sharing of information. Coordinate the cooperative relationship among members. Through varied forms and flexible timing, provide members with information on production, skill and market, as well as enquiry and business service. Organize agricultural product fairs, sale shows and press releases. Work on agricultural product recommendations, launch marketing campaign services, and facilitate common development among mutual cooperatives with dedication. ii. Launch credit service and build risk compensation mechanism. First, regulate the fund surplus and deficit among the cooperatives, and handle agency business as well as clearing business. Second, negotiate with financial institutions to obtain capital financing from financial institutions of the banking industry, in order to provide support on credits to peasant credit cooperatives. Third, provide 304

loan guarantee to peasant credit cooperatives through the surety companies of the federation. iii. Provide business training and organize members to participate in skill and job training. Raise the standard on production development, economic capability and management. iv. Organize purchasing and supply production material required by members. Organize sale of products produced by members. Initiate and develop services required by members on logistics, processing, packaging and so on. Introduce new skills and new species. Launch skill training, skill sharing and enquiry services. v. Strict management control. The supervising committee shall conduct supervision on the various cooperatives’ financial conditions, loan approval, financial discipline, and so on. Strengthen safeguarding of risk and ensure sound operation. Article 5    The federation enjoys the right of ownership, usage and disposal on asset accumulated from member contributions, provident funds, financial subsidy, third party donations as well as other legally obtained assets, and shall use the aforementioned asset to bear responsibility on debts. Article 6    The federation shall invest to establish economic entities relevant to the business content of the federation, subsequent to discussions and approval of general assembly. The federation accepts engagement from units relevant to the federation’s business, conduct intermediary services on purchasing and consignment, organizes the execution of state-supported construction projects for developing agriculture and rural economy, by applying to relevant state departments or accepting engagements from relevant state departments. The federation participates in donations for public interest of the community, in accordance with the amount and form as determined by the federation. Article 7    The federation and all members abide by social civility and business ethics, and shall legally initiate and develop activities on production as well as business operation. Chapter II  Members Article 8    Those which possess the legal person status of peasant credit 305

cooperatives, or legal person status of other institutions, which can make use and accept the services provided by this federation, which admit to and abide by the guidelines, fulfill the entry procedures stipulated by the guidelines, where initiation funds come from owned assets of legal source and reach the entry threshold stipulated by the guidelines, with integrity and honesty and of good reputation may successfully apply to become members of this federation. Article 9    Rights of Federation Members: i. Participate in the general assembly and enjoy the right to vote, to elect and to be elected. ii. Make use of the services provided by the federation. iii. In accordance with resolutions from the general assembly, enjoy the right to share in surplus of the federation. iv. Inspect the guidelines of the federation, members’ roll, minutes of the general assembly, resolutions of meetings of the boards of directors and supervisors, financial accounting reports and accounting books. v. Question, criticize and make suggestions on the work of the federation. vi. Propose to convene extraordinary general assembly. vii. Freely make statement of withdrawal and, in accordance with regulations stipulated in the guidelines, withdraw from the federation. Article 10    The federation adopts the system of “one person one vote” for general assembly elections and resolutions. Article 11    Obligations of Members of this federation: i. Abide by the federation’s guidelines and various regulatory systems. ii. Make fund contribution to the federation in accordance with stipulations in the guidelines. iii. Actively participate in various business events of the federation, accept technical guidance provided by the federation, conduct production in accordance to quality standard and production skill 306

regulations, fulfill business contracts signed with the federation and promote the spirit of mutual cooperation to pursue common development. iv. Protect the interest of the federation and safeguard the common asset of the federation’s members. v. Not participate in activities that will damage common interest of members of the federation. vi. Cannot use loans made to the federation or to other members as payments on share contributions or subscribed but not yet paid contributions. Cannot use fund contributions to pay for loans owed to the federation or to other members of the federation. vii. Bear the loss of the federation. Article 12    Under one of the following circumstances, a member’s membership status will be terminated: i. Self-initiated withdrawal, ii. Member federation bankrupted or dissolved, iii. Taken off from the members’ roll by the federation. Article 13    Where a member requests to withdraw from the federation, the request should be made six months before the end of the accounting year (by law). Membership status of the member terminates at the end of the accounting year. Terminated member will share in the loss and liability of the federation prior to termination of membership. Article 14    Under one of the following circumstances, a member will be taken off the members’ list after discussions and a resolution made in the general assembly: i. Failure to observe obligations of members; ii. Bringing serious damage to the reputation or interest of the federation. For members taken off the members’ list, the federation will refund the 307

contributions made by the member in accordance with the member’s account record and share of the provident fund, clear the share of debt obligation and return the remaining surplus entitlement. For the second circumstance mentioned above, a corresponding compensation to the federation is required. Chapter III  Organize Institution Article 15    The general assembly is the institution of highest authority for the federation, made up of all members. The general assembly will exercise the following functions: i. Review and revise the guidelines of the federation, organize the form of cooperation, election method and various regulatory systems. ii. Nominate, propose election and announce the honorary president and honorary supervisor. iii. Elect and dismiss president, directors, secretary-general, vice secretary, chief supervisor and supervisors. iv. Determine the standard for members’ fund contributions, and to increase or decrease the contribution. v. Review the development plan and annual business plan for the federation. vi. Review and approve the annual financial budget as well as final program. vii. Review and approve the allocation program of yearly surplus and the handling program of loss. viii. Review and approve the annual business report submitted by the board of directors and board of supervisors. ix. Resolve handling of major asset items, external investment, external guarantee and other significant events arising from production operation activities. x. Resolve on merger, split, dissolution, liquidation and external alliance and so on. xi. Employ operation management personnel and professional technical personnel in accordance with proposal by the board of 308

directors on the number, qualification, remuneration and term. xii. Listen to the board of directors’ report on membership change situation. Article 16    The federation adapts a membership system and cooperative system to form the federation, constituted by the legal person of each peasant credit cooperative, the legal person of relevant institutions and relevant departments. Membership term is three years, and may be re- elected for office. Article 17    The federation convenes a general assembly at least once a year. The board of directors is responsible for convening the general assembly, and to advise all members on agenda of the meeting fifteen days before. Article 18    Under one of the following circumstances the federation will convene an extraordinary general assembly:

i. ii. iii.

Proposed jointly by more than 30% of members; Proposed by the board of directors; Proposed by the board of supervisors;

In the event the board of directors cannot execute, or within the stipulated timeframe, without valid reason, does not execute the role of convening extraordinary general assembly, the board of supervisors shall convene and preside over an extraordinary meeting, as well as propose election to replace the board of directors. Article 19    The general assembly can only be convened with more than two third of the members in attendance. Members who cannot attend may authorize in writing the vice director of that peasant credit cooperative to be present at the meeting. Elections and resolutions made by the federation should be voted for by more than half of the members of the federation. Resolutions on major events such as revisions to the federation’s guidelines, changes to members’ fund contribution standards, increasing or decreasing the amount of members’ fund contribution, merger, split, dissolution, liquidation and external alliance require more than two third of the member voting in order to be passed. Article 20    The federation sets up one president position who will be the legal representing person of the federation. The term for the president is three years, and may be re-elected for office. 309

The president exercises the following roles and functions: i. Presiding over the general assembly, convening and presiding over meetings of the board of directors; ii. Signing receipts for fund contributions from the federation’s members; iii. Signing employment letters or dismissal letters for the federation’s manager, financial accounting personnel as well as other professional technical personnel. iv. Organize the execution of resolutions from general assembly and board of directors, following-up on the situation of execution; v. Signing contracts and so on representing the federation or on authorization in writing by other members. Article 21    The federation sets up a board of directors responsible to the general assembly. This is made up of nine members, one president, two vice presidents and six directors. The term of the board of directors is three years, and may be re-elected for office. The board of directors exercises the following powers: i. Convene the general assembly and conduct work report; execute resolutions adopted in the general assembly; ii. Prepare development plan for the federation, yearly business operation plan, internal control regulatory system and so on, for submission to the general assembly’s review; iii. Prepare annual financial budget as well as programs for surplus allocation and loss make-up, for submission to the general assembly’s review; iv. Organize launching of member training and various cooperative activities; v. Manage the federation’s asset and finance, safeguarding the security of the federation’s possession; vi. Receive, respond and handle the execution of relevant questions and suggestions from the chief supervisor or the board of supervisors; vii. In accordance with resolutions in the general assembly, make 310

decisions on members’ affairs such as entrance, withdrawal, inheritance, taken-off from members’ roll, reward and penalties; viii. In accordance with resolutions in the general assembly, decide on employment or dismissal of the federation’s manager, financial accounting personnel and other professional technical personnel; Article 22    In meetings, the board of directors adopts “one person one vote.” Major events are discussed collectively, and decision is formed based on agreement of more than two thirds of the directors. Dissenting opinions of individual director on a specific item are recorded in the minutes with signature. The board meetings will invite the attendance of chief supervisor, manager and members. Those in attendance do not have voting right. Article 23    The board of directors sets a secretariat, an integrated department, a surety company and an operation department. The federation sets three positions in the secretariat with one secretary-general to manage daily affairs and two vice secretaries to assist the secretary-general in daily affairs. Particular duties of the secretariat, integrated department, surety company and operation department are formulated by the board of directors. Personnel of the integrated department, surety company and operation department are decided on by the board of directors, in accordance with the situation of business development. Article 24    The federation’s president, directors, secretary-general, manager and financial accounting personnel who are currently in office cannot also hold positions of supervisors. Article 25    The federation’s president, directors, secretary-general, manager and management personnel cannot have the following actions: i. Encroach, appropriate or privately dividing the federation’s assets; ii. Violate the stipulations in the guidelines or, without approval by the general assembly, make loans to others with the federation’s funds or using the federation’s funds to provide guarantee to others; iii. Receive and take ownership of commissions from others on transactions with the federation; 311

iv. Conduct activities that damage the federation’s economic interest; Income received by the president, directors and management personnel by violating the above-mentioned items i to iv shall be confiscated by the federation. Losses done to the federation shall be borne and compensated. Article 26    The federation sets a board of supervisors made up of five supervisors with one chief supervisor, with a term of three years and may be reelected for office. The chief supervisor attends meetings of the board of directors. The supervisory committee exercises the following duties and powers: i. Monitor the situations on execution of general assembly resolutions and the federation’s guidelines by the board of directors; ii. Monitor and inspect the situation of the federation’s production operation; business, as well as responsible for financial audit and monitor of the federation; iii. Monitor the situations on fulfillment of duties by the president, the board members and managers; iv. Submit annual supervising report to the general assembly; v. Bring up questions and make work improvement suggestions to the president or the board of directors; vi. Propose to convene extraordinary general assembly vii. Represent the federation to be responsible for recording situations of business transactions when transactions take place between directors and the federation. Article 27    The meetings of the board of supervisors are convened by the chief supervisor. Meeting resolutions are communicated to the board of directors in writing. The board of directors, within five days of receiving notice, gives replies to relevant questions. Article 28    Voting in the board of supervisors adopts “one person one vote” system. The board meetings shall only be convened with agreement of more than two third of the supervisors. Resolutions on major events are effective only with agreement by more than two third of the supervisors. Dissenting opinions by individual supervisors are recorded in meeting minutes and signed.


Chapter IV  Financial Management Article 29    The federation adapts independent financial management and accounting audit, strictly adheres to the ministry of finance’s financial system and accounting system formulated for peasant credit cooperatives in auditing costs and expenses arising from production operation and service management. Article 30    The federation establishes a sound financial and accounting system in accordance with the relevant legal and administrative regulations, as well as regulations of related government authorities. The system of regular monthly public reporting on 5th day of the month is adopted. Financial personnel of the federation should hold qualification certificates for accounting practice. The accountants and cashiers should not be the same people. The boards of directors and supervisors and their direct families cannot serve as financial personnel of the federation. Article 31    All business transactions between members and the federation are recorded by name under the account of respective members, as basis for allocating return of eligible surplus in accordance with transaction volume (amount). Article 32    When the account year closes, as stipulated in the federation’s guidelines, the board of directors organizes preparation of the federation’s annual business report, program for allocating surplus, loss handling program and financial accounting report. After auditing by the executing supervisor or the board of supervisors, it is displayed at the office location fifteen days before the general assembly, for members’ inspection and questioning. Article 33    Fund resources for the federation include the following items: i. Members’ contributions; ii. Provident fund and community interest fund taken out of the surplus of each accounting year; iii. Unallocated income; iv. Subsidy fund from the government’s financial support; v. Donations from others; vi. Other funds.


Article 34    Federation members contribute in cash. Article 35 Subscribed contribution amounts by federation members should be fully paid within one month. Article 36    In case of requirement to adjust contributions from members in order to realize the development target of the federation and members, pursuant to discussions and adoption in the general assembly to formulate a resolution, each member should contribute in accordance with the resolution of the general assembly in terms of adjustments to the form and amount of contributions. Article 37    The federation takes a provident fund of 5% from surplus of the current year, to be used towards expanding production operation, making up losses or converting to member contributions. The provident fund taken out each year is quantified into shares for each member in accordance with proportion of members’ contributions. The federation takes a community interest fund of 2% from surplus of the current year, to be used towards technical training, cooperative knowledge education, as well as cultural, welfare business and daily mutual assistance. Article 38    The financial subsidy and donations from others received by the association are accounted for in accordance with methodology stipulated in the federation’s guidelines, to become the federation’s fund (assets) and used towards development of the federation in accordance with stipulated usage and intention of donors. In case of dissolution, bankruptcy and liquidation, the asset from direct financial subsidy should not be regarded as distributable residue for allocation to members. Method of disposal will be executed in accordance with regulations of the state. For donation from others, where there are separate agreements with donors, disposal is in accordance with agreed method. Article 39    After deducting cost of production operation and management service, making-up losses, taking out provident fund and community interest fund of the current year, the distributable surplus is allocated in accordance with the following priority: i. Return to members in accordance with proportion of members’ contributions. The total amount of return is not lower than ________ % (note: by law not lower than 60%. Specific ratio to be determined in general assembly discussions); ii. The remaining amount after return in accordance with the 314

previous item is allocated to federation members in accordance with proportion of contributions and provident funds in members’ account records, and to be entered in members’ records. Assets from state financial subsidy and donations from others received by the federation are not quantified to members’ accounts. Article 40   If a loss occurs for the federation, after discussions and adoption in the general assembly, it will be made up by the provident fund. Any deficiency can also be made up from surplus of subsequent years. Article 41    The board of supervisors is responsible for daily review and monitoring of the federation’s daily financial affairs. In accordance with resolution of the federation, the federation engages auditing institutions to conduct annual audit on the federation’s finance, specialized audits, as well as audits on change of term and departure from office. Chapter V.  Merger, Split, Dissolution and Liquidation Article 42    Merger of the federation with other federations must be resolved in the general assembly and communicated to debt holders within ten days of the merger resolution. Debt obligations and loan ownership subsequent to the merger shall continue after merger or taken on by the newly merged organization. Article 43    Pursuant to resolution to split by the general assembly, the asset of the federation will be divided accordingly, and communicated within ten days of the split resolution to debt holders. Responsibility on debts prior to the split is taken on by the organizations after split. Nevertheless, exceptions are made where there are separate agreements with debt holders prior to split on debt repayment. Article 44    Under one of the following circumstances, pursuant to resolution in the general assembly report to the registration authority and dissolve with permission: i. Members of the federation lower than five; ii. General assembly resolved to dissolve; iii. The federation needs to dissolve subsequent to split or merger with other specialized peasant cooperatives; 315

iv. Impossibility to continue operation due to indefensible factors; v. Revoked by law. Article 45    When the federation is dissolved due to items i. ii, iv and v above, within fifteen days of the event leading to dissolution, the general assembly will appoint members to form a liquidation committee to take over management of the federation and start dissolution liquidation. If the liquidation committee cannot be established within this time frame, members and debt holders may apply to the people’s court to appoint members to form liquidation committee and conduct liquidation. Article 46    The liquidation committee is responsible for handling unfinished business relevant to liquidation, disposing of the federation’s asset, debt ownership and debt obligation, formulating programs for repayment, allocating residue asset after debt repayments, representing the federation to participate in legal suits, arbitration or other legal procedures. After completion of liquidation, communicate to all members of the situation of liquidation within ____ days and de- register with relevant registration institutions. Article 47    The liquidation committee shall notify members and debt holders within ten days of formation, and publish newspaper announcements within sixty days. Article 48    After repaying liquidation expenses and common debt obligations, the residue asset of the federation is paid in accordance with the following priority: i. Liabilities owed on transactions that have occurred; ii. Salaries and social security costs owed to employees; iii. Liabilities on taxation; iv. Other liabilities; v. Return of members’ contributions and provident funds; vi. Allocate residue asset in accordance with liquidation program. The liquidation program is executed only after it is adopted in the general assembly or applied for confirmation by people’s court. When the federation’s asset is insufficient to repay debt obligations, apply to people’s court for bankruptcy according to law. 316

Chapter VI.  Supplementary Provisions Article 49    Events that should be announced to members are released by ____________. Events that should be announced publicly are released by ______________. Article 50    The federation shall, depending on the situation of development, prepare management method on share rights through the board of directors, to be executed after its passage in the general assembly. Article 51    The guidelines shall be voted on and passed in the founding meeting, then become effective after signatures of all founders. Article 52    Revision of the guidelines requires proposal by more than half of the members or proposed by the board of directors. The board is responsible for making revisions for discussions in the general assembly, and execution after adoption. Article 53    The interpretation of the guidelines is the responsibility of the board of directors of this federation. Signatures and seals of all founders:


The First Federation of Peasant Credit Cooperatives Established in Fengyang County of Anhui Province Author: Farmers Daily  Xia Shu        Published Date: May 4, 2009 Peasants “Testing the Water” with Mutual-Aid Credit Cooperation With the furthering in rural socio-economic development, peasants and rural cooperative organizations have made increasing financial demands. Shortage of funds becomes more and more the bottleneck constraining the rural economic development. The conflict between supply and demand in rural finance is obvious. In September 2006, twelve peasant families in Lin Huai Township of Fengyang County became “the first people to try the crab” (the first adventurers) in the county. Each household took out 2,000 RMB, putting it together to set up a “credit cooperative.” Whichever household of the twelve had an urgent need of production capital might submit an application for credit, which was loaned and controlled by other members of the cooperative with a fixed repayment date. Since then, under the assistance and guidance of the local government, the People’s Bank, industry and commerce, civil affairs and other authorities, the credit cooperative formulated guidelines to regulate daily operation and management. With registration permission from related authorities, the cooperative officially launched mutual funding services among villagers who are members and non-members of the cooperative. The credit cooperative had as its founding missions “trustworthiness, convenience, low risk; the priority of profit goes after the convenience of fund availability.” It aimed to help underprivileged groups on development funding, offering the financial services that banks did not want to and governments could not afford to do. This is the very first peasant credit cooperative in Fengyang County-Haozhou Peasant Credit Cooperative--a pioneer for the county’s rural cooperative finance, putting together idle rural funds and facilitating the development of rural cooperative economy. Haozhou Peasant Credit Cooperative was initiated and organized by twelve peasant households. The cooperative’s founding share capital totaled 30,000 RMB, with 2,000 RMB each share. After two years’ of operation, the cooperative at present has recruited another six households as members, with the total share capital of 60,000 RMB. In the operation period of more than one 319

year, the cooperative made twelve loans, the highest at 10,000 RMB. With the exception of three loans not yet due, the other nine have all been timely repaid. The credit cooperative has obtained interest gains of more than 1,000 RMB. After that, peasant credit cooperatives in places like Huangzhuang Village of Randeng Township, Gongzhuang Village of Xiquan Township, etc. announced their founding one after another. Almost all these credit cooperatives have made identical regulations: through members’ cooperation and alliance, the cooperatives provide surety and mutual-aid services on small sums of operation funds. They are based on rural economic cooperative organizations undertaking crop farming, aquaculture, agro-material supply, agricultural and subsidiary products purchase, processing, operation and services, with the principles of “operated and managed by the people, for the benefit of the people, and the concepts of security, convenience and promptness.” The greatest advantage of the credit cooperatives is that members know the background of one another very well. Those who do not have the credibility are not allowed to enter the cooperative, not to say borrowing money.” While reporting in Xiaogang Village, Yen Deyou said, “The family in need of money could submit a loan application the evening of that day. Members of the cooperative meet and discuss a bit at night, feeling alright about it, then the loan can be granted the next day.” Government’s Pilot Experiments, Members’ Sail Launch The Central Government’s Document No. 1 clearly proposes the acceleration of rural financial reform and innovation, actively developing specialized rural cooperatives and rural service organizations, positively cultivating micro-credit organizations. Anhui provincial party committee and provincial government also demand to explore the development of micro-credit organization and rural credit cooperatives. On June 18th, 2008, pilot experiments on specialized rural cooperatives and rural service organizations were launched in Fengyang County. The government twice called for meetings to conduct on-spot demonstrations and exchanges, supporting the rural cooperative economic organizations initiated by peasants. A series of supporting policies were released, including tax concession, granting of financial credit, support in loans, asset rights as shares, fund subsidies simplifying registration procedures and so on. The relevant county authorities supported the pilot experiments with the lowest possible charges and simplest procedures. The 320

county industry and commerce administration has, with regard to registration of the credit cooperatives, performed a “001” service: zero distance, zero fee, onestop. The civil affairs bureau completed the registration within 3 working days. The county quality supervision and inspection administration waived the penalty on late handling of organization barcode of the cooperatives. The county financial institutions handled account opening for the cooperatives on a timely basis, and regarded assisting the cooperatives as the priority in rural credit support. The threshold for lending was lowered; privileged credit rates were granted. At the same time, the county also conducted oversight and inspection on the pilot programs, and performed audit assessment on integrated benchmarks. Up to this point, 57 peasant credit cooperatives are established throughout the county, 1,562 rural households are enrolled, and the total share capital has reached 12.01 million RMB, providing effective relief for the problem of insufficient investment in production and motivating job creation and employment for almost 10,000 peasants. Peasant credit cooperatives insist on having peasants as subjects, reflecting their populous nature in organization, democratic nature in governance and flexible nature in operation. As principles in management, it insists on governmental guidance but no interference, voluntary membership and freedom to withdraw, self-democratic management and self-risk management. Based on the principles of “operated and managed by the people, for the benefit of the people” and in accordance with the operational concepts of “security, convenience, petty profit,” the cooperatives help underprivileged groups in funding development, changing the situation of what “the banks are not willing to handle, and the governments not able to handle.” Working in Groups for Better Performance, Helping One Another as in the Same Boat The policy-makers of Fengyang County have discovered in surveys that the fund scale of peasant credit cooperatives was relatively small, hard to satisfy the fund needs of cooperative members in production development. There was a lack of market information on production and agricultural products, but no communicating channels and means between the cooperatives, the financial sector and the corporate champions. The county therefore proposed a “federation of peasant credit cooperatives within the boundary of the entire county,” so as to facilitate the sound 321

development of the cooperatives, establish cooperative economic organizations and operational models that are in line with the rules of market economy, and fully boost the positive functioning of the cooperatives in aspects of relieving the difficulty in borrowing, facilitating the development of modern agriculture, adjusting industrial structure, enhancing the level of peasant organization as well as their integrity, etc. In this way, a relatively fast yet stable rural economic and social development could be achieved in the county. In March this year, the task of organizing and establishing the federation was officially kicked off. The Fengyang County Federation of Peasant Credit Cooperatives organizing proposal, guidelines (draft) and federation layout, task responsibilities, operational procedures, working rules for the boards of directors and supervisors, etc. were drafted. In addition, member enrollment and the registration with civil affairs authorities were conducted. On April 29th, the Fengyang County Federation of Peasant Credit Cooperatives held a general assembly election, establishing the first county federation of cooperatives in the whole country. The founding member units included 52 peasant credit cooperatives, 23 corporate champions, 7 financial institutions and the county credit surety companies, etc. The “Guidelines for the Fengyang County Federation of Peasant Credit Cooperatives” was adopted and the first leaders for the federation elected. Xu Huaxin of the County Agricultural Commission was elected president of the federation. The Fengyang County Federation of Peasant Credit Cooperatives is composed of the peasant credit cooperatives, corporate champions, and county agriculturerelated authorities. Members join on a voluntary basis by paying a membership fee, operating on the principles of “voluntary membership, freedom to withdraw, democratic decision, democratic management, self-service, self-management, economic participation, sharing of benefit and risk.” The main functions and competences are to provide information to members, offer credit services, conduct business training, management, coordination and so on. Through the platform of the federation, information exchange and cooperation among cooperatives as well as between cooperatives and corporate champions are realized. Furthermore, the cooperation between cooperatives and corporate champions as well as financial institutions effectively resolves problems of connection between cooperatives and banks, of difficulties in both borrowing and lending in rural areas, enhances the cooperatives’ capability in self-service, self-development and self-management, 322

and facilitates the growth in agricultural production and peasant income, promoting the county’s new socialist rural reconstruction. The supervisor of the federation Li Xuemei commented, “With the government’s guidance, oversight and regulation, everyone is joined together in good comradeship. The Federation of Peasant Credit Cooperatives will definitely be able to initiate a benign cycle. Available funds in the vast rural areas to support development will grow increasingly, and the cooperative funds will become like ‘grassroots banks’ to benefit more poor peasants.”


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