Formal and informal sector credit institutions and interlinkage

Nationalized banks in poor countries often ration rural credit. This creates demand for loans from monopolistic landlord/moneylenders who often interlink credit and product contracts allowing the latter to extract more of the tenant’s consumer surplus. In the presence of asymmetric information such arrangements can be inefficient. We find that increasing the fixed credit allocation to the rural sector at a subsidized rate does not reduce that inefficiency. The entire benefit of the subsidy is extracted by the moneylender. An alternative policy of providing credit at subsidized rates but in a flexible manner is more effective in reducing the inefficiency.