Usufructuary mortgages in rural South Asian economies: collateral valuation and internal rates

American Journal of Economics and Sociology, The,  April, 1993  by M. Abdullah Shibli

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I

Introduction

MONEYLENDING in the rural areas of South Asia takes various forms. One type of informal loan agreement commonly found in many areas is the usufructuary land mortgage, hereinafter abbreviated to ULM. Under this type of contract, the borrower transfers to the lender a parcel of his land, to be held by the latter as collateral until the exact monetary amount of the loan is repaid in full. In all cases, after the loan is made, the lender is in possession of the collateral with the authority to cultivate or lease out the land.

In this type of loan, the lender, the mortgagee, charges no explicit interest on the loan. However, because the mortgagee is free to utilize the land for his own cultivation, income from the land is, in effect, an implicit form of interest.(1) The repayment period for the principal is not specified when the loan is contracted--the landowner is free to reclaim his land as soon as he has the means to pay back the loan. In practice, the land is held for a few years. Field research shows that at least four to five years usually elapse before a loan is repaid, and the average repayment period is much longer than that (Bertocci, 1972; Rashid, 1983).

Under some arrangements, the title of the mortgaged land is also transferred to the lender with a verbal stipulation that when the loan is repaid, the land title would revert to the borrower. In such cases, the lender becomes the owner of the land in legal terms and acquires all usufruct rights, including the right to sell. However, social sanctions deter sale of collateral unless the borrower is in default.

While there is no stated term for the loan, default and foreclosure are relevant and meaningful concepts in the context of ULM. However, these concepts cannot be interpreted in purely legalistic terms. Foreclosure can occur for a variety of reasons. For example, if a borrower expresses his inability or unwillingness to repay the loan, he forfeits the collateral. On the other hand, a lender can foreclose if a borrower is deemed to be in default. A not too uncommon foreclosure scenario involves a majlish (gathering) or shalish (arbitration) of village elders. If the elders make a determination that the borrower has no chance of redemption owing to his worsening financial conditions, or other reasons, the land belongs to the lender, de jure as well as de facto. One interesting thing to note is that if, as in some cases, the borrower is given the title to the land when the loan is made, foreclosure proceedings take place only for social validation of the transfer of ownership.

The literature on rural credit has largely focused on the determinants of the high rate of interest on loans (Bhaduri, 1973; Long, 1968; Wai, 1958). Many have noted, in passing, that collaterals, including land, are often undervalued by the lender in loan contracts (Wai, 1958; Bottomley, 1963b; Bhaduri, 1977). Since providing an explanation for the high rate of interest has been the prime concern, the collaterals and their valuation have not always been integrated in the analyses.

In this paper, the informal credit market and usufructuary land mortgage is examined from two points of view: to seek the rationale for the undervaluation of collateral, and to explore the implications of the undervaluation for the determination of interest rates for secured loans. Contrary to the literature which sees undervaluation of collaterals, and thus the high interest rates, as attributable to risk and monopoly power (see Section II below), this paper provides a model that shows the proper relationship between undervaluation of collaterals and the high implicit rates of interest on ULMs. This relationship only can be understood by comparing the opportunity cost of funds and return from money-lending: The opportunity cost of funds tied up in loans is equal to the net income foregone, including capital gains, from comparable pieces of land, whereas return from moneylending is given by net income from the land collateral, after factoring in default. It is shown that, for any rate of default less than 100%, return from such moneylending is lower than the return from land purchase if the price of land appreciates faster than the general price level and land is collateralized at face value, i.e., there is no undervaluation of the collateral. It is argued that undervaluation of collateral may be a mechanism to compensate the lender for the opportunity cost of his funds.

The paper is organized as follows. In section II, the literature on rural credit is reviewed with an emphasis on issues discussed in the paper. This is followed in section III by a discussion on the opportunity cost of moneylenders' funds. In section IV, an alternative model on undervaluation of collaterals and internal rates of return is presented. Implications of the model using numerical values are discussed in section V. The final section contains a summary and the conclusions.

II

A Critical Review of the Literature

THE USUFRUCTUARY LAND MORTGAGE, in spite of its ubiquitous presence in the rural landscape of South Asian countries, has not received much attention.(2) The literature has, by and large, sought to explain the more egregious high interest rates. Most references have been parenthetical--the implicit assumption being that the processes and forces underlying ULM lead themselves to the same analytical framework as the general theory of rural credit market and usurious interest rates. (See, for example, Bottomley, 1963a, 1963b and Bhaduri, 1977). Since, interest rate determination for ULM has not been treated separately, their rate of interest is thought to be influenced by the same forces that determine interest rates for short-term (mostly unsecured) loans (Bottomley, 1963b; Long, 1968; Rashid, 1983).