How Does Debt Relief Impact Consumption? : Evidence from a Policy Experiment

We investigate the impact of a large scale debt waiver program for small agricultural borrowers in India on the short term and long term consumption levels of the beneficiaries. We obtain consumption data from three national level surveys conducted before and after the waiver by a federal statistical agency. We find that even a 100% debt waiver does not lead to increase in consumption expenditure. In fact, in the short run, beneficiary households experience a 13.6% decline in overall consumption, which includes a sharp decline in spending on essentials such as food, clothing and education. Monthly consumption expenditure of the beneficiary households remains subdued even after 4 years from the waiver announcement date. In our theoretical framework, we attribute this negative shock to the collapse of the informal bailout mechanism, which was developed by the loan officers in order to avoid defaults. This breakdown is a result of increased moral hazard, which in turn increases expected default rates and hence makes such bailouts costly from the point of view of a loan officer. This leads to increased credit constraints and hence the waiver beneficiaries are left with fewer resources to invest and consume. We point out a significant unintended consequence of a political intervention in debt contracts