Interest‐Free Loans between Villagers

Interest‐free loans are a common feature of low‐income rural economies. In much of the economics literature, lending at zero and positive interest are viewed as being highly segmented in the community, with interest‐free loans an essential component of long‐term mutual consumption agreements between households. An alternative interpretation is that zero‐interest loans are a credit contract that, in lieu of interest, includes an option allowing the lender to tax the borrower at a future date. This option can take a variety of forms, including the provision of labor or draft animal services or possibly a future loan. In this paper, we develop and test a model of household contract choice between zero– and positive–interest rate loans that builds on this alternative perspective. It highlights the role of borrower and lender attributes and the economic environment in which they interact in determining contract choice. Enforcement considerations are secondary. We use a unique household‐level data set for rural China for the mid‐1930s to examine key predictions of the model.