Innovative finance models for enhancing agric productivity
The Herald 31 August 2017
Dr Gift Mugano
Last week my discussion was centred on threats to agricultural viability in Zimbabwe. Among a number of threats, I mentioned low productivity and pricing regimes.
In my discussion, it was clear that our pricing regimes especially for the grains are aimed at compensating inefficiencies caused by low productivity. This week’s article draws lessons from developing countries in showcasing how innovative financing models can be used to enhance productivity.
Innovative concepts such as group liability, village banking, micro insurance, and index-based insurance were tested in new and emerging microfinance institutions.
Localised finance
Whereas in the 1960s and 1970s, large (agricultural) development banks were created with a top-down approach to rural finance, in the past two decades the emphasis has been on the creation of rural and village banks, credit cooperatives/unions, self-help groups, and NGO-type microfinance institutions in many forms and shapes. Many are user-owned and managed, but nearly always regulated at the national level through an APEX body.
Microfinance institutions, local savings and credit associations and rural (micro) banks are currently the most credible financial service providers to smallholder farmers in remote areas in Ethiopia. Community-based financial organizations (CBFOs), that is, user-owned, user-operated intermediaries are common in Ethiopia. Though some are informal – as they are not registered – many can be described as semi-formal because they are registered as associations which offer financial services but are not regulated. Examples include Rotating Savings and Credit Associations (ROSCAs) and Savings and Credit Cooperatives. CBFOs usually offer savings and credit facilities to members. These financial innovations are then used to fund agricultural activities.
Agricultural leasing
Leasing is a contract between two parties, where the party that owns an asset (the lessor) let the other party (the lessee) use the asset for a predetermined time in exchange for periodic payments. Leasing separates use of an asset from ownership of that asset. There are two main categories of leasing: financial leases and operating leases.
In Kazakhstan, agricultural leasing has been practiced for more than a decade, typically for long-life farm equipment. These financial leases are promoted by banks’ special leasing departments in collaboration with the equipment suppliers, who offer the equipment at a discount.
The literature provides examples of profitable agricultural leasing in Ethiopia, Kenya, Mexico, Pakistan and Uganda. MFIs (micro-) lease such items as water pumps, dairy equipment and tools for honey production.
Agricultural factoring
Agricultural Factoring is a financial transaction, in which a business sells its accounts receivable (ie invoices) at a discount. Factoring differs from bank loans in three main ways.
First, the emphasis is on the value of the receivables, not the firm’s creditworthiness. Secondly, factoring is not a loan – it is the purchase of an asset (the receivables). Finally, a traditional bank loan involves two parties, whereas factoring involves three. Three parties directly involved in a factoring transaction are: the seller, the debtor, and the factor (the specialised financial company). The seller (eg input supplier or wholesaler) is owed money (usually for products or goods sold) by the buyer of goods, the debtor. The seller sells its receivable invoices at a discount to the third party, the factor, to obtain an advance payment (eg 75–85 percent).
An innovative financial model which involves agricultural factoring is found in Kenya. Invoice discounting and factoring are completely normal financial services in developed markets. However, such services are unusual in developing countries and in agriculture in particular. Kenyan smallholder tea farmers found that it took them a long time to be paid for their tea, which was because the processors and exporters were in turn kept waiting by their international clients. Farmers were often forced to sell tea to local traders at unfavourable prices to get quick cash.
Extension services and financial literacy
The generally low level of education and technical know-how of farmers is one of the main reasons why banks decline to finance agriculture. Farmers and smallholders in particular, generate little cash, and even when they do, they may not be able to provide the documentation to convince bankers that this is so. Research has shown that there is a strong correlation between farm performance (increase in production and profits) and the use of extension services provided by the regional branches of the Ministry of Agriculture. Naturally, the farms’ repayment capacity will have increased as well. In recognition of this finding, some banks in Moldova oblige their agricultural clients to seek government-subsidised extension services.
Research done in India found that credit to poor farmers has little impact on their income, hence levels of poverty. However, when combined with extension services and input supply for productivity enhancement, risk mitigation (through insurance), education and market development, the results were much better. It was found that farmers are willing to pay for these services. Farmers preferred cost-saving and risk-reducing solutions over yield-enhancing technology that requires investment. The literature also shows that financial education can play an important role in better preparing farmers for their interaction with finance providers.
Agricultural Insurance (index insurance)
Index insurance is an important recent innovation. It is a “derivative” instrument in that the pay-out to farmers is effected when the threshold value for an underlying risk indicator (the “index”) is breached, this without actually having to observe the damage done to the farmers’ fields or livestock. This greatly reduces the transaction costs, the risk of moral hazard and adverse selection. In many index insurance policies, multiple thresholds are defined, with increasing pay-outs as the risk event increases in severity.
The index can be based on the amount of rainfall (lack of or excess), humidity levels, arrival of locusts, water levels in a river, occurrence and strength of a hurricane, sea-surface temperature, frost, hailstones, etc. This requires highly capable and independent measurement tools, such as weather stations. Remote-sensing techniques with satellites are being used as well (eg Canada, US). In some insurance systems, an estimate is made, via sampling, of the average crop yield in an agricultural region (eg Brazil). Farm losses are modelled with actuarial methods (given detailed and long-term data). Successful index insurance is characterized by a high level of transparency and rapid payment after the index has been triggered (both are a problem in traditional harvest insurance, which requires assessment of actual losses by an expert). To be effective, the index used must be highly (and spatially) correlated with the damage that farmers actually incur (in order to avoid basis risk).
The key innovation in combining index insurance with credit is the standardization of the approach, making reinsurance possible, and thus reducing lending risk. In many of the successful examples, index insurance is part of a value chain finance approach. This also solves the problem of how to distribute the insurance. Index insurance incorporated into value chain financing is distributed by the same entities that provide the credit, namely traders, technical operators, farmers’ associations, or (micro) finance institutions.
Value chain finance
In our fast-paced development context, value chain finance is an evolving term that has taken on a range of meanings and connotations. The flows of funds to and among the various links within a value chain comprise what is known as value chain finance. Stated another way, it is any or all of the financial services, products and support services flowing to and/or through a value chain to address the needs and constraints of those involved in that chain, be it a need to access finance, secure sales, procure products, reduce risk and/or improve efficiency within the chain.
Value chain finance offers an opportunity to expand the financing opportunities for agriculture, improve efficiency and repayments in financing, and consolidate value chain linkages among participants in the chain. It can improve the quality and efficiency of financing agricultural chains by: identifying financing needs for strengthening the chain;
tailoring financial products to fit the needs of the participants in the chain; reducing financial transaction costs through direct discount repayments and delivery of financial services; and using value chain linkages and knowledge of the chain to mitigate risks of the chain and its partners.
As agriculture and agribusiness modernize with increased integration and interdependent relationships, the opportunity and the need for value chain finance becomes increasingly relevant.
Various value chain finance models which have been successfully used around the world trade credit, contract farming, out – grower schemes and warehouse receipting system.
Trade credit, farmers receive credit from input suppliers, intermediary traders and shops, or agro-processors, pledging to repay from future harvest income. Typically, this does not directly involve a bank, and the agreement is usually informal and based on trust. Trade credit is often provided in-kind (seeds, fertilisers, consumption goods), and payment is made in kind as well (final produce). Such arrangements nearly always concern seasonal credit only. The cost of credit (interest) is embedded in the agreed prices for inputs and outputs, and may be quite high.
Contract farming, trader, exporter or agro-processor establishes pre-harvest purchase contracts with selected farmers or their representatives (an association or cooperative). This involves forward contracting of the crop (the price or pricing formula is fixed). The main motivation is to secure a supply of produce, of a certain quality and at a specified time. Technical support to ensure quality may be part of the contract. Product standards are agreed to beforehand. As part of the forward contract, farmers receive partial prepayment. A bank can also be involved through a triangular arrangement (the sales contract becomes the surety). This arrangement nearly always concerns seasonal credit only. A special case is pre-harvest credit provided to cooperatives, enabling them to buy goods from their members. Pre-finance usually has a maturity of only several weeks.
Out grower scheme, an out-grower scheme is an elaborate contract-farming arrangement emanating from a nucleus – a lead farm or processor (also called a “technical operator”) – which gives out growers access to its marketing, operational and logistical capabilities. Technical support may be provided to the out growers. Loans may include investment financing (eg in trees and equipment). Out grower schemes are most common in high value, specialty crops with niche markets. These schemes have been extensively used in Ethiopia, Kenya and India. Warehouse receipt financing, the key innovation in warehouse receipt finance is that it solves a financing and collateral problem. It offers the bank a safe and liquid collateral asset, which is easy to monitor. In Tanzania, defaults on warehouse receipt finance are below 1 percent.
Dr Mugano is an Economic Advisor, Author and Expert in Trade and Competitiveness Strategy. He is a Senior Lecturer at Zimbabwe Ezekiel Guti University and Research Associate of Nelson Mandela Metropolitan University. Feedback: +263 772 541 209 or [email protected]