Module 028 Policy Highlights
by the Agricultual Policy Support Service, Policy Assistance Division, Rome, Italy based on Agricultural Development Policy: Concepts and Experiences by Roger Norton for the Food and Agriculture Organization of the United Nations, FAO About EASYPol EASYPol is a an on-line, interactive multilingual repository of downloadable resource materials for capacity development in policy making for food, agriculture and rural development. The EASYPol home page is available at: www.fao.org/tc/easypol. EASYPol has been developed and is maintained by the Agricultural Policy Support Service, Policy Assistance Division, FAO. The designations employed and the presentation of the material in this information product do not imply the expression of any opinion whatsoever on the part of the Food and Agriculture Organization of the United Nations concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries. FAO January 2006: All rights reserved. Reproduction and dissemination of material contained on FAO's Web site for educational or other non-commercial purposes are authorized without any prior written permission from the copyright holders provided the source is fully acknowledged. Reproduction of material for resale or other commercial purposes is prohibited without the written permission of the copyright holders. Applications for such permission should be addressed to: copyright@fao.org.
Table of Contents 1 Introduction... 1 2 Past failings in rural financial services... 1 3 Inherent difficulties with rural finance... 2 4 Some lessons from experience... 2 5 Sustainability and viability factors... 4 6 Macroeconomic ramifications... 6 6.1 Production or income policy objective...6 6.2 Poverty alleviation vs outreach...6 6.3 Adopting market rate for loans and deposits...6 6.4 Situations of high inflation...7 6.5 Deciding on government and donor roles...7 7 Principal elements of rural finance policy... 7 Module metadata... 9
1 1 INTRODUCTION The traditional conception of agricultural credit s role is that it is merely an input necessary for acquiring other production inputs, with resources for this having to originate from outside the sector. Directed, subsidised credit for agriculture had generally been closely tied to production of principal crops or livestock products. This may have a positive net effect on output, but not necessarily for agricultural income, and less so for rural income. By delaying the transition out of uneconomic crops, directed credit programmes have often acted as drags on the sector s growth.such a view has nowadays been largely replaced by a new broader vision of rural finance that encompasses its service role in helping meet the needs and livelihood strategies of rural households. This includes catering for consumption smoothing, education of family members, off-farm income generation, human capital enhancement, and insurance against future cash flow requirements, besides meeting current production needs. Cutting across the household perspective is the role of financial intermediation in helping optimise the allocation of financial resources, between alternative uses and over time. There exist within the agricultural and rural sectors: Opportunities for reallocation of funds from those who save to those that invest. Possibilities for reallocating costs of lumpy investments over time, out of future or past incomes, or both. Each of these could be exploited to achieve greater efficiency in the overall use of financial resources within the national economy. At the same time, access to financial services of various kinds can be a crucial factor in catalyzing rural households to break out of poverty and stagnation, and embark on a self-sustaining path of improving incomes and well-being. 2 PAST FAILINGS IN RURAL FINANCIAL SERVICES For many decades now, government interventions in credit markets have taken the form of directed allocations of loans, subsidised interest rates and State ownership of banks. The overwhelming evidence is that many such interventions incurred huge and unsustainable fiscal burdens, had limited outreach and resulted in little identifiable impact at the farm level. Moreover, large numbers of small rural credit organisations that depended on external donor funding have ceased operating as the programmes that sustained them came to an end. Official rural lending institutions have seen their activities shrink drastically over the past ten to fifteen years, with a real decline in formal agricultural credit in most regions
2 Thematic Overview EASYPol Module 028 of the developing world. How to satisfy the credit needs of a growing agriculture in a viable way has therefore become a central issue of development policy. In an extreme example, during the 1980s, one Latin American rural financial institution with more than 500 branches and 27,000 employees received $10.3bn in fiscal and quasi-fiscal transfers (that is, capital injections and interest subsidies), while recovering only 10 15% on its portfolio and serving only 2% of the rural population. Elsewhere, government-sponsored rural credit programmes and institutions, from Peru to Malawi to Indonesia have collapsed under the weight of losses generated by traditional directed credit strategies... The World Bank Research Observer, vol. 13, no. 2 (August 1998) p.148. 3 INHERENT DIFFICULTIES WITH RURAL FINANCE Rural populations in developing countries are inherently more difficult to provide with financial services than urban populations, for a number of reasons: Access is constrained by spatial dispersion and relatively high costs of transportation and outreach. The cost of loan processing is also high, due to the large number of small loans. Documented credit histories and collateral are generally hard to come by. Climatic and price fluctuations could mean lower and/ or more variable incomes, increasing the risks to borrowers. Thus, commercial banks may prefer the less challenging task of lending to the industrial and service sectors, and to urban consumers, rather than face uncertainties and difficulties of lending to agricultural and other rural households. They generally do not have, nor the interest to acquire, the necessary expertise to evaluate and lend to agricultural projects and clients. Loans provided largely for non-agricultural and trading activities, in many cases to urban and peri-urban clients; and modalities for participation in microfinance programmes that were too demanding for already impoverished people, are some of the design problems that need to be resolved. Difficulties experienced by agricultural credit institutions have given rise to a search for approaches that will be sustainable as well as ensuring that sufficient volumes of credit are available. 4 SOME LESSONS FROM EXPERIENCE A considerable amount of experience in rural financial systems has been accumulated over the past twenty years or so, and a number of useful lessons learnt. Most important of these are listed below: a) Poor people, women, and other marginal groups often make good use of rural credit, have high repayment rates, and pose little credit risk. That is, they are often highly bankable.
3 b) The capacity of low-income rural households to save has often been underestimated. In fact significant mobilisation of savings in rural areas of low-income countries can occur when the proper incentives are present. c) Informal, indigenous financial institutions, including community based organisations, such as savings and credit associations, can be highly cost-effective and sustainable in financial services provision. Transaction costs are generally lower than modern banks due to lower information and administrative costs, while interest rates, being non-regulated, could adjust more quickly to market conditions. d) Microlenders cannot afford to subsidize borrowers, nor do small farmers and other micro-entrepreneurs always need subsidies. The priority for many low income borrowers is rapid and continued access to financial services, rather than subsidies. e) Rural financial institutions that provide a range of needed services, such as handling financial transfers (e.g. payment for a child studying in the city or receiving remittances) will have additional sources of fee income and earn greater client loyalty, hence increasing the possibilities of high rate of loan recovery.f) Savings and microfinance have found an important niche in rural financial services. But many challenging issues remain, including how to ensure greater institutional outreach, cost-effectiveness and sustainability. Financial institutions neglecting savings mobilisation are incomplete institutions. Where they deal with clients only as borrowers, they forego useful information about the savings behaviour of those clients that would help refine estimations of their creditworthiness. The success of microfinance has destroyed three commonly held myths in rural finance: that the poor are not creditworthy, that women represent greater credit risks than men, and that the poor do not save conclusions of a study of three microfinance programmes in Bangladesh in the late 1990s. Three rural financial institutions in Asia are widely considered to have been successful in terms of outreach and self-sustainability: the Bank for Agriculture and Cooperatives (Thailand); the Village Banks, or Unit Desas of Bank Rakyat Indonesia; and Bangladesh s Grameen Bank. All have succeeded in providing financial services at unprecedented levels to millions of rural people. One common thread is the low to complete absence of government subsidies.approaches to rural finance are evolving in response to past failures. Overall, there is a felt need for reorientation of rural finance away from sole emphasis on channeling production credit to agriculture to one of strengthening rural financial intermediation in general. It is anticipated that, over time, the role of private sector organisations and NGOs will grow in importance. Governments nonetheless must retain a key supportive and facilitative role. Nowhere is this more important than in the capacity development, institutional and policy arenas.
4 Thematic Overview EASYPol Module 028 5 SUSTAINABILITY AND VIABILITY FACTORS In the light of the largely disappointing experiences with agricultural credit programmes in the past, the overriding objectives for rural financial institutions must be institutional sustainability and viability. These are achieved when they have eliminated dependency on donor funds and reached the status of financial profitability. There are two main sets of determinants: At level of the institution itself. Critical here are financial institutions own strategies relating to savings mobilisation, subsidies, interest rates, type of governance, including institutional structures and management, and the extent of market orientation (further elaborated in Box 1). At the policy level. Despite the best institutional strategies, its viability depends, in no small measure, on national policies through their influence on profitability of agricultural production and the conditions of operation for financial institutions in general. Key here are: The national regulatory framework for finance, covering areas such as collaterals for bank loans, including risk mitigation; bank supervision; interest rates; and contracts. The national economic policy framework, where macroeconomic policies, such as on the exchange rate, can affect producers access to credit. One of the most important strategies for development of the rural financial system is strengthening the regulatory framework, to give both lenders and depositors greater security and incentives. Sound governance and capable management of financial institutions are mirrored in risks presented by such institutions to their clients, to the regulatory agencies and to themselves.
5 Box 1 - Main Determinants of Sustainability of Rural Financial Institutions a) Savings mobilization. An institution that does not generate its own sources of loanable funds is likely to find eventually that outside sources are not reliable. Awareness by borrowers that their own funds are at risk is also likely to enhance their commitment to repayment. b) Minimal dependence on subsidies. Grants or low-interest rediscount loans from governments and donor agencies can substitute for savings mobilization by financial institutions. But the greater the use of such funds, the less sustainable the institution, since access to low-cost sources of funds is likely to weaken the institution s drive for operational efficiency. c) Setting interest rates at market levels. Subsidised interest rates usually mean low real deposit rates, which weaken savings mobilization, unless offset by significant subsidies, which generate their own problems. Other arguments against subsidised interest rates are: They erode the capital base of the financial institution, progressively diminishing its capacity to serve its clientele. They encourage lending for low-return activities, weakening the possibilities for the credit program to generate increases in sector income. Since low real interest rates cannot be used to screen applicants or projects, rationing of credit tends to be carried out on the basis of non-economic criteria. Small-scale loans entail higher administrative costs per unit lent, and higher interest rates are needed to cover those costs. Agricultural loans are generally risky: sustainability and viability of the financial institution may require building a risk premium into the interest rate for agricultural lending. d) Sound governance. A basic requirement here is institutional autonomy, in which absence, strong pressures are often applied to make loans on political criteria. It also means adequate institutional structures and arrangements to avoid conflicts of interest in making loan decisions, and to ensure accountability. Capacity development is often needed in this regard. e) Capable management. Selecting the management well and training the managers and staff of a rural financial institution are vital to its effectiveness and viability. Training can be expensive but its benefits justify the costs. f) A market orientation in designing its financial services. It is now recognised that creation of savings instruments and other financial services in developing countries must be based on a careful assessment of clients needs and preferences. In Bulgaria in the late 1990s the government s frequent justification for budgeted credit subsidies is the lack of collateral mechanisms for agricultural producers and intermediaries. The country s legal system does not permit movable property (machinery or livestock) to be used to secure loans, and most banks are reluctant to lend to agriculture. But supplemental guarantees cannot fix these deficiencies in collateral. The solution lies more in changing the investment environment to reduce risk and increase profitability. This will require changes in laws and procedures that govern collateral in the country.
6 Thematic Overview EASYPol Module 028 6 MACROECONOMIC RAMIFICATIONS Various studies have found a positive links between liberalised financial markets and more efficient resource allocation and higher rates of economic growth. One such study of 76 countries in 1993 demonstrated the importance of financial institutions charging or offering positive real interest rates. It found that those countries which had the highest deposit rates had GDP growth during the period 1974 1989 of 2 % higher than those with the lowest rates; growth was in fact negative for the latter group of countries.mobilisation and allocation of domestic resources in agricultural development will be enhanced by application of efficiency as well as equity criteria in macroeconomic policy, including monetary and banking policy. Some important macroeconomic considerations are: 6.1 Production or income policy objective Arriving at a clear decision as to whether rural finance is meant to fund production maximisation or agricultural sector income growth. Opting explicitly for the latter is preferred since it takes into account prices farmers receive and their costs of production, and permits application of comparative advantage and profitability principles. Abandoning policies to provide directed and subsidised agricultural credit for selected crops is thus integral to a sound rural financial system. 6.2 Poverty alleviation vs outreach Taking cognisance of possible trade-offs between targeting a portion of poor people and simply attempting to reach large numbers of the poor. Microfinance programmes provide but one feasible option for poverty alleviation. Attaining minimum consumption thresholds; reaching a basic level of technical or entrepreneurial skills; and availability of viable yet relatively low risk investments for the very poor may be conditions that will first have to be met if this option is to prove workable. Reaching and benefiting the poorest remain a daunting task. Credit-based interventions may, under some conditions, be best targeted at those among the poor who can respond and benefit through income generation activities, whereas there may be other more cost effective means of benefiting the ultra-poor. The latter would include investments in basic education and productive infrastructure to raise their living standards and make them eventually better placed to avail of production credit. Rural finance systems cannot therefore be viewed in isolation from the gamut of policy options which might be used in the fight against poverty. 6.3 Adopting market rate for loans and deposits Efficiency in both mobilisation and allocation of savings is maximised when institutional interest rates are set at their free-market equilibrium levels, with discriminatory taxes on financial services removed. Governments can do this by issue of treasury bills and bonds with attractive yields, thereby stimulating a competitive market interest rate for deposits. Thus, whilst artificial ceilings or government subsidies on loan interest rates should be removed, policy intervention in managing the bank deposit rate is often justified.
7 Market failure exists when the price established in the market does not equal the marginal social benefit of a good and the marginal social cost of producing the good. Sources of market failure include monopolies, externalities, and imperfect information flows, which lead to sub-optimal allocation of resources and consumer welfare. 6.4 Situations of high inflation Under such conditions, and when drastic macroeconomic stabilisation programmes are underway, attempting to move to a positive real interest rate of borrowing may be problematic. Profitability and financial incentives for agricultural enterprises are adversely affected, since inflation works through proportionately more for input costs (funded by loans) than output prices. There may thus be a case for deferring the easing controls on interest rates till after relative price stability. Along with stabilisation programmes, a policy of reducing money supply growth combined with improved deposit rates could also be used to stimulate growth. Most farmer cannot afford to pay the positive real interest rates where inflation remains high for extended periods of time, as was the case for countries like Turkey during the 1980s and 1990s. 6.5 Deciding on government and donor roles Selective government support is justified when based on the principle of removing the causes of market failure in a cost-effective way. Facilitating the effective working of market forces may be done through: grants or subsidies for information generation; assisting rural financial intermediaries with access to re-financing facilities and seed capital; and capacity development. Subsidies and grants should be transparent and temporary. External donors and NGOs could also assist in reforming rural financial systems. These include: supplementing the pool of loanable funds mobilised by local intermediaries; start-up funding of institutions to enhance managing of savings deposits; special incentives to help offset higher costs of servicing specific target groups, and filling gaps in long term funding. Here again, contributions should be temporary and complementary to local effort. 7 PRINCIPAL ELEMENTS OF RURAL FINANCE POLICY Appropriate macroeconomic and sector development policies are prerequisites to forging an effective rural finance system. Governments role here should remain largely supportive and facilitative. This should focus on designing and following through the necessary policy and legal provisions, including addressing specific market failures where they occur. Special consideration ought to be given to the following policy elements as possible ways forward: Setting a conducive overall legal and regulatory environment, especially concerning interest rates, bank supervision capacities, property rights, and legislative framework for contracts and all forms of collateral.
8 Thematic Overview EASYPol Module 028 Emphasising savings mobilisation by rural financial institutions, large and small. Here the policy thrust should be encouraging private efforts at financial intermediation, aided by technical assistance and relatively modest direct financial support. Designing and adopting innovative techniques of lending on the basis of intangible collateral, to extend the outreach of rural financial institutions to poor households. Providing on a selective and temporary basis only assistance to microfinance and rural finance institutions that show sufficient management capabilities and appropriate governance structures, to facilitate their attaining sustainability and targeting the poor. Paying particular attention to gender mainstreaming in the design of rural finance programmes. The main rationale here is on efficiency and sustainability grounds, rather than of equity per se 1. Giving due care to the organisational structure of financial institutions, with emphasis on governance issues and, in some cases, the role of second-tier institutions. The creation of supporting institutions such as credit bureaus to improve financial information may need to be considered. Last, though not least, making ample provision for capacity development, including systems design and strengthening, and training of financial institutions personnel as well as farmers and rural households in financial management. Despite the great deal learnt todate, the reach of formal rural finance is still slight compared to the overall needs. The learning and implementation process must continue, along with constant adaptation of experiences that have proven viable and cost effective in one context or another. 1 Further discussed in EASYPol Module 030: Policy Highlights: Gender in Agricultural Development Policies.
9 Module metadata 1. EASYPol Module 028 2. Title in original language English French Spanish Other language 3. Subtitle in original language English French Spanish Other language 4. Summary 5. Date January 2006 Policy Highlights 6. Author(s) Agricultual Policy Support Service, Policy Assistance Division, FAO, Rome, Italy based on Agricultural Development Policy: Concepts and Experiences by Roger Norton 7. Module type Thematic overview Conceptual and technical materials Analytical tools Applied materials Complementary resources 8. Topic covered by the module Agriculture in the macroeconomic context Agricultural and sub-sectoral policies Agro-industry and food chain policies Environment and sustainability Institutional and organizational development Investment planning and policies Poverty and food security Regional integration and international trade Rural Development 9. Subtopics covered by the module 10. Training path Analysis and monitoring of socio-economic impacts of policies 11. Keywords