International Agricultural Development Policy AGEC 689 Dr. Roger D. Norton Module 6. Challenges in Agricultural Financial Policy
Issues in module 6 p Nature of rural financial markets p Managing risk in agriculture p Generating more sources of rural credit p Keys to sustainability and effectiveness of rural finance p Adapting regulatory structures p Providing other rural financial services p Medium- and long-term agricultural finance p Generating funding for innovation
The Importance of Rural Finance
WHY IS CREDIT IMPORTANT FOR AGRICULTURE? u The period between incurring production costs (e.g., for fertilizer, seeds) and receiving return on the costs (harvest time) may be several months, and most farmers in developing countries poor u Agriculture is BOTH more capital-intensive and more labor-intensive, per unit of output, than industry, and smallholders do not have the cash for new capital investments (e.g., irrigation, livestock, tree crops) u Equity finance is scarcely available (Stiglitz 1998)
Savings are also important in the rural economy p It is a myth that rural households have no savings; if so, most would have gone extinct long ago p While informal credit often is available, it will go only to those who have savings or the capacity to save p When banks offered to open rural savings accounts, financial savings in rural areas mushroomed (BKK in Indonesia, Banco Agrícola in Dominican Republic)
Savings are also important for sustainable financial institutions and financial intermediation w Not having savings accounts means less information about credit capacity of borrowers w Savings accounts help ensure repayment and thus encourage institutions to lend more w For local credit institutions, borrowers are more likely to pay promptly knowing that the funds are the savings of neighbors w Savings mobilization draws funds away from unproductive uses and enables lending for more productive uses
Broad Issues in Rural Finance
In the past, governments reacted to perceptions of i) inadequate volumes of rural credit, ii) excessive interest rates on informal markets, with: q Directed allocations of credit q Subsidized interest rates q State-owned development banks
The results were uniformly counterproductive p Credit was directed to low-return uses (less productive sub-sectors or crops) p Interest rate subsidies went largely to the better-off farmers and ranchers p With weak loan administration in State banks they were kept afloat only with repeated infusions of cash from the national treasury p A credit mentality was fostered among farmers that loans did not have to be repaid p Sustainable private finance did not grow because of the low interest rates and poor credit mentality
ALSO: u When State banks closed or scaled down, even creditworthy borrowers were left without finance; u Small rural credit funds dependent on external donor support folded when projects ended, again leaving borrowers without financial support Hence the policy goal has shifted from supplying quantities of cheap credit to facilitating the development of SUSTAINABLE modalities of rural finance
As in the case of urban water supplies, artificially low prices (in this case, referring to the price of capital) do not do any favors for the sector, least of all for the poor.
The Nature of Rural Finance
Finance is difficult in rural areas of developing countries p p p p p p Populations widely dispersed: higher transport costs (hence mobile banks in Brazil) Small loans: high unit transactions costs Lower literacy rates No documented credit histories Low and fluctuating incomes from yield and price risks Less documented collateral
Other characteristics of rural financial markets p Formal and informal sectors co-exist with differing interest rates! p Interest rates may not equilibrate supply and demand for finance! p Credit markets are segmented with marked differences in interest rates (local monopolies of informal lending)! p Even high interest rates may not attract commercial lenders! p There is asymmetric information about risks, between borrowers and lenders!
Three issues faced by lenders in rural areas u Difficulty of determining riskiness of borrowers (screening problem) u Costly to develop incentives for repayment (incentives problem) u Difficult to compel repayment (enforcement problem)
Local banks and credit unions and informal financial institutions can be efficient p They know their clients better than large commercial banks do (reducing information costs) p Administrative costs are less p Interest rates are not regulated and can adjust to the market p They are not subject to the reserve requirements of commercial banks -- Maxwell Fry, Money, Interest and Banking in Economic Development, Johns Hopkins, 1995
Managing Risk in Rural Finance
Developing-world agriculture is risky because: u Crop yields vary a lot because of weather effects, disease, infestations u Crop quality may be damaged by inadequate post-harvest handling, reducing prices u Market prices fluctuate
Developing-world agriculture also is risky because: u Farm animals may get sick and die u Farmers are poor and have little or no cash reserve
IN VIEW OF THE RISK IN AGRICULTURE HOW CAN COMMERCIAL BANK LENDING BE ENCOURAGED? q Sectoral rediscount lines from the Central Bank to commercial banks have been tried, to lower the cost of capital to banks for lending to agriculture but: -- They can be subject to fund diversion, i.e., a farm owner can obtain a loan and use it to remodel the city house (a fairly common experience). The administrative cost of monitoring for this is very high. --Governments frequently limit the use of the rediscount lines to what they term strategic crops, which may not be the most promising crops for farmers or offer the best returns on capital.
Also to overcome the risk issue: p The World Bank has tried subsidizing the opening of rural branches of commercial banks. p Partial loan guarantee funds for agriculture have been implemented (e.g., letting commercial banks recover from the government, say, 50% of nonperforming farm loans). The coverage should not be 100% or close to it, or it may encourage banks to make unduly risky loans (moral hazard). p Some commercial banks buy into local banks and microfinance institutions that know the borrowers --key information for reducing risk.
Further to the risk issue: p Better training of bank staffs in evaluating agricultural projects can help them reduce risk. Often the skills in evaluating projects in agriculture are very limited. p Banks can shift part of the risk to the buyers of harvests by lending to farmers and collecting the loan from the buyers. The buyers reduce the price paid to farmers enough to cover the loan. There is risk for buyers if they don t know the farmers well or don t have a long history with them: what happens if the farmer decides to deliver the harvests to someone else, for a better price? But this model is used in conditions favorable for contract farming.
Microfinance institutions handle risk through various approaches! u u u u u Self-selecting groups ( solidarity groups ): all members are responsible for the payment of loans to each member (for the screening and enforcement problems) A variant: lending first to one member (of, say, 5); when payment goes well, lending to a 2 nd member, and when that goes well, lending to a third one, etc. (for the incentives problem) Lending to the woman in the household (screening). Scaling up successive loan amounts, starting from very small loans (incentives) Often microfinance will require weekly payments on loans, and will visit the homes of borrowers weekly (enforcement).
Risk is always present in agriculture and needs to be faced In the end a central question is how should the risk be SHARED in lending operations?! u Borrowers can pay part through higher interest.! u Lenders can pay part through higher provisioning and reserves for agricultural portfolios! u Government (taxpayers) can pay part through subsidized guarantee funds, subsidized crop insurance, or other schemes!!
Increasing the volume of agricultural credit
Greater volumes of rural finance can be obtained by attracting diverse kinds of lenders u Suppliers of inputs and equipment! u Buyers and processors of farm products (value chain finance)! u Local banks or credit unions! u Microfinance organizations!
To attract these and other sources of finance, expanded legal forms of collateral are important (via new legislation) Ø Ø Ø Ø Ø Ø Invoices Crops in storage Processed or semi-processed products Livestock Farm equipment Export contracts
Local banks and credit unions attract savings and channel them into investments Credit unions affiliated with the World Council of Credit Unions (WOCCU) now exist in 101 countries, have 200 million members, and hold $1.3 TRILLION in savings and loans totaling $1.1 TRILLION. See www.woccu.org They are in 23 countries in Africa, 17 countries in Latin America, 21 countries in Asia, and 17 countries in the Caribbean. In addition, networks of local banks exist (e.g., cajas rurales in Honduras, SACCOs in Rwanda). There are many microfinance organizations throughout the world, but they do not have savings deposits.
Issues to be alert for in each of these types of institutions p Credit unions (credit cooperatives): a majority of the members may be borrowers, so the danger is that policies and administration may be biased toward loose management of loans. p Local banks: These entities (and credit unions) individually are exposed to high covariance risk because their clients are in a small area, growing similar crops and exposed to similar weather threats. They can benefit from having an apex organization that can manage liquidity flows among the entities, although apex organizations should not necessarily serve as additional capital sources.
Issues to be alert for in each of these types of institutions, cont. p Microfinance: They depend on external capital sources for funds to lend, since they do not capture local savings. p Local banks and credit unions: They should not receive too much capital from external sources. A study in Honduras showed that those that received the most external funding had the highest failure rates; the quality of their loan portfolio declined when they received extra funding.
Issues to be alert for in each of these types of institutions, cont. p All rural finance institutions: Good governance is critical. A good board of directors can: i) Eliminate conflicts of interest and establish trust among depositors, managers, shareholders and boards of directors. ii) iii) iv) Help construct and preserve the vision of the institution Help find a balance among growth, risk and profitability Hold management accountable
A major area in which volumes of rural credit remain inadequate is medium- and long-term investments This kind of funding is required for investments in livestock herd expansion, tree crops, irrigation systems, hillside terraces, post-harvest equipment and other uses.!
To fill this gap government intervention may be required. Microfinance, local banks and commercial banks will not do it on their own. Government support can take the form of partial guarantees for long-term loans or rediscount lines from second-storey financial institutions.
The gender gap in rural finance
Another major area in which volumes of lending are insufficient is for rural women clients In spite of advances in this area, the vast bulk of rural finance still goes to men throughout the developing world, even though it has been demonstrated that women are more reliable clients for lending.
Reasons for the continuing gender disparity in access to finance: p Credit is more concentrated on crop production, where men predominate, rather than small ruminants and value chain activities, where women have a bigger role.! p Credit is seldom provided for consumption, and it is women who are more likely to borrow to meet the family s consumption needs.! p Credit is sometimes channeled through organizations that do not have women members.! p Collateral requirements disadvantage women who do not have assets in their name.!
Reasons for the continuing gender disparity in access to finance, cont.: p Women s lower educational rates give them less literacy and numeracy, which holds them back for financial transactions.! p Cultural barriers may hold women back from interaction with formal sectors.! p Credit is sometimes channeled through organizations that do not have women members.! p Collateral requirements disadvantage women who do not have assets in their name.!
Policy to overcome the gender gap in finance can include: p Training for financial institutions regarding the importance of having women clients! p Training women clients in basic literacy and numeracy, and loan procedures! p Remove legal constraints to women s access, such as the requirement for a head of household to sign contracts! p Reform land tenure laws to give women more formal access to land assets! p In legislation for moveable collateral, include jewelry and household items likely to be owned by women!
Progress on the gender gap is being made in many countries For example, Women s World Banking has 14 million women clients, $4.4 billion in savings deposits, $6.9 billion in loans, and trains managers and leaders throughout the world!
Regulatory frameworks for rural finance
Prudential bank regulation is vital to protect depositors and shareholders It also helps avoid having a crisis in one bank spread to the entire system. It is designed both to prevent crises and to deal with them once they have occurred. The regulations apply only to institutions that take deposits.
Bank regulations may have to be adapted for agricultural loan portfolios p With agricultural risks, capital-to-loan ratios should be higher! p Frequent reporting on loan status is not workable for, say, six-month crop loans.! p Much of documentation required is not relevant for rural loans, for the borrower s character is more important and documents do not exist!
Bank regulations may have to be adapted for agricultural loan portfolios, cont. p Rules restricting bank branches to a given area may increase risk to the lender (less diversification in terms of crops, micro-climates, etc.)! p Loan provisioning requirements (reserve-to-losses ratios) for lack of collateral are not applicable when the collateral is not tangible (social collateral)! p Requirements that provisioning be increased when the loan is a few days overdue are not applicable for production loans because a harvest may be delayed for two weeks or more!
The cost of bank supervision for small institutions is very high u Even rural banks and microfinance that take small deposits as loan guarantees do not necessarily have to fall under bank regulation u For all these reasons many countries are now moving to modify bank regulation and supervision requirements for rural lending
Sustainability in rural finance
Keys to sustainable rural finance p Positive real interest rates and flexible rates p Acceptable rates of loan recovery and profitability for financial institutions p Trust among depositors and investors; they need to feel the institution is wisely managed
Much formal rural lending is still made at negative real interest rates, especially with government loans and rotating project credit funds u Positive real rates are essential for sustainability u High interest rates on informal loans are not always higher than formal bank rates. In Bangladesh it was found that formal rates were as high as 108% including costs of travel, bribes and the opportunity cost of time.
Other elements of sustainable rural finance p Wider use of crop insurance p Mobilizing rural savings p Appropriate regulatory frameworks for rural lending p Giving autonomy to government financial intermediaries p Closing government retail credit lines, which are not sustainable and undermine private finance
Trained and professional management is required for rural financial institutions. That is why many rotating credit funds established by projects eventually fail. In formal financial institutions with professional staff, more training is needed in evaluating agricultural projects.
Credit is not always the best answer for agricultural investment needs Innovation grant funds, with competitively allocated funding, are increasingly used for agriculture and small agri-business investments. Examples include Uganda, Brazil, Colombia, Peru, Nicaragua and Panama!
Looking ahead: Strategic approaches for rural finance
The strategic elements include:! p Appropriate legal and regulatory frameworks, especially for interest rates, bank supervision, property rights, and laws for contracts and collateral p Transitory, selec;ve and modest subsidies for small rural financial ins;tu;ons showing good management and governance p Emphasis on savings mobiliza;on in large and small ins;tu;ons p Use of modern techniques of lending with intangible collateral
The strategic elements also include:! p Greater aben;on to gender issues in design rural financial programs p ABen;on to structural considera;ons, including governance and the role of second- ;er ins;tu;ons p Emphasis on training farmers and households on becoming credit clients and financial management p Training of farmers on tracking costs of produc;on and profits of their opera;ons p Use of well- designed innova;on funds