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How Can Finance Influence Productivity of Agricultural Firms?

Claudia Ruiz's picture

Worldwide, agriculture is the main source of income among the rural poor. Relative to other sectors, agricultural growth can reduce rural poverty rates faster and more effectively (Christiaensen and others 2011). As discussed in the GFDR 2014, one relevant vehicle to achieve growth in the sector may be finance.

Farmers’ decisions to invest and to produce are closely influenced by access to financial instruments. If appropriate risk mitigation products are lacking, or if available financial instruments do not match farmers’ needs, farmers may be discouraged to adopt better technologies, to purchase agricultural inputs, or to make other decisions that can improve the efficiency of their businesses. Improving access to finance can increase farmers’ investment choices and provide them with more effective tools to manage risks (Karlan and others 2012a, Cai and others 2009).

What is then preventing farmers and agricultural businesses to obtain finance? Historically, financial institutions have been reluctant to serve the sector for many reasons.

One major reason is geographical. Low population density and large geographical dispersion of clients in rural areas make it difficult for banks to operate at a profitable scale. The lack of financial institutions branches has translated in a limited provision of saving, insurance and credit products to farmers and agribusinesses.

A second factor inhibiting financial institutions from serving the sector has to do with the systemic risk characterizing agricultural activities. When natural hazards or adverse weather conditions take place, they typically affect a large number of farmers and firms simultaneously, making it more challenging for financial providers to diversify their portfolio of clients, since when one client fails to pay, many others will be in the same situation. This problem is aggravated by the paternalistic behavior or political motives that governments may have. Policies ranging from bailouts to relieve households from their debt obligations to political loans to the sector may distort firms and farmers incentives and discourage financial providers to enter the market. Kanz (2012) finds that India’s largest bailout program (the Debt Waiver and Debt Relief Scheme for Small and Marginal Farmers) did not alleviate problems of debt overhang of its beneficiaries. Instead, program recipients increased their reliance on informal credit and reduced their productive investment. His findings suggest that beneficiaries were concerned of the stigma of being identified as defaulters due to the program, and the effects this may have in their future access to formal credit.

Another challenge that banks face when serving the agriculture sector is that financial infrastructure in rural areas is in general very poor. Tracking identity of clients or monitoring production outcomes becomes extremely difficult in rural areas. If financial provides cannot track their clients back, then the punishment of default or underperform for a farmer is low, especially if contract enforcement is low. Hence, potential lenders or insurers may well decide not to engage with the sector in the first place, or to respond by excessive credit rationing or over-reliance on traditional forms of collateral, which many farmers lack.

In the last two decades, new approaches attempting to reduce these challenges have been developing in agricultural finance. One with great potential in agricultural settings is the use of technology to facilitate financial transactions. Credit and movable collateral registries, mobile banking and correspondent banking are examples of ways in which technology can help ease market failures in the agriculture setting. While rigorous impact evaluations on many of these new developments are pending, there are some studies that provide some insights. In Malawi, Giné and others (2012) found that the use of fingerprints to identify clients made the threat of future credit denial credible. As a result, the incentives for clients to pay back the loan increased, while simultaneously incentivizing lenders to engage in more transactions. Even though projects of this type are in piloting stages, these initiatives show great potential in reducing information costs of lenders or insurers. Other examples include Kenya’s M-Pesa and initiatives to introduce registries for movable collateral.

Proper risk management strategies are of extreme relevance to the sector. Instruments such as index insurance succeed in minimizing moral hazard and adverse selection, and under some circumstances can incentivize farmers to take riskier but more profitable investments (Karlan and others 2012b, Mobarak and Rosenzweig 2012, Giné and others 2010). However, index insurance remains a small fraction of the broad range of insurance products, and there are some challenges that index insurance still faces- having a low take-up rate, being too complicated for farmers to understand and value (World Bank 2007), or failing to dissipate an important part of the risk faced by farmers (Carter 2008).

As agricultural production transforms into integrated and more complex market chains, value chain finance has gained importance, helping link small farmers with the rest of the chain. As defined by FAO, value chain finance refers to the financial services that flow through the value chain to address the needs of those participating in the chain. Financial needs could range from securing sales, to procuring products, or obtaining finance. Several financial products have been developed to finance value chains, such as trade finance instruments, warehouse receipts, leasing, factoring, etc.  An innovative business model in value chain financing is Agrofinanzas in Mexico. Agrofinanzas specializes in lending to small farmers with little experience with banks and formal financing. Its business model is based on relationships with larger firms that are connected to smaller farmers. Agrofinanzas identifies its borrowers with information obtained by large firms on their small suppliers.

Summing up, evidence suggests that productivity in the agricultural sector can benefit from better access to financial instruments tailored to the needs of farmers and agribusinesses. Policy makers can take a series of steps to make this happen. First, investing in rural financial infrastructure can overcome the information asymmetries that discourage financial providers from serving agricultural firms. The availability of public databases on agricultural and weather statistics would allow lenders and insurers to distinguish good clients from bad ones more precisely and monitor their actions. Governments have a comparative advantage in providing information to help lenders or insurers identify their risks and price them accordingly (World Bank 2007). Second, strengthening property rights and contract enforcement can open up access to important financial products to farmers and agribusinesses. Third, governments should abstain from paternalistic policies that discourage financial providers from entering the market and that distort the incentives for farmers and firms. Public subsidies directed at agriculture should be carefully considered because they provide inappropriate incentives for farmers to invest in unprofitable farming activities. While certain subsidized insurance products could be justified on the basis of achieving the higher take-up of these products and allowing users to understand their value, subsidies that do not involve proper assessments of the quality or feasibility of projects should be avoided.

References:

Christiaensen, Luc, Lionel Demery, and Jesper Kuhl. 2011. The (Evolving) Role of Agriculture in Poverty Reduction: An Empirical Perspective. Journal of Development Economics 96 (2): 239–54.

Cai, Hongbin, Yuyu Chen, Hanming Fang, and Li-An Zhou. 2009. Microinsurance, Trust and Economic Development: Evidence from a Randomized Natural Field Experiment.  PIER Working Paper 09–034, Penn Institute for Economic Research, University of Pennsylvania, Philadelphia, PA.

Carter, Michael. 2008. Inducing Innovation: Risk Instruments for Solving the Conundrum of Rural Finance. Keynote paper prepared for the Agence Francaise de Developpement and European Development Network’s 6th Annual Conference, Paris, November 12.

Gine, Xavier, Jessica Goldberg, and Dean Yang. 2012. Credit Market Consequences of Improved Personal Identification: Field Experimental Evidence from Malawi.  American Economic Review 102 (6): 2923–54.

Gine, Xavier, Pamela Jakiela, Dean Karlan, and Jonathan Morduch. 2010. Microfinance Games.  American Economic Journal: Applied Economics 2 (3): 60–95.

Karlan, Dean, Isaac Osei-Akoto, Robert Osei, and Christopher Udry. 2012a. Examining Underinvestment in Agriculture: Measuring Returns to Capital and Insurance. Innovations for Poverty Action, New Haven, CT.

Karlan, Dean, Robert Darko Osei, Isaac Osei-Akoto, Christopher Udry. 2012b. Agricultural Decisions after Relaxing Credit and Risk Restraints. Unpublished working paper, Yale University, New Haven, CT.

Kanz, Martin. 2012. What Does Debt Relief Do for Development? Evidence from India’s Bailout Program for Highly Indebted-Rural Households. Policy Research Working Paper 6258, World Bank, Washington, DC.

Mobarak, Ahmed, and Mark Rosenzweig. 2012. Selling Formal Insurance to the Informally Insured. Economics Department Working Paper 97, Yale University, New Haven, CT.

World Bank 2007. World Development Report 2008: Agriculture for Development. Washington, DC: World Bank.

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