Financing For Agriculture: How To Boost Opportunities In .

INVESTMENT IN AGRICULTUREPolicy Brief #3Financing for Agriculture: How to boostopportunities in developing countriesMarina RueteSeptember 20151. IntroductionAccess to finance is critical for the growth of theagriculture sector. The shift from subsistenceto commercial agricultural production requiresfunds. However, in developing countries, whereagriculture is a source of livelihood for 86 per centof rural people (International Finance Corporation[IFC], 2013), financing for investments inagriculture is scarce, even for large investors. InAfrica, less that 1 per cent of commercial lendingis destined to the agriculture sector (IFC, 2013).Financial institutions are reluctant to accept therisks prevalent in the agricultural sector, suchas droughts, floods, pests and diseases, or thetransaction costs of covering large geographicaldistances. Consequently, although governmentsare now making efforts to attract investmentfor agriculture, the lack of understanding of thefinancial risks and opportunities in agriculture,deprives the sector of much-needed funds to boostproduction, processing and marketing.This policy brief explores the financial needsof agriculture in developing countries and theinstruments available to address these needs. Weexamine the challenges in obtaining financing foragricultural investments, the role of different actors,and the options for governments to enhance thelegal and policy environment of the financial systemto support agricultural development.2. Challenges of AgriculturalFinancingSimilar to other sectors, those who invest inagriculture, particularly local farmers, but alsoforeign-owned plantations, processing factories,storage facilities or fertilizer companies, mayneed funds from third parties to carry out theirbusinesses. However, in the current globalfinancial system, a number of factors frustratethe development of solid financial services inrural areas in most developing countries. First,transaction costs in rural areas are higher than inurban areas due to a more dispersed populationwith weak infrastructure (International Fund forAgricultural Development [IFAD], 2009a).Second, and more importantly, the risk factorsinherent in agriculture often inhibit financialinstitutions from lending. These include productionrisks linked to natural hazards (such as droughts,floods and pests), farmers weak ability to providecollateral (either because the farmer lacks title toland to offer as a loan guarantee or the value of theland may be too low) and the volatility of prices(IFAD, 2009a).Third, the financial sector may not be sophisticatedenough in some developing countries. Theavailability and innovation on sector-specificfinancial instruments and services is usually poor.Also, although financial services may be available,they may not be suitable for all types of agriculturalactivities, which will have diverse needs with respectto timing for disbursements, amounts and risks, 2015 International Institute for Sustainable DevelopmentIISD.org1

among others. For example, in seasonal farming,funding is needed in particular stages of theproduction process (IFAD, 2009a). At the sametime, the offer of financial products may only beavailable to large-scale farming operations withsound track records, and therefore may not meetthe specific needs of the client.Finally, the lack of records and statistics on farmingin developing countries makes assessment of creditsuitability challenging for financial providers. Thischanges the conditions required to access financialproducts and undermines opportunities forprofitable investment.3. Who Needs Finance in theAgriculture Sector?Agriculture encompasses a broad range of activitiesfrom small-scale farming to infrastructure projectsto research and development. As a result, whenreferring to agriculture finance, the market clustersit in four groups. The groupings correspond todifferent approaches to addressing the needs of thesectors: (1) the needs of farmers and entrepreneurs,(2) the transactions between the actors alongthe value chain, (3) infrastructure needs and (4)generating knowledge to support the sector.1. Farmers and small agriculturalentrepreneurs: This approach is focused onthe actors in the agriculture sector that needfinancing. Farmers and small entrepreneurs,like small supply companies, need financeto allow them to expand production and/or diversify products. This can include, forexample, finance for inputs (such as seeds andfertilizers), production (such as machinery andequipment) and marketing (such as processing,packaging and transport) (Food and AgricultureOrganization [FAO] & World Bank, 2013).2. Actors along the value chain: The focus ison the links between different actors along avalue chain. Agriculture entails a sequence ofinterlinked activities—transactions—in a chainthat starts from the supply of seeds and fertilizersand finishes in the mouth of the consumers(IFAD, 2012). There are financial instrumentsspecifically designed to strengthen these linksbetween the actors along the value chain.INVESTMENT IN AGRICULTURE Policy Brief #33. Rural infrastructure: Financing can be alsoconcentrated on the infrastructure neededto carry out agricultural activities. The sectordepends heavily on infrastructure such as ruraltransport systems, irrigation systems, watersupply, sanitation, electricity, storage andtelecommunication facilities. These projects arecostly and require large amounts of financing.4. Research and Development (R&D):This last approach focuses on financiallysupporting knowledge generation for the sector.This includes the generation of agriculturaltechnology and new technical knowledge aboutproducts, processes and services for the sector(Anandajayasekeram, 2011). R&D also providesvaluable knowledge to help producers preparebusiness plans for banks or other financialinstitutions, to support financial planning andcredit assessment by financial institutions, andgovernment planning in general.4 . An Overview of FinancialInstruments for the Rural SectorDifferent financial instruments respond to differentneeds in the agriculture sector. Within each of thefour groups, the financial instruments depend onthe level of sophistication of the financial system ineach country, and the willingness of the financers totake the risks in that particular market. Regulationand awareness programs also play a key role in theresponse to the financial needs. In addition to localfinancial institutions, foreign banks, developmentbanks, governments and even actors in need offinancial assistance, also provide financial solutions.This section describes some of the availablefinancial instruments and initiatives generally usedin different countries.4.1 Direct FinanceFinancing a particular actor of the agriculturesector is the traditional approach to financingin developing countries. This includes not onlyfarmers but also other actors, such as inputsuppliers, processors, traders and exporters. Allneed financing to get food from the farm to theconsumers. The following financial instruments areavailable:Financing for Agriculture: How to boost opportunities in developing countriesIISD.org2

1. Savings. An informal financial sector exists incountries all over the world, particularly in leastdeveloped countries, and provides for basicaccess to finance. The financing comes from theactors themselves. In many countries, it takes theform of community savings and non-formalizedgroup financing mechanisms. The tontine, forexample, is a Senegalese rotating system of smallamounts savings and credit organized by smallgroups of people (Balkenhol & Gueye, 1992).In Ghana, women have formed groups, calledsusu groups, to finance among them agricultureactivities with a system that distributes theresponsibility of collection and payments amongthe group members (IFAD, 2000).2. Inclusive finance (or micro-finance). Thisinstrument is slightly more sophisticated butstill part of the informal financial sector. It isreferred to as inclusive finance or micro-financeand has grown considerably in the last decade.The goal is to “expand access to affordable andresponsible financial products and services bypoor and vulnerable populations” (Principlesfor Responsible Investment, 2013). It includessavings, credit, insurance, remittances andpayments and even guarantees to accessfinance. Micro-finance is particularly popularin developing countries. It has become sopopular that specialized banks or units withinfinancial institutions are also providing smallloans and savings services, while accepting awide variety of assets as collateral. The strengthof microfinance institutions is the close contactwith the community and, consequently, theunderstanding of the risk profile of customers.3. Traditional finance. Within the formal financialsystem, the term “finance,” which includes loans,leasing and equity finance (selling part of whatyou own to raise funds), is used to encompass themost common forms of finance for larger sumsof money over longer periods of time. Financecan come from commercial banks, agriculturaldevelopment banks, non-governmentalorganizations (NGOs), cooperatives or investors,in the case of equity finance. Recipients of theseinstruments can also benefit from support fromgovernment or international development banks(such as the World Bank and IFAD).INVESTMENT IN AGRICULTURE Policy Brief #34. Leasing and factoring. In a country witha more developed financial system, financialinstitutions also offer more complex andinnovative financial instruments to farmersand entrepreneurs, such as leasing andfactoring. Leasing is used to finance machinery,automobiles and equipment in agriculture.Factoring is when a company sells its invoices toa third party (the factor) at a discount in orderto improve cash flow. These mechanisms aimto reduce some of the traditional lending risksof agriculture. They are an alternative optionfor borrowers with limited collateral and credithistory, to be able to rent machinery, equipmentand other assets related to production (WorldBank, 2009).5. Weather-based insurance. This is aninstrument that improves the chances foraccess to finance by insuring against badweather. Although farmers prefer insurancefor production loss, many financial institutionsfind the assessment too tedious and subjective.Weather-based insurance responds to objectiveparameters like rainfall or temperatures (WorldFood Program & IFAD, 2011). Farmers whocan obtain weather-based insurance have betteraccess to other forms of financing as well. Thisinstrument will seldom be offered in countriesthat lack sound statistical information (IFAD,2011).6. Credit guarantee schemes: This instrumentalso improves the chances for access to finance.These schemes “provide guarantees to groupsthat do not have access to credit by coveringa share of the default risk of the loan. In caseof default, the lender recovers the value of theguarantee” (Organisation for Economic Cooperation and Development [OECD], 2010).The types of financing described above can becombined in many different ways in the sameproject, with the participation of different actors.For example, development banks can makeloans to financial institutions, which can act asintermediaries to lend or guarantee producerswho, at the same time, can be also financed by alocal bank. This structure has been carried out,for example, by the Inter-American InvestmentCorporation in Latin America (2014).Financing for Agriculture: How to boost opportunities in developing countriesIISD.org3