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The missing middle in agricultural finance
Relieving the capital constraint on smallholder groups and other agricultural SMEs
17 December 2009
Alan Doran, Ntongi McFadyen and Robert Vogel

Acknowledgements: FANRPAN acknowledges Oxfam as the source of this document

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Addressing costs and risks to improve capital supply

So far the private sector has made only small progress in responding to the needs of, and opportunities in, the market segment of small-scale agricultural enterprises, after the widespread withdrawal of the paradigm of government funded and controlled agricultural development. The unmet needs for finance of producer associations and other forms of SMEs (small- and medium-sized enterprises) in agriculture, for transactions in the size range £5,000 to £500,000, constitute the missing middle. The crucial issue is how to overcome the barriers to scaling-up the private sector’s response.

Rural households typically adopt a diversified strategy for survival – including non-agricultural activities –making microcredit, offered in tiny amounts and over short terms, a financial product that can be viable in terms of costs, risks, and returns. By contrast, small- and medium-scale agricultural activities are exposed to a narrower range of crop, market and other risks, including those internal to the business. Appraising and monitoring loans to SMEs requires analysis of all aspects of the enterprise. Because loans are larger and longer-term, lenders also require collateral or other more formal guarantees. Transaction costs are thus much higher. These costs can be recovered from interest rate margins and fees but only if loans are large enough. In many cases, agricultural SMEs are too small to absorb this quantity of external capital; hence the missing middle.

Equity investors need higher returns to compensate for the higher costs and risks in primary agriculture. Up to now, nearly all other sectors have been much more attractive, even for socially-oriented funds. Transaction costs for lenders and investors, as well as some risks, will diminish with improvements in the infrastructure of the financial sector. A complementary approach is to extend the use of collateral substitutes such as leasing, factoring, and contract finance.

Local lenders, whether commercial banks, rural financial co-operatives, or larger microfinance institutions (MFIs), have the advantage of knowing the immediate business environment for SME agriculture, but may find it hard to diversify risk. Even then, they need access to affordable external liquidity for survival during the inevitable bad times in their localities.

The promise of index-based weather insurance as a mechanism for transferring and pooling risk is large, and expectations are high. However, the difficulty of obtaining data is underestimated, the lead times are long, and the affordability is in question. Climate change is steadily increasing risk, reducing the scope of the insurance approach.

Nationwide lenders, including larger commercial banks and agricultural development banks, are better diversified – the latter to a lesser extent – but often lack systems for effectively delegating decisions to local rural branches. Many agricultural development banks need substantial reform in this and other respects before they can make a strong contribution.

Government imposed interest-rate ceilings and subsidised interest rates should be avoided: they usually result in rent-seekers or other larger-scale borrowers capturing the limited credit available, and are inherently unsustainable. Crucially they also crowd out sustainable private-sector initiatives.

Risk-sharing, through partial credit guarantees, is a more promising approach, since it works with the grain of the private sector. It encourages commercial banks to enter the market for longer-term finance for enterprise development. The new generation of guarantors include powerful philanthropic foundations, international finance institutions, and banks with a special interest in agricultural development, such as Rabobank. Their contracts with banks have features that should produce outcomes better than those of historic government guarantee funds.

Because the pay-off is so much more certain than intervening directly in the market for finance, and the goods and services supplied are public goods, government and donor resources are better directed to supporting infrastructure improvements, both for the financial sector and outside it.

Releasing effective demand

As well as supply, effective demand for missing middle finance is also constrained. Only one third of smallholders are aggregated in some form of group enterprise, appropriate for larger transactions. Individual farmers with more land, employing labour, will not take on the risk of debt, unless they have access also to savings and insurance products. Formal collateral is frequently lacking.

Women farmers suffer from educational discrimination, limited mobility, lack of land rights, and restrictive social norms. They are virtually excluded from agricultural credit and extension services. This is despite heading up one in five farms, and being capable of achieving gains in productivity as large, if not larger, than men farmers. Producer associations of both women and men often lack organisational capacity, a business culture, and specific finance-management skills, making them unacceptable as potential borrowers or investees.

A range of (mainly) non-profit actors offering technical assistance, often bundled with brokering access to external finance, or actual financial supply, is addressing these constraints. It includes specialised business development NGOs (non-government organisations) and bank-linked foundations. However, these efforts are usually focused on easier market segments involving high-value export commodities or Fair Trade goods, and relatively large transactions.

Poverty-focused NGOs such as Oxfam are also making a contribution through capacity building of very small co-operative businesses and introducing them to finance suppliers. This is an element of livelihoods programming, often working with disadvantaged women in remote areas.

Much of the external capital is required to finance fertiliser; other chemical inputs; irrigation and spraying equipment; and costly seed varieties in order to raise yields and incomes. A knowledge-based LEIT (low external input technologies) approach can also raise productivity, but often more slowly. Apart from needing less capital, it can be better for the environment, including climate change mitigation and adaptation, and for social development. On the other hand, LEIT agriculture requires efficient delivery of education and extension services, itself a major challenge. The existence of the LEIT alternative is a reminder that maximising the application of capital, or the effective demand for it, is not always the correct approach, and can exaggerate the size of the missing middle gap.

Improving infrastructure – financial and non-financial

Collateral contracts are the normal accompaniment to lending. Therefore changes in the regulatory and administrative environment, allowing more flexibility; ease of operation; and lower costs are important. Among these are the availability of independent services recording legal ownership of items and their location; working markets for land in rural areas; allowing collateralisation of debts owed to the enterprise; crops in various stages of processing; and personal property such as jewellery.

For all types of finance, the availability of credit history reduces the lender’s risk. Thus credit information bureaux are valuable, and can be made, with the right regulations and incentive structures for financiers, to cover the smallest loans in rural areas.

Bank reluctance to lend to SMEs will be lessened if risk-based supervision replaces the traditional, inflexible approach based solely on the presence of correct documentation, resulting in inaccurate and excessive provisioning. The new basis means assessing a lender’s ability to manage risks systematically, in particular the risks that come from the challenges of diversification over new sectors and from the delegation of decisions to local levels.

Local financial suppliers, such as small commercial banks, rural financial co-operatives, or larger MFIs can benefit from apex organisations or their equivalent, as centres to their networks, which can diversify risk and provide emergency liquidity. Donors and governments can make further contributions to institutional strengthening of this kind.

There is more to be done by national governments, supported by multilateral donors, in reforming national agricultural development banks, which may or may not benefit from privatisation.

Electronic and mobile technologies, which are improving the infrastructure for financial transactions in rural areas, need to be extended beyond household needs to meet more SME requirements.

Non-financial physical infrastructure – water supply, roads, power, telecommunications, schools, health posts, and so on, is usually relatively neglected in rural areas, which obviously weakens farming at all scales as well as all other rural economic activities, including financial services. This is a local government responsibility, though judicious donor support in the form of technical assistance and partial funding can obviously help.

Extension services, and educating farmers about business, are also good candidates for government budgetary support, though delivery models can vary. Another high priority for government within non-financial infrastructure is the sponsorship of local, participative agricultural R&D (research and development).

Combining aggregation, market linkage, and finance

Aggregating smallholder agriculture clearly improves access to markets but the financial constraint often remains. Risks and transaction costs are still high in relation to expected returns. Finance along, or linked to, tightly-integrated and hence lower-risk value chains, may be valuable, but cannot meet the needs for finance of all smallholder farmers, most of whom are not in any organised group.

Moreover, value-chain finance has so far been mainly concentrated in higher-value export crops or commodities, rather than in staple food production for local or regional markets. External finance, provided directly, can also better preserve the independence and diversification of the primary producers, and encourages the development of local financial institutions.

The most common form of aggregation is the producer association. Other aggregation and market-linkage models, such as the hub-outgrower model and various forms of contract farming, offer an alternative to individual farmers, both those on family plots, and more commonly those with larger landholdings, that want to remain more independent. Again, some of these are focused on international markets, but others are combining local food production and export crops. External finance is sometimes present as a component in these arrangements, leveraged in by the reduction in risk brought about by market linkage.

Concerted and multiple actions required

This paper seeks to show that while the reason for the missing middle is fairly straightforward, eliminating it requires a multi-track approach to match the complex pattern of demand, supply, and infrastructure features.

Setting up new institutional arrangements or intermediaries to divert scarce public or donor capital always adds costs, and does not in itself reduce risk, or increase returns. The possible benefits of this type of response, often put in the category of learning, or demonstration of viability, need to be carefully assessed against the danger of duplication of similar initiatives and the opportunity costs for all players involved of employing the resources in this way.

Many of the promising initiatives aimed at reducing the missing middle finance gap rely on combinations of actors, playing to their respective strengths. The common theme is working with the grain of the private sector to remove frictions of various kinds, thus improving the balance between risk, cost, and return. In this way, scale should be achieved. A number of initiatives cited in the paper are reviewed below:
  • NGOs with a financial focus and a business development culture often have a crucial role, at least in the early stages, creating linkages and networks among financial suppliers, women and men producers, buyers, and other service providers;
  • multilateral donors can be key sponsors of financial sector reform programmes working with national governments and central banks. Reforms can focus on specific institutions such as agricultural development banks, on better regulation, on improvements to financial infrastructure, or on stimulating competition in rural finance;
  • donors and international financial institutions (IFIs) have pump-primed innovative financing mechanisms, such as warehouse receipts and leasing;
  • alliances have been struck between commercial banks and non-financial distribution networks: for example, of irrigation equipment or mobile phone services;
  • socially responsible investors of various kinds have been important in Fair Trade transaction financing, either working directly or in conjunction with banks. There are a few examples of business development investment in activities closely linked to primary agriculture;
  • foundations and socially-oriented banks are offering partial and temporary guarantees on a commercial basis, sometimes working with other risk mitigation mechanisms, in order to encourage commercial banks to take the small-scale agricultural sector seriously as a profitable market segment.
  • poverty-focused NGOs have explored the possibilities of building capacity in women’s and men’s smallholder groups, and other small-scale producer associations, in remote and difficult locations and then brokering linkages to formal sources of finance to support livelihoods.
Continuation of these and other efforts will be needed, as well as careful and independent evaluations of what works and what does not, if progress to solving the missing middle gap is to be maintained and indeed accelerated.

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