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. As indicated in the Global Financial Development Report (GFDR) 2019/2020, one key avenue to achieve growth in the agricultural sector is access to production and postharvest financing.
Farmers’ decisions to invest and to produce are closely influenced by access to affordable 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 in the right quantities and at the right time, 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.
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 savings, insurance, and credit products to farmers and agribusinesses.
A second major factor inhibiting financial institutions from serving the sector has to do with the systemic risk of 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. Literature finds that for instance, India’s largest bailout program (that is, the Debt Waiver and Debt Relief Scheme for Small and Marginal Farmers) did not alleviate the problems of debt overhang of its beneficiaries. Instead, program recipients increased their reliance on informal credit and reduced their productive investment. The evidence from the literature suggests that beneficiaries were concerned about the stigma of being identified as defaulters due to the program, and the effects this may have on their future access to formal credit.
Another challenge that financial institutions or banks face when serving the agriculture sector is that financial infrastructure in rural areas is in general very poor. Tracking the identity of clients or monitoring production outcomes becomes extremely difficult in rural areas. If financial providers cannot track their clients back, then the punishment of credit default or underperformance 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 agricultural finance setting. While rigorous impact evaluations on many of these new developments are pending, there are some studies that provide some insights. In Malawi for instance, a study by Giné et al. (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 the 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. Rural agricultural finance 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. However, index insurance remains a small fraction of the broad range of agricultural 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, or failing to dissipate an important part of the risk faced by farmers.
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 the Food and Agricultural Organization (FAO), agricultural value chain finance involves the provision of diverse 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 rural agricultural value chains, such as trade finance instruments, warehouse receipts, leasing, factoring, and so on.
An innovative business model in rural agricultural value chain financing is Agrofinanzas in Mexico. Agrofinanzas specializes in lending to smallholder rural farmers with little experience with banks and formal financing. Its business model is based on relationships with larger firms that are connected to smallholder rural farmers. Agrofinanzas identifies its borrowers with information obtained by large firms on their smallholder rural suppliers.
Summing up, evidence suggests that productivity in the rural agricultural sector can benefit from better access to rural financial instruments tailored to the needs of farmers and agribusinesses. Policymakers 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. Second, strengthening property rights and contract enforcement can open up access to important rural agricultural financial products to farmers and agribusinesses. Third, governments should abstain from paternalistic policies that discourage financial providers from entering the rural financial market and that distort the incentives for farmers and firms. Public subsidies directed at agriculture should be carefully considered (that is, should be SMART) 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 (rural farmers) to understand their value, subsidies that do not involve proper assessments of the quality or feasibility of projects should be avoided as much as possible by governments.