By Alan de Brauw (published on November 17, 2021)
Photo credit: World Bank
Several constraints limit the ability of smallholder farmers in low and middle income countries (LMICs) to reach their production potential. One such constraint is access to formal finance; smallholders and other agricultural value chain participants frequently cannot access credit necessary to invest in new crops or technologies and deal with risks and shocks and/or savings products necessary to safely carry wealth from harvest to planting. A combination of new technologies, markets, and government priorities in several Southeast Asian countries suggest that new opportunities are emerging to overcome these long-standing challenges to expanding agricultural finance.
Yet new technology will neither fully eliminate barriers to increased production nor improve resilience against shocks if farmers lack markets for additional output or if financial providers lack sufficient information to assess potential clients, supervise loans, and address risks. As such, incorporating digital technologies into existing models of whole-of-value chain agricultural finance, or agricultural value chain finance (AVCF), is a potentially attractive approach to increase smallholder farmer returns, financial viability, and resilience and improve livelihoods.
AVCF blends relational contracting with more formal contracting observed in modern value chains. A standard AVCF scheme allows a formal lender (e.g. a bank) to lend to a single enterprise (e.g. a processor), which then buys crops from individual farmers. The relationship between the enterprise and farmers acts as a substitute for more formal collateral provided by the farmers. The enterprise can more effectively monitor and screen farmers while providing the individualized loans that banks find too costly to make, and the bank retains the ability to make a formal loan to an enterprise under standard terms and conditions.
In the IFS4Ag project, we have studied the necessary conditions for AVCF to work and how government policy and action in three countries—Indonesia, Myanmar, and Viet Nam—affects the potential of AVCF to help alleviate credit and liquidity constraints among farmers, thus limiting their potential. Here, we describe the level and method of government involvement in credit markets in the three countries, examining how this involvement may affect the quantity and quality of smallholder credit. We conclude with some simple recommendations to improve the climate for AVCF.
Credit markets, not just agricultural credit markets, tend to be regulated by governments. Governments typically play the role of ensuring that financial institutions carefully track deposits, charge the interest on loans that they state beforehand, and maintain reserves so that they continue to be solvent. They also regulate entry into financial markets. Governments do not just regulate credit markets; in fact, in all three countries studied in the IFS4Ag project, many or all of the largest banks are government-owned. State-owned enterprises also play an important role in each economy.
Since agricultural credit markets are even thinner than credit markets in general, governments often use further regulations or interventions to attempt to increase the agricultural credit supply. These interventions can be categorized as the establishment of agricultural banks and interest rate regulations. Collateral regulations can also play an important role in helping or hindering AVCF.
One way several countries have intervened in rural credit markets is by establishing an agricultural bank, with branches in rural areas to lower the transaction costs of serving farmers. In fact, each of the countries in our study has or had an agricultural bank. In Myanmar, the Myanmar Agricultural Development Bank and Myanmar Economic Bank have combined to play that role in the past. In Viet Nam, the agricultural bank is the Viet Nam Bank of Agriculture and Rural Development (VBARD). In Indonesia, there is not currently an agricultural bank, but Bank Rakyat Indonesia (BRI) was set up as an agricultural bank.
While agricultural bank branches reduce transaction costs to establishing bank accounts or obtaining credit, they have several potential drawbacks.
- Agricultural banks are often the only bank in a rural area. In the absence of other regulations, theoretically a credit monopoly will decrease credit supply and increase equilibrium interest rates. As a result, these banks may not offer credit terms much better than the informal money lenders often present in rural areas.
- ·Similarly, agricultural banks need not offer market-level interest rates on savings, therefore reducing incentives for rural residents to establish bank accounts, particularly given the spatial dispersion of villages.
- Finally, if, and when agricultural banks are privatized, they maintain that monopoly position.
So although agricultural banks are a useful way to improve credit access in rural areas, they may not be a panacea for agricultural credit.
Interest Rate Regulations
All three countries in the IFS4Ag study have policies affecting interest rates in ways that affect agricultural credit markets.
- In Myanmar, all loan interest rates by commercial banks are capped at 13 percent when collateralized and 16 percent when not for loans of up to MMK 10 million ($7610). Microfinance institutions can lend at 28 percent. Commercial banks largely find these rates too low to make profitable loans, so most agricultural lending is by MFIs or cooperatives.
- In Viet Nam, VBARD and the Viet Nam Social Bank for the Poor (VSBP) are both mandated to make agricultural loans at below market interest rates; VBARD charges 1 percent per month and VBSP 0.7 percent per month, significantly lower than the non-state-owned commercial banks. In fact, according to the 2018 VHLSS survey, 65 percent of all loans to the poor are made by VSBP and another 15 percent by VBARD.
- In Indonesia, the government makes agricultural credit more affordable through subsidies to banks on Kredit Usaya Rakyat (KUR) loans. KUR loans are subsidized by the government and borrowers are charged an interest rate below the market rate (6 percent). The government then pays the difference to the bank. The structure of KUR loans makes them less market distortionary than interest rate ceilings for agricultural loans because banks continue to receive the market interest rate. However, KUR loans are not targeted to agriculture or agricultural businesses, and the majority of KUR loans go to non-agricultural businesses.
Restrictions on collateral remain a challenge for agricultural lending in all three countries. There are several good reasons for this:
- Land Policy: In Myanmar and Viet Nam, all land is owned by the government, and farmers therefore only have land use certificates that can be used as collateral. However, not all households have land use certificates for the land they use, making it impossible to use as collateral.
- Policy Confusion: Bank officials are often confused about regulations around collateral. In Myanmar, it was found that banks misunderstood regulations and thought they could not loan more than MMK 1.5 million ($1141) to farmers.
- Poor Credit Scoring: In Indonesia and Viet Nam, banks are often risk averse in their lending, in part because they lack the ability to assess potential creditors. As a result, lending without collateral is limited, and banks sometimes even require collateral for loans that are not required by policy.
Financial institutions may face more than just difficulty assessing credit risk of individual borrowers; they may just be too unfamiliar with agriculture to feel comfortable lending to agricultural enterprises. This problem appeared acute in Myanmar even prior to the coup, as banks and other lending institutions lacked capacity to assess agricultural developments or enterprises in general. Similarly, in Viet Nam where VBARD and VBSP dominate lending and branches throughout the country, other banks likely lack much capacity to assess agricultural lending or even agribusiness lending.
Indonesia in particular has an interesting model used for investing in rural areas. Profitable corporations are required to pay a small percentage of profits into corporate social responsibility funds. Some of these funds are directed toward industries that are important for agriculture—for example, rice milling. In the second phase of IFS4Ag, we are working with a group of CSRs to understand whether additional lending through the CSR can lead to increased local supply.
To foster AVCF development, some policy rules of thumb could be considered by the governments of countries studied here and beyond.
- Agricultural loans, by nature, have different requirements than non-agricultural loans. Revenues tend to be lumpy, occurring only at specific times; liquidity requirements are typically short term (weeks or months) rather than long term, except for tree crops; and weather plays a different role in determining risk. Policies can hinder agricultural lending if they require consistent payments or unsuitable loan terms (too short or too long relative to crop and cash flow cycles), or if they inappropriately price risk.
- It is important to clarify collateral requirements for agricultural lending; if loan officers are confused about requirements, they may hinder borrowers from obtaining credit. Moreover, technology should make it possible to develop improved credit scoring and new types of collateral; governments should encourage this development.
- ICTs can be useful tools in catalyzing agricultural growth, but regulations such as caps on mobile money transfers can hinder their use in agriculture. Ensuring the appropriate use of technology to enhance financial options for farmers should be an important goal of regulators in all three countries. Indonesia has started this process, as the Financial Services Authority (Otoritas Jasa Keuangan) has been cautiously approving new financial products that are already helping some farmers find new markets and finance options. In Viet Nam, the State Bank of Viet Nam should consider how to allow current mobile money options to enhance financial inclusion in ways that facilitate agricultural lending.
This work was undertaken as part of, and funded by, the CGIAR Research Program on Policies, Institutions, and Markets (PIM) led by the International Food Policy Research Institute (IFPRI). PIM is in turn supported by these donors. This blog has not gone through IFPRI’s standard peer-review procedure. The opinions expressed here belong to the author, and do not necessarily reflect those of PIM, IFPRI, or CGIAR.