Agriculture Microfinance : Changing Face of Indian Farming Agriculture Microfinance Rural finance, as defined by the World Bank, is the provision of a range of financial services such as savings, credit, payments and insurance to rural individuals, households, and enterprises, both farm and non-farm, on a sustainable basis. It includes financing for agriculture and agro processing. Agricultural finance is defined as a subset of rural finance dedicated to financing agricultural related activities such as input supply, production, distribution, wholesale, processing and marketing. Microfinance is the provision of financial services for poor and low income people and covers the lower ends of both rural and agriculture finance as seen in the diagram below. Microfinance loans are fungible and are often already used for agricultural activities, microfinance products are often a poor fit with agricultural cashflows and as a result can be more risky for lenders and borrowers alike. Where rural financial services have reached poor households, these have tended to be households with diversified non-farm income sources or income from non-seasonal agricultural activities. Specificity of Agriculture Finance The agricultural sector is different from other economic sectors in a number of ways. Activities are generally located in isolated areas with low population density and poor infrastructure. They are dependent on weather and production cycles; income is seasonal and monetary income is limited.
Agriculture Microfinance : Changing Face of Indian Farming
Agriculture Microfinance
Rural finance, as defined by the World Bank, is the provision of a range of financial services
such as savings, credit, payments and insurance to rural individuals, households, and
enterprises, both farm and non-farm, on a sustainable basis. It includes financing for
agriculture and agro processing. Agricultural finance is defined as a subset of rural finance
dedicated to financing agricultural related activities such as input supply, production,
distribution, wholesale, processing and marketing.
Microfinance is the provision of financial services for poor and low income people and
covers the lower ends of both rural and agriculture finance as seen in the diagram below.
Microfinance loans are fungible and are often already used for agricultural activities,
microfinance products are often a poor fit with agricultural cashflows and as a result can bemore risky for lenders and borrowers alike. Where rural financial services have reached poor
households, these have tended to be households with diversified non-farm income sources or
income from non-seasonal agricultural activities.
Specificity of Agriculture Finance
The agricultural sector is different from other economic sectors in a number of ways.
Activities are generally located in isolated areas with low population density and poor
infrastructure. They are dependent on weather and production cycles; income is seasonal and
maintenance), (re)constitution of herds, land purchase.
Family needs: personal, durable goods, housing.
Savings
Non-financial services: monitoring demand, technical assistance and extension.
Understanding how to best meet these financial needs and finding ways to mitigate the risks
associated with them are added challenges that further hinder the expansion of financial
services for agriculture. Moreover, as microfinance is increasingly integrating into
conventional financial markets, the sector has no choice but to apply cost-covering interestrates. Such rates often contradict the expansion of rural coverage and agricultural finance due
to the low profitability of the activities financed. All these factors explain the relative lack of
interest in agriculture on the part of urban and peri-urban zones. Consequently, liberalized
markets coupled with contractual innovations — elements promoted under the new
paradigm — have not fulfilled their promises vis a vis rural and agricultural finance.
Need for Agriculture Microfinance in India
Agriculture plays a crucial role in the development of the Indian economy. It accounts for
about 19 per cent of GDP and about twothirds of the population is dependent on the sector.
The importance of farm credit as a critical input to agriculture is reinforced by the unique roleof Indian agriculture in the macroeconomic framework and its role in poverty alleviation.
Recognising the importance of agriculture sector in India‘s development, the Government
and the Reserve Bank of India (RBI) have played a vital role in creating a broad-based
institutional framework for catering to the increasing credit requirements of the sector.
Agricultural policies in India have been reviewed from time to time to maintain pace with the
changing requirements of the agriculture sector, which forms an important segment of the
priority sector lending of scheduled commercial banks (SCBs) and target of 18 per cent of net
bank credit has been stipulated for the sector. The Approach Paper to the Eleventh Five Year
Plan has set a target of 4 per cent for the agriculture sector within the overall GDP growth
target of 9 per cent. In this context, the need for affordable, sufficient and timely supply of
institutional credit to agriculture has assumed critical importance.
The evolution of institutional credit to agriculture could be broadly classified into four
distinct phases - 1904-1969 (predominance of co-operatives and setting up of RBI), 1969-
1975 [nationalisation of commercial banks and setting up of Regional Rural Banks (RRBs)],
1975-1990 (setting up of NABARD) and from 1991 onwards (financial sector reforms).
The genesis of institutional involvement in the sphere of agricultural credit could be traced
back to the enactment of the Cooperative Societies Act in 1904. The establishment of the RBI
in 1935 reinforced the process of institutional development for agricultural credit. The RBI is
perhaps the first central bank in the world to have taken interest in the matters related to
agriculture and agricultural credit, and it continues to do so (Reddy, 2001). The demand for
i) lack of simultaneity between the realisation of income and act of expenditure;
ii) lumpiness of investment in fixed capital formation; and
iii) stochastic surges in capital needs and saving that accompany technological innovations.
Credit, as one of the critical non-land inputs, has two-dimensions from the viewpoint of its
contribution to the augmentation of agricultural growth viz., availability of credit (the
quantum) and the distribution of credit. In this paper, the trends in agricultural credit are
analysed in Section I; Section II covers Statewise distribution of institutional credit; Section
III deals with recent policy initiatives; issues and concerns are dealt with in Section IV;
Section V draws implications for the future followed by the concluding observations in
Section VI.
The new development challenge
Andhra Pradesh, which witnessed a spate of suicides, especially by cotton farmers in recentyears, saw the biggest drop in agricultural workers -- from 56% in 1991 to 43% in 2002,
according to a report in the Hindustan Times dated December 5, 2005. The figures for Kerala
and Tamil Nadu are 50% (from 78%) and 35% (from 43%) respectively.
The new states, Chhattisgarh and Jharkhand, with little industrial activity, have the largest
numbers of farm workers -- 75% and 76% respectively. Himachal Pradesh fits into the same
category, with 75% of its population dependent on agriculture for their livelihood.
The national average for people engaged in cultivation is around 60%. It was 76% in 1971
and 66% in 1991.
This trend poses a challenge for the development sector, especially those in micro-finance, in
terms of retaining the involvement of people with their landholdings and strengthening the
tentative linkages of micro-finance with agriculture.
More importantly, as people struggle to move out of the ambit of agriculture in search of
newer avenues, there is a need to extend support to non-farm activities and also help resolve
the problem of migration.
To address these issues, sessions on self-help initiatives and the micro-finance sector formed
part of the National Conference on Empowering Livelihoods organised by the PACS
Programme in New Delhi on October 24-26, 2005.
Micro-finance: New look required
Over the past decade or so, the micro-finance sector has made significant progress in
fostering savings and extending credit to small groups, especially women, in rural India (only
20% of the Indian populace has access to credit from the formal sector).
The sector has spawned over 2 million self-help groups (SHGs) and 1.6 million have been
linked with banks since 1992. Total SHG-bank linkage lending over 2004 alone was over Rs
3,000 crore (Source: Andhra Pradesh Mahila Abhivradhi Society, or APMAS).
Although growth in the Indian micro-finance sector has been exceptional, concern is being
expressed over issues like internal control systems, fund management, accounting and
governance. In recent years, SHG federations have been mushrooming all over the country.
Andhra Pradesh alone has over 30,000 federations, informal and formal. The question now is
how to tweak and mesh this growth into the development process.
There is need for a new understanding and structure for micro-finance, one that looks
‗beyond credit‘, offering solutions to the multifarious issues germane to rural economies such
as micro-finance and agriculture, livelihood security, migration, insurance, rural
entrepreneurship, technology infusion, market linkages, the role of agribusiness, etc. This
requires a certain degree of restructuring and innovation of approach, which is happening.
The faint contours can already be seen.
At a time when interest in agriculture is waning, can micro-finance rekindle and sustain
livelihoods around agricultural activities? Can micro-finance undertake this task by
continuing with the present mechanism or does it call for a radical change in approach? Can
we learn from global trends and tailor a model suitable for India? What are the trends, andwhich model is right for us?
A new model
The Consultative Group to Assist the Poor (CGAP), supported by the International Fund for
Agricultural Development (IFAD), recently examined over 80 providers of micro-finance
across the developing world. The idea was to pin down sustainable approaches to providing
financial services to farming-dependent households.
While the focus of the CGAP analysis was on lending, it nevertheless recognised and
explored the importance of deposits, insurance, and money transfer services. It also addresses
the need to look at markets and market linkages seriously, to ensure agricultural
sustainability, and recommends a collaborative or contractual approach to problem solving.
The new model is described plainly as ―agricultural micro-finance‖ by the CGAP. It
combines the most relevant and promising features of traditional micro-finance, traditional
agriculture finance (bank/institutional), and a host of other approaches including leasing and
area-based insurance.
The area-income-based Farm Insurance Income Scheme was tried out for the first time in
India across 19 districts, during the rabi season in 2003-04, by the Agriculture InsuranceCompany of India. In 2003, ICICI-Lombard experimented with rainfall insurance, based on a
composite index. AIC followed with Varsha Bima in 2004. These schemes harnessed
technology and existing infrastructure and contracts with processors, traders and agribusiness.
This forms an agriculture micro-finance model characterised by 10 principal features.
Ten principal features of the model
The CGAP analysis stresses that successful agricultural micro-finance lenders rely on a
judicious mix of the 10 features, but that it is not necessary for an effective model to
Most of the features, naturally, are specific to financing agriculture; some address the
common challenges of operating in a rural setting, and some are basically good practices in
delivering small, unsecured loans. In India, bits and pieces of these features are already being
tried out.
The features:
1. Repayments are not linked to loan use: Under this model there is a conscious effort to
‗de-link‘ loan uses from repayment sources (traditional lending is a medley of production
loans narrowly designed for varieties of crops or livestock-rearing). The new approach says
that even if a loan is given to raise a certain crop, the borrower‘s entire household income is
taken into account when judging repayment capacity. Deploying this approach has apparently
worked remarkably well in increasing repayment rates.
The approach is based on detailed studies on how poor households earn, spend, borrow and
accumulate assets. Farming households often engage in a number of activities that align with
agriculture cycles -- petty trading, rudimentary processing, labour, livestock, temporarymigration, etc. (Non-farm income of a typical farming household in Asia is around 32%; the
non-farm part of rural full-time employment is 25%.)
2. Character-based lending techniques are combined with technical criteria in selecting
borrowers, setting term loans, and enforcing repayment: This feature emphasises the
principles that most self-help groups adhere to -- group guarantee, peer pressure, follow-up
on late payments, etc. It also stresses on infusing the credit mechanism and process with
specialised agricultural knowledge. The few micro-finance programmes that have entered
into full-scale agricultural activities have agronomists and vets to support loan decisions and
methodologies.
3. Saving mechanisms provided: However poor an individual or household may be, there
still exists the need to manage liquidity, conduct transactions and accumulate assets. When
rural financial institutions offered deposit accounts to farming households, which enabled
them to save funds for lean periods and handle life events, the number of such accounts
quickly exceeded the number of loans.
4. Portfolio risk is highly diversified: Diversification has been one of the primary risk-
mitigation strategies in financing. A number of micro-finance institutions with stable lending
portfolios have minimised risks by lending to households or groups that have a diverse crop
mix and also earn from other sources such as livestock-keeping. Organic farming undertakenby small, marginal farmers would therefore be an ideal plank, for organic principles
encourage diversity, inter-cropping, buffer, companion crops, etc. Most organic farmers are
also adept at livestock-keeping, for it is integral to the system. Dung, urine and other on-farm
resources are vital ingredients in the bio-composting and pest management techniques
adopted by farmers practising sustainable agriculture.
5. Loan terms and conditions are adjusted to accommodate cyclical cash flows and
bulky investments: Successful agricultural micro-lenders, keeping in mind that farming cash
flows are highly cyclical, have modified loan terms and conditions to track these cash flows
more closely. All this without compromising on the principle that repayment is expected
regardless of the success or failure of an individual productive activity, even that for whichthe loan was used. Promoting flexible repayment has worked well. For instance, Caja Los
Andes in Bolivia has tuned its repayment options with the agricultural activities of its
borrowers. The options include:
One-time payment of capital and interest.
Periodic payments of equal amounts.
Periodic interest payments with payment of capital at the end of the term loan. Plans with differing, irregular payments (for clients with several crops).
PRODEM, another micro-finance institution in Bolivia, has expanded this tenet to embrace
rural non-farm enterprises as well. Cash flows of rural grocers, for instance, were found to be
significantly higher in the months when the local dominant crops were harvested. To adapt
financial products to fit agriculture cycles, monitor uptake and performance and improve
their design over time, micro-finance institutions have to plug into better management
information systems.
Long-term lending is also an area that bedevils the micro-finance sector. However, this need
too can be addressed successfully as shown by the Small Farmers Cooperative of Prithvinagar, a tea-growing area in Nepal. Earlier, its loans were not big enough or
sufficiently long-term to encourage tea-growing. Therefore, an eight-year-long loan that
covers three-fourths of the average cost of starting a small tea farm (0.6 hectares), with a
three-year grace period, was introduced.
Interest payments are made every three months between the third and fifth years of the loan
term, while principal instalments are made every six months between the sixth and eighth
years. Most importantly, the cooperative goes beyond credit. It offers tea farmers marketing
services to help ensure loan repayments, and higher prices for harvests. Tea from individual
farms is pooled and marketed collectively. The sale proceeds are given to the farmers after
deducting loan payments.
6. Contractual agreements reduce price risks, enhance production quality and help
guarantee repayments: Because of the complexity of production risks, many lenders feel
that small farmers require far more support than simply receiving loans, especially if they are
engaged in the production of a complex crop. Such lenders offer technical assistance and
other types of support directly to farmers, either because they seek to improve farm practices
as part of an integrated development programme, or to guarantee minimum yields and quality
of commodities for processing or resale.
Traders, processors, other agribusinesses, and individuals reduce the production andoperational risks associated with lending to farmers, by linking credit to the provision of
technical advice (such as on input use or what crop variety to grow to meet market demand),
or timely delivery of appropriate inputs (seeds, etc). Or by building relationships with farmers
over one or more years.
Many also tie credit to subsequent sales of produce, a practice often called interlocking or
interlinked contracts because it provides inputs on credit based on the borrower‘s expected
harvest. Operating costs for providing credit can be low because credit is built into crop
purchase and input supply transactions with farmers, for which agribusinesses may have
existing physical infrastructure (warehouses), agents, processing facilities, information
technology systems, farmer networks and market knowledge.
This approach has already taken root in India. For instance, Rallis with ICICI Bank/SBI and
Picric of the UK worked quite successfully with basmati rice farmers in Haryana. Rallis
provided all the inputs for growing, ICICI Bank extended loans for the inputs, and Picric
bought the produce. Such instances now abound across the country. Mahindra Shubhlabh
runs a similar initiative. Many models of contract farming are being practised. Pepsico was
one of the pioneers when it started work with tomato and chilli farmers in Punjab, in the1990s.
Basix, an Andhra Pradesh-based micro-finance institution that has over the years disbursed
over Rs 355 crore, has been propagating the collaborative/contractual approach to livelihood
solutions. Basix has replicated what the commercial banks have been doing. Its drip irrigation
experience is an eye-opener. Under this initiative, the Delhi-based NGO International
Development Enterprises provided the technology, and Sowbhagya Seeds did the marketing.
Demonstration trials were carried out by the Andhra Pradesh government‘s District Poverty
Initiative Programme (DPIP) together with the UNDP‘s South Asia Poverty Alleviation
Project (SADAP).
Similar initiatives have been undertaken by a variety of operators in other sectors including
dairying. A host of crops -- potato, soybean, paddy, red gram, lac and even seaweed -- have
been covered by contractual arrangements.
The only apprehension often aired about contract farming as it is practised today is theinherent potential of big players to be exploitative. Therefore, farmers and farmers‘ groups
have to be educated and enabled to stand up and negotiate fair terms. Collective bargaining
and arbitration mechanisms must be in place.
Contractual arrangements have tremendous potential to secure livelihoods. A host of
corporates are already engaged with, or are entering the agricultural sector in a big way. They
include Mahindra & Mahindra, Hindustan Lever, ITC, Reliance, the Tata Group,
Venkateshwara Hatcheries, Pepsico, Nestle, McDonalds and now even Airtel. The challenge
is in establishing lasting linkages between agribusiness and micro-finance and, most
importantly, reaching out to the small and marginal farmer. NGOs can play a role as pivotal
intermediaries in capacity-building and monitoring, as, for example, Banco Wiese in Peru
and the NGO CES Solidaridad.
7. Financial service delivery piggybacks on existing institutional infrastructure, or is
extended using technology: Increasing the supply of agricultural finance requires creating
institutional capacity. One way to do this is by building on existing institutional infrastructureand networks such as post offices, agribusiness agents or collection centres, and state-run
banks, and using technology appropriate to rural areas such as mobile banking units.
All rural lenders need to invest in techniques and technologies that deliver financial services
sustainably, in areas characterised by poor transportation and communications infrastructure,
low client density and low levels of economic activity. NABARD and the Department of
Posts are all set to launch a pilot project in Tamil Nadu for disbursing loans to SHGs through
post offices. The project will be tried out in three districts, from December 2005, and then
scaled up across the country. NABARD has decided to take all the credit risks, while the post
The challenge of devising new channels of delivery to 70% of the Indian populace living in
rural areas is daunting. Harnessing technological innovations such as kiosks and smart cards
could reduce transaction costs considerably and improve access. ICICI Bank is already
piloting the use of smart cards, in association with SEWA Bank in Ahmedabad. The bank is
also working on a ―high quality shared banking technology platform‖ that can be used by
MFIs, cooperative banks and regional rural banks. Wipro, Infosys, I-Flex and 3iInfotech arespearheading this initiative.
8. Membership-based organisations can facilitate rural access to financial services and
be viable in remote areas: Lenders generally face much lower transaction costs when
dealing with an association of farmers as opposed to numerous individual, dispersed farmers.
Associations or groupings of farmers can also administer loans more effectively.
Membership-based organisations can be viable financial service-providers themselves.
According to Y S Nanda, former chairman of NABARD, 20 lakh SHGs was too great a
number for banks to be interested in. He would like to see newer structures emerging, such as
a collection of groups. The challenge now is in creating and sustaining producer/farming
SHGs.
Experiences with producer/farmer associations have been mixed, with problems of lack of
member motivation and association capacity. Smaller and more marginal farmers need
considerable handholding and training in order to establish effective associations.
The upfront costs may be more than what private sector actors are willing to pay. Therefore,
the situation merits donor support through specialised intermediaries/NGOs that can provide
training, systems support and other assistance to existing associations and to farmers wishing
to set up producer associations.
Creating a second-tier institutional support structure for small rural financial organisations,
such as a network or federation of savings and loan cooperatives, could address some of these
challenges.
Audits and benchmarking are also key to the success of initiatives in this area. They promote
transparency and performance standards. In addition, services can be offered that make it
easier for member organisations to negotiate funds from banks and donors, lobby for policy
and legal reform, monitor performance and meet short-term cash flow needs. A refinancing
facility, for instance, would help in this regard.
9. Area-based index insurance can protect against the risks of agricultural lending:Area-based index insurance, which can be applied to both production and price risks, is a
promising approach. Such insurance is defined at a regional level and provided against
specific events that are independent of the behaviour of insured farmers.
Examples include weather-related insurance policies linked to rainfall or temperature in a
defined area, offering indemnity payments if the relevant index falls or rises above a certain
level, and price-related policies with payouts based on crop prices.
Such policies enable providers to insure against a specific risk rather than all agriculture-
related risks, and being defined at a regional level makes them more viable and attractive to
private insurers because they reduce administrative costs and risks of fraud and moral hazard.
Index-based insurance has the potential to reduce both the risks of losses for individual
farmers and the operational risks of lenders.
The basic difficulty for insurers in extending such coverage to small farmers is the same as
that faced by micro-finance institutions: how to profitably service small contracts and
transactions.
Governments and donors can adopt or support measures that enhance the potential for index-
based insurance from the private sector to include small farmer clients. They can, for
example, ensure the existence and availability of accurate, timely and comprehensive
databases -- for example, on national or regional rainfall levels and commodity prices -- that
private insurers can use to value instruments for weather and price risks.
10. To succeed, agricultural micro-finance must be insulated from political interference:
Agricultural micro-finance cannot survive in the long term unless it is protected from
political interference. Even the best designed and best executed programmes wither in the
face of government moratoriums on loan repayment or other such meddling in well-functioning systems of rural finance.
Some Key Issues in Agricultural Microfinance
The issue at hand is not about the straightforward application of microfinance technologies
to agriculture in order to provide small farmers and other agriculture-based economic agents
with access to sustainable finance services. The case at hand is much more complex and
challenging than can be imagined. Christen and Pearce (2005) have documented the
problems faced by lending institutions in the agriculture sector. In Uganda a bumper maizeharvest in late 2001 and early 2002 caused maize prices (and farmer incomes) to fall,
significantly affecting loan repayment in four branches of the Centenary Rural Development
Bank. In Mali, Kafo Jiginew, a federation of credit unions suffered a deteriorated portfolio
at risk (over 90 days) from 3% of the total in 1998 to 12% in 1999 due to a slump in cotton
prices. Cotton loans had a very a large share of the credit union‘s loan portfolio.
It is, thus, necessary to have a keen understanding of (a) agricultural conditions, (b) the
configuration of risks in the rural areas, the availability of riskmitigation instruments and
how to use those instruments, and (c) the incentives that will affect the design of the finance
(loan) product, including mechanisms for recovery — in the case of a loan product, the loanrecovery methods. These issues can be largely understood in terms of three significant
characteristics of rural credit markets identified by Besley (1994), which shape the nature of
appropriate credit policy and program responses, namely: 1) the scarcity of collateral, 2) the
absence of complementary institutions to reduce risks, and 3) covariant risks and market
segmentation.
Scarcity of Collateral
Traditional collateral may be scarce because borrowers may be too poor to have significant
assets that can be pledged as collateral. The scarcity of collateral may also be attributed tothe relatively small sizes of farm lands and the lack of secure titles to those small pieces of
land. In the case of the Philippines, the fragmentation of farm lands and the demise of land
markets because of agrarian reform have imposed an additional constraint (Estanislao and
Llanto 1995; David et al. 2003; and Llanto and Ballesteros 2002). Certain provisions of the
Comprehensive Agrarian Reform Law such as: (a) the prohibition against mortgaging/selling
of the land within 10 years of its award and upon full payment by farmer- beneficiaries to theLand Bank of the Philippines; (b) the setting of a ceiling on the ownership of agricultural
lands at five hectares; (c) the designation of government as the sole buyer of awarded lands;
and (d) the prohibition against share-tenancy arrangements, have eroded the collateral value
of land. This has hampered the small farmer‘s access to credit in the formal financial markets.
The World Bank‘s Land Administration and Management Project (LAMP) in Thailand and
the Philippines underscores the severity of land titling and administration problems in the two
countries, particularly in the rural areas of the latter country. Llanto and Magno (2002) note
that the inefficient land administration system has resulted in high transaction costs in
securing, registering and transferring property rights. There is no efficient mechanism toresolve land disputes, and the land administration system does not generate the reliable
information needed by the courts to hear land cases. Also, the high cost of registering land
discourages registration and consequently investments on land. Poor land administration can
erode public confidence and trust in the titling and land registration system, and this puts
especially the poor at a great disadvantage.
Secure property rights, which are a fundamental requirement for a collateral-oriented banking
system, may be poorly developed or even absent. Of course, MFIs have long ago shown that
microenterprise loans, including loans to poor individuals (mostly women), do not
necessarily require the traditional land collateral as security. MFIs have lent to asset-less
individuals and have successfully recovered the loans. However, one may argue that the
context of urban micro-lending is quite different from that of rural and agri-based lending,
where borrowers may demand bigger and longer-term loans. The size of the loan may be
larger and the loan maturities are typically longer than the usual micro-loans that have to be
repaid within a 90-day period in view of the rural borrower‘s different consumption and
investment requirements. Both rural borrowers and lenders face the challenge of discovering
alternative mechanisms such as contractual arrangements, contract farming and others,
viewing rural households as integrated business and family units with multiple sources of
income, and adjusting loan repayment schedules to the households‘ cash flow and to theagriculture cycle.
Thus, rural lenders have to adopt a ―business unusual‖ approach and innovate because the
constraint imposed on rural credit markets by the ―scarcity of collateral‖ seems to be a myth.
Christen and Pearce (2003) gave the example of Banco del Estado de Chile, which spent two
years improving its micro-enterprise lending techniques before expanding into farming
activities. It also improved agricultural finance techniques, for example, by integrating crop-
based analysis into its wider client analysis and by having flexible loan repayment schedules
based on seasonal income cycles. The Economic Credit Institution, a microfinance institution
in Bosnia and Herzegovina, uses spreadsheets for key agricultural products compiled by anagronomist as an aid to cash-flow analysis.
Skees (2003), Ibarra (2003), Bryla (2003), and Christen and Pearce (2005) provide a neat
summary explanation of the risk issues faced by rural borrowers such as small farmers and
their rational behavior toward risks. Bryla cites a 1999 World Bank study showing how price
volatility significantly impacts on the incomes of farmers and the macroeconomic health of
their countries. From 1983 to 1998, the prices of many commodities fluctuated from below
50 percent to above 150 percent of their average prices. Facing a spectrum of risks, the most
frequently cited of which are price, weather and health risks, farmers respond by adopting
low-risk and low-yield crop and production patterns to ensure a minimum income at the
expense of rural growth and accumulation of capital. Alternatively, in the absence of
insurance markets, farmers try to cope with price and other risks by: (a) asset accumulation,
savings, and access to credit; (b) income diversification; and (c) informal insurance
arrangements. Ibarra (2003) views the increased labor market participation by small farmers,
the reduction of consumption, the resort to interest-free loans or donations from relatives andfriends, and the sale of assets such as livestock, as risk-coping strategies, and not risk
management strategies.
Successful agricultural microfinance as indicated by the experience of Banco del Estado de
Chile is about pooling and managing risk. But how well can rural lenders cope with the
correlated risks in agriculture? Traditional agriculture loans portfolios, especially those of
government banks or development finance institutions, show a concentration of production
loans to certain crops, e.g., rice, maize, cocoa, and livestock. The concentration of
production loans creates concentrated risks for the rural lending institution. There seems to
be no major problem if the risks involved are individual and are not correlated. However, the
reality is that risks in agriculture are correlated. When agricultural commodity prices decline,
everyone faces a lower price for their crops. Natural disasters such as widespread flooding
that destroy crops, livestock, shelter and rural infrastructure, severely impact rural households
in many contiguous areas. Price and yield risks are spatially correlated and this poses a major
challenge to agricultural microfinance. On their own, small rural lenders, e.g., rural banks,
cooperatives or credit-granting NGOs, are simply not capable of pooling and managing
correlated risks. Worse, they may have no experience whatsoever in dealing with these
different types of risks. Because of this, many rural lenders, which may have experienced the
adverse effects of correlated risks in agriculture on their loan portfolios or which may beaware of the negative experience of other lenders in this regard, would tend to avoid
agricultural lending or drastically limit their loan exposure to smallholder agriculture.
Anecdotal evidence from the author‘s interviews with rural bankers in Mindanao, Philippines
shows that the wary rural lenders have nonetheless practiced rational decisionmaking
through loan diversification to minimize credit risks. This is evident, for instance, in their
moves to cap their agricultural lending, shift their target clientele to teachers and other
government employees who they provided with salary loans, and focus on urban micro-
lending. In Latin America, diversification is one of the primary risk-mitigation strategies of
rural lenders. The MFIs tend to limit agricultural lending to less than one third of theirportfolios, e.g., about 25% of the portfolio for Confianza (a rural finance institution in Peru),
but only 6% for Bolivia‘s Caja Los Andes, with a similar level for Uganda‘s Centenary Bank.
Some Latin American MFIs, e.g., PRODEM of Bolivia and Calpia of El Salvador do not lend
to rural households without non-farm income or those dependent only on one or two crops, as
a strategy to contain risks in agricultural microfinance (Christen and Pearce 2005). Box 1 is
an illustration of the experience of a Latin American financial institution with concentrationand diversification in the loan portfolio.
Observing local rural economies, Vogel and Llanto (2005) pointed out that there seems to be
a parallel diversification of risks among rural households — mirroring a risk management
strategy as opposed to an ex post coping strategy such as liquidation of households assets in
response to, say, a catastrophe like flooding that wipes out standing crops. Rural households
have tried to diversify their risks through family members engaging in non-farm activities.
Rural income still largely comes from farm production, although income from non-farm
activities is becoming significant in Asian countries, as pointed out earlier. Philippine data
show that in 1987, on-farm income contributed 56 percent to total rural income, while off-farm income‘s share was 7 percent. This means that 63 percent of the rural income came
from both on-farm production and off- farm activities, e.g., livelihood projects. By 1990,
farm incomes (on-farm and off-farm incomes) had declined to 57 percent while income from
non-farm and other sources has increased to 43 percent (Agricultural Credit Policy Council,
1992). Incomes from non-farm activities and other sources such as remittances have become
a significant source of rural incomes.
Remittances from overseas Filipino workers (OFWs) and relatives based abroad have also
become an increasingly important source of income for many rural households. They
contributed 32 percent of the total income generated within the period 1991-2000 and helped
keep the economy afloat. With the decline in incomes from agriculture and agriculture-
related activities, remittances have become an alternative and significant source of income for
rural families. Although a large number of OFWs are from urbanized areas, such as the
National Capital Region (NCR) and Southern Tagalog, many of them also come from mainly
agricultural regions with high poverty levels. Some families depend entirely on these
remittances as their main source of income while others have used a portion of these funds to
pursue informal lending activities that provide external financing to farmers and
entrepreneurs. Thus, these remittances either directly or indirectly provide the rural areas with
the necessary liquidity that formal institutions cannot supply. The significant increase of overseas remittances has contributed to the growth of business and economic activities in the
rural areas.
In sum, it is important for formal rural lenders to be equipped with accurate information on
the agricultural crop cycle; the pattern of risks; how rural households earn, spend, save and
borrow money; what risk management and risk-coping strategies and instruments are used by
those households; the variety of farm and non-farm activities; and attempts to diversify local
economies, among others. In short, rural lenders must have a thorough understanding of their
potential clients and the milieu or context of their daily lives and economic and business
The main unrecognized challenge in rural finance is the problem of overcoming the systemic
risks arising from the undiversified nature of local economies. Notwithstanding the
diversification efforts of small-scale farmers and most other rural residents, especially low-
income ones, rural areas themselves remain largely undiversified economies. In fact, the
typically undiversified nature of rural areas presents a major challenge to most rural residents
– even shopkeepers in a rural town will be adversely affected if the major product (e.g., rice)
suffers a decline in price or loss of output due to adverse weather or insect pests. Thus, a
rural lender does not escape this lack of diversification by lending to shopkeepers rather than
to farmers. In finance, risks are dealt with by portfolio diversification, but for a local lender
the opportunities for loan portfolio diversification are sharply limited, so the lender is likely
to be left with the alternative of holding relatively large amounts of liquid assets and thereby
curtailing local lending. Realizing the absence of effective demand, one type of lender
woulddecide to park the excess liquidity in commercial papers, bills and securities, e.g.,government bonds and securities. On the other hand, there is the lender who has lending
opportunities but is pressed with temporary lack of liquidity and has to abandon the
likelihood of lending.
In the Philippines, there is no institution dedicated to providing a much-needed liquidity
service, i.e., providing short-term loans to rural lenders that are temporarily short of liquidity
but fully solvent in the longer run if the liquidity problem can be overcome. Rural banks can
potentially access liquidity from the Bangko Sentral ng Pilipinas (BSP), but conditions
surrounding access are appropriately rather draconian, based on the usually correct
assumption that lack of liquidity indicates potential insolvency. Government financial
institutions such as the Land Bank of the Philippines or the Development Bank of the
Philippines or a federation of credit cooperatives could perhaps fulfill the function of
providing liquidity to local lenders with temporary liquidity problems, but in general,
government entities and cooperative federations do not exhibit the appropriate degree of
toughness in separating temporary liquidity shortages from pending insolvency. An obvious
solution to this problem of systemic risks in local areas could be to rely more heavily on
nationwide financial institutions (e.g., large banks) to provide most rural loans. However,
recent experience in the Philippines shows that even slightly adverse financial conditions
could trigger a reduction in rural lending by commercial and universal banks. Clearly, thesebanks view rural lending as a relatively risky undertaking – not unlike most banks worldwide
that have failed to develop effective mechanisms to delegate lending decisions adequately to
small branches while maintaining appropriate systems of internal audit and financial controls.
Absence of Risk-reducing Institution
As pointed out earlier, risks are correlated in agriculture, and this can potentially ruin a rural
lender who does not have an effective risk management strategy and who may not have
access to risk-reducing instruments or institutions. Insurance markets are important
institutions for overcoming systemic risks but complementary institutions, such as insurance
markets and credit information bureaus, that may help to reduce those risks may be lacking or
underdeveloped in developing countries in Asia.
The absence of such risk-reducing mechanisms to manage correlated risk and insulate lenders
from its adverse impact constrains agricultural microfinance (Skees 2003; Ibarra 2003; Bryla
2003).
In this regard, a comment on the performance of the Philippine crop insurance is in order.
Where crop insurance has been implemented, the costs have typically been extremely high, in
part because of the difficulties of administering large numbers of small contracts spread over
wide areas, but more often because of problems of adverse selection and moral hazard (Vogel
and Llanto 2005). The experience of the Philippine Crop Insurance Corporation (PCIC) can
be seen in this light.
The number of farmers covered by crop insurance exhibited a declining trend from 108,512
in 1995 down to 54,093 in 2004. At the peak of its operation in 1991, the PCIC providedsome 336,000 farmers with rice and corn insurance amounting to over 3 billion pesos and
covering more than half a million hectares of land. Crop insurance coverage has since
declined. Crop insurance coverage for the period 1995-2004 exhibited a declining trend
although it showed improvement toward the later years. Insurance coverage decreased by 18
percent during the period 1997-1998. It improved only slightly in 1999 by 1.6 percent, but
this was negated by a decrease of 1.3 percent in 2000. The largest decrease happened in 2001
when insurance coverage dropped by 31.5 percent from P1,274 million in 2000 to P874
million. The government‘s crop insurance scheme was simply no match to covariant risks.
There is insufficient diversity in the ―risk pool‖ to deal with covariant risks. Brazil, India andMorocco also have crop insurance schemes but the overall verdict, it seems, is that crop
insurance schemes failed because of moral hazard and adverse selection problems and high
transaction costs.
Systemic risks brought about by insufficient diversification in local rural economies,
changing weather patterns, seasonality of supply, and fluctuations in global markets have
discouraged not only private investments but also the participation of private banks in
agriculture finance. Both crop insurance and credit guarantee schemes have failed to expand
private bank lending to agriculture. A better package of risk-reducing instruments could
consist of the following: efficient infrastructure, access to technology and information,credible regulatory regimes, and recently developed marketbased instruments designed to
address price- and weather-related risks.
The problem of correlated risks is not insolvable. Innovations in global financial markets,
which can deal with correlated risk and reduce the rural lenders‘ exposure to local risks, e.g.,
drought, have been developed. These are the futures exchange markets to shift price risk; and
international exchanges. Combined with physical sales, it will guarantee a minimum price
level based on an international price for a given commodity over a number of months. When
price rises during the option contract period, the producer receives no payout from the
contract but can still sell his physical product at the prevailing market price. In this situation,
the producer benefits from rising prices. When price falls during the option contract period,the producer receives a payout equal to the difference between the price the producer chose to
insure with the put option contract and the international market price on the last date of the
option coverage. The problem faced by the small producer may not necessarily be the
market-based premium paid for such price risk management instrument but access to the
international exchanges.
On the other hand, weather risks are covariant and typically shock entire regions and entire
farming communities at one and the same time. Weatherbased index insurance has been
developed as a risk management instrument. Under this scheme, a farmer can insulate
himself from production risk by purchasing an index insurance that pays in case rainfall fallsbelow a certain threshold. Farmers can elect coverage for a given period, taking into
consideration the crop cycle. Farmers who have bought such an index insurance receive a
payment if the rainfall index level falls below an agreed rainfall threshold. The farmer
receives more protection the higher is the rainfall threshold but this is bought at a higher
premium. A farmer wishing to minimize the cost to him of this index insurance may go for a
lower rainfall threshold but at the price of lower protection. He, thus, has to evaluate the
trade-off and make a decision.
Missing Opportunities in the Agriculture Supply Chain
Understanding the agriculture supply chain may create profitable opportunities in agricultural
microfinance for rural-based economic agents. Research (Boehlje, Hofing and Schroeder,
1999a; 199b) on value chain in agriculture indicates that 21st century agriculture is likely to
be characterized by: 1) adoption of manufacturing processes in production as well as
processing, 2) a systems or food supply chain approach to production and distribution, 3)
negotiated coordination replacing market coordination of the system, 4) a more important
role for information, knowledge and other soft assets (in contrast to hard assets of machinery,
equipment, facilities) in reducing cost and increasing responsiveness, and 5) increasing
consolidation at all levels raising issues of market power and control.
As the raw produce goes through each link of the chain, it undergoes varying degrees of
value adding, such as processing and packaging, before it is distributed to consumers, thus
ultimately increasing the original value of the good. The supply chain can also be loosely
referred to as a value chain. The added valuation to a raw product is a result of the increasing
stratification in consumer tastes and the need to be more efficient, which is an offshoot of
competition in global markets. The agriculture supply chain offers scope for small farmers
to participate but they have to deal with the problem of aggregation of the produce from a
large number of small farmers and the associated distribution and marketing of the
According to Kaplinsky (2000), the importance of the value chain lies in the concept that the
chain is a repository for economic rents, i.e., each link in the chain carries a premium from
which profits can be made. Increasingly, primary economic rents in the chain of production
are to be found in the areas outside of production.
Globalization has highlighted the need for an effectively functioning supply chain to meet
diverse consumer needs. As world markets converge, inefficient local agricultural producers
are pitted against competitive producers in the global arena. Due to insufficient capital,
inadequate infrastructure, and weak institutions, small farmers and other rural producers in
developing countries may find it quite a challenge to cope with the demands of global
markets for competitively priced goods and commodities (Van Roekel, Willems, and Boselie
2002). Local producers sometimes find it hard to match the significantly lower production
costs and lower transport and handling expenses of other countries. Consequently, the cost of
domestic goods, which is already higher relative to those from other countries due to higher
input costs, is further driven up by high processing, marketing, and distribution costs.
One of the most important links in the value chain is the provision of transport and storage
facilities. It links primary producers to processors and packagers and finally to marketing and
distribution units for the consumption of end-users. Costales and Macapanpan (2004) stressed
the need for transportation and storage systems as important factors of productivity and
competitiveness in agro-industry. There is therefore a very great need for an efficient
transport infrastructure, which includes road, ship and air transport, and adequate storage
capacity. Rural linkage with domestic and global markets depends to a great extent on the
availability, quality, and location of transport and storage systems, which will help dispersed
rural communities to overcome their isolation.
Understanding the great potential of supply chains will enable rural producers/clients to
position themselves strategically in the different subsystems of these chains. Subsystems in
the agriculture supply chain have their respective value-added activities and banks could
provide financial services for those value-adding activities.
In crafting appropriate responses, policymakers should learn lessons from the prominent role
played by traders in the supply chain and rural financing systems. Traders act as
moneylenders at the start of the cropping season and as buyers during the harvest season.
They are available to rural borrowers at the time and place where their help is needed. Theiraccess to rural information brought about by close association to rural clients and their keen
understanding of rural networks and economies have served them well in plying their loan
products (based on simple, timely, accessible, and flexible loan terms) and in creating
interlinked contracts. Traders may act as independent buyers of local produce or as
middlemen between major integrators, wholesalers or processors and farm producers. In any
of these major roles, they add value and provide timely financing that otherwise would not be
provided by formal financial institutions. Government-directed credit programs have found it
very difficult to compete with the interlinked contracts, timely access to financing, and
storage and transport facilities that traders have effectively provided to rural-based clients formany, many years.
Microfinance has developed and expanded generally because of the permissive (within
bounds) attitude of the regulators, who are aware of the vital task of finding an appropriate
regulatory framework for microfinance. The pioneering efforts of the Philippine central bank
to develop such framework can be cited. The Philippine Congress recently revised the
General Banking Act, which recognized the peculiar nature of microfinance and tasked the
central bank to develop an appropriate regulatory framework.
Regulators in many developing countries seem to recognize that microfinance promises to be
a sustainable mechanism for providing financial services to poor households and micro-
enterprises. However, there should be prudence in the way a regulatory framework is crafted
and in the manner of supervising banks engaged in microfinance. As stressed by Valenzuela
and Young (1999), regulation that comes too early can hamper innovation in financial service
and institutional forms. On the other hand, an overly strict approach would suffocate
innovative microfinance practices. In general, regulatory authorities are still developing
anunderstanding of the microfinance phenomenon, making sincere attempts to flesh out an
appropriate regulatory framework, and building the required capacity for effective
supervision (Llanto 2006). The same observations may be said of agricultural microfinance.
Regulators should bear in mind that the timing of the introduction of regulation is important
(Christen and Rosenberg 2000) and that microfinance cannot be simply placed in the
category of conventional credit categories, that is, consumer loan, commercial loan or
mortgage credit (Jansson 2001).
The key challenge is finding the appropriate regulatory framework for agriculturalmicrofinance which would recognize the different risks faced by rural lenders (that is, the
regulated lenders such as banks) and which would ensure the soundness of those rural lending
institutions, including the protection of deposits. Recent literature shows that poor rural
households and micro-enterprises demand different types of financial services and products,
including savings deposits with (regulated) banks. Successful methods for delivering
financial products and services to poor households and micro-enterprises have grown and
matured outside conventional banking and conventional regulatory frameworks. The Holy
Grail of regulation and supervision is developing an appropriate regulatory framework that
ensures the soundness of financial institutions and protects depositors without dampening
innovative impulses.
Fine-tuning existing regulatory frameworks may not be sufficient. On the contrary, it may
create a false sense of complacency on the part of tradition-minded regulators that all is well
with the approach when in reality the innovative financial impulses that are so important in
microfinance and in this case, the more challenging phenomenon of agriculture microfinance,
are either constrained or dampened.
Van Greuning et al. (1998) point out that the approaches to regulation and supervision of
microfinance can range from ―non-existent‖ to ―full regulation,‖ either through the existing
prudential regulatory framework or by modifying the existing regulatory requirements to fit
