AgCLIR Chapter: Getting Credit
Virtually all modern businesses rely upon credit: for operations, to bridge the gap between production of products and payment for them; for investment, as buildings and capital equipment are generally multiples of annual revenues; and to cover swings in supply and demand conditions. Farmers in developing countries often point to the lack of credit as the greatest barrier to increasing production and the profitability of agricultural enterprises.
The ability of entrepreneurs to borrow money at reasonable interest rates and for appropriate durations depends on a number of factors that collectively affect the risks associated with lending. These include a mix of policies, laws, and regulations; property rights; processes and standards for loan approval; the quality of registration systems; and enforcement mechanisms. In jurisdictions where these and other factors do not work to protect lenders (or borrowers), the risk of default is typically high, and this risk is reflected in the increased cost and, in many cases, decreased availability of credit. Further, certain types of borrowers are perceived as raising additional risks due to their limited capital, entrepreneurial history, or precarious social situation such as depending on rain for each crop cycle. As a result, agribusinesses and other less secure groups typically face significant obstacles in securing credit.
Agribusinesses suffer from a number of industry specific risk:
- Seasonality of production—this leads to “lumpiness” in credit needs and repayments;
- High correlation of risks experienced by borrowers in a geographic area—drought, pests, and floods have widely shared impacts;
- Producers’ inability to use real or movable property as collateral; and
- Difficulties in enforcing contracts for which the subject matter is intangible property.
The fact that many enterprises are family operations (and essential for the family’s survival) raises social issues that are not encountered in lending to other small or medium-scale enterprises. Lenders have proved reluctant to seize agribusinesses’ assets—even when legally allowed to do so—when it is clear that total impoverishment would result.
Agricultural production enterprises that are more diverse—i.e., include the production of several products and services—might seem better candidates for credit. Diversity of production could mitigate some of the risks associated with seasonality or the price risks associated with a large number of producers bringing the same product to market at the same time each year. Nonetheless, the complexity of diversified operations makes evaluation of their creditworthiness more difficult. The developed world has, in fact, moved in the opposite direction—toward more specialization and on a larger scale. Government underwriting of some of the risk through credit subsidies has been an important factor in making this possible.
Producers who join cooperatives gain a significant edge in accessing credit. Lenders’ costs are reduced—the transaction costs of dealing with one cooperative are far lower than the costs of dealing with hundreds of individual producers. Lenders’ risks are reduced to the extent that co-op membership is voluntary and members accept a level of mutual responsibility for loan repayment. Lenders’ risks are reduced even further where services that enable cooperatives to succeed as business enterprises (e.g., training, information, technology) are provided by donors or government entities.
The possibility of expanding the microfinance model to an increasing array of agribusinesses, especially small and family-owned/-operated businesses, has been explored in some countries. Microfinance institutions are cautious about explicitly expanding their business in the agricultural sector because of two risks noted at the outset: the seasonality of borrowing and payback for most agricultural production enterprises, and the high level of correlated risk among borrowers as adverse conditions due to weather, pests, or diseases affect many borrowers at the same time.
Trade financing for agricultural products can be secured by contracts for sale or against inventory as collateral. This requires significant organization and formalization of markets, especially regarding grades and standards of products traded. Many—and, in some cases, the majority of—agricultural traders on domestic markets are said to personally finance their business operations. Agribusinesses that engage in international trade, however, are generally forced to seek trade financing to manage cash flow between the time of shipping and payment.
Agribusinesses that deal in the import and distribution of production inputs and process raw agricultural materials into value-added products face credit conditions similar to those of other processing or manufacturing industries. Lenders’ risks can be assessed using standard business evaluation tools. For this reason, “supplier credit,” that is, credit provided to producers by input dealers and/or agricultural processing companies, is a major source of credit in many developing countries. Contract law is an essential underpinning for such credit, since the ownership of intangible property (a yet-to-be-realized harvest) serves as security for such agricultural credit.
For more information, please see the Getting Credit – Lessons from the Field Briefer.
AgCLIR Case Studies
AgCLIR assessments on ‘Getting Credit’ have been conducted in the following countries: