The Missing Middle in Agricultural Finance: Relieving the capital constraint on smallhold groups and other agricultural SMEs

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Private-sector finance has made a start in filling this long-established gap, widened over the last decade as public-sector financing frameworks for small-scale agriculture have been withdrawn. However, the flow of capital to agricultural SMEs needs to be scaled up. This paper looks at the barriers to doing so.Both transaction costs and risks are high in lending to agricultural SMEs compared to microcredit, and returns are lower than in other sectors. More private capital will flow if there are competitive lenders and investors with the necessary local presence and understanding, and if the balance between risks and returns, net of costs, becomes more favourable.
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    The Missing Middle in Agricultural Finance Relieving the capital constraint on smallholder  groups and other agricultural SMEs 17 December 2009   OXFAM RESEARCH REPORT    Alan Doran, independent consultant on SME finance Ntongi McFadyen, independent management consultant Dr Robert C. Vogel, independent financial sector consultant  Disclaimer This paper was written by Alan Doran, Ntongi McFadyen, and Robert Vogel who were working as consultants to Oxfam GB. The views expressed in the text and its recommendations are those of the authors. The authors take responsibility for any errors herein. The Missing Middle in Agricultural Finance , Oxfam GB Research Report, December 2009 2  Contents Executive summary.......................................................................................................4   1.   Introduction.........................................................................................................8   2.    Why the middle is missing.............................................................................11   3.   The lack of effective demand.........................................................................13   4.   Capital suppliers and their constraints.........................................................17   5.   The evolution of financial and risk management services.......................24   6.   Improving the infrastructure for financial services...................................34   7.   The private sector and the missing middle..................................................37   8.   Summary and conclusions..............................................................................41   Notes..............................................................................................................................45   Acknowledgements......................................................................................................0   The Missing Middle in Agricultural Finance , Oxfam GB Research Report, December 2009 3  Executive summary 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 The Missing Middle in Agricultural Finance , Oxfam GB Research Report, December 2009 4
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