Basic Challenges in Agricultural Finance, by IFC

Given the characteristics of rural areas and rural economic activities, rural financial services provision has to tackle a number of specific challenges, in addition to those inherent in any financial intermediation. These specific challenges are related to seasonality, covariant risks, and low population densities.

Many rural economic activities are subject to seasonality and gestation periods, which often lead to a slow rotation of the invested capital and are reflected in the cash flows of rural entrepreneurs. Longer loan maturities and irregular repayment schedules are more risky and present additional challenges to liquidity management. More than in other sectors, the profitability of agricultural enterprises depends to a significant extent on external factors such as weather, major outbreaks of pests and diseases, or prices of inputs and outputs, which are largely beyond the control of farmers. In addition to idiosyncratic risks affecting individual clients (e.g., illness or death of family members, theft of productive assets, etc.), agricultural enterprises are exposed to covariant risks arising from the above external factors, which may simultaneously affect large numbers of farmers in a given area.

Finally, agriculture is a politically sensitive sector prone to government interventions. Although permanent interventions through lending quotas, interest rate ceilings, or direct government provision of financial services have been reduced substantially in the last decades, governments continue to intervene on an ad hoc basis. Such interventions include loan rescheduling or forgiveness and preferential lending programs for specific target groups, which are often granted after major economic downturns or natural calamities, and especially in the advent of elections. They create additional uncertainties for financial institutions and tend to weaken the repayment culture. Despite these challenges, rural financial services providers have fewer instruments at their disposal to manage the various risks and reduce operational costs than their urban counterparts have. Many rural financial institutions try to protect themselves against the various risks through excessive credit rationing and over-reliance on collateral. However, rural assets are less suitable as loan collateral than, for example, urban real estate. Due to legal and administrative impediments as well as cultural factors, land and other rural assets are often not registered and may be more difficult to foreclose and sell. Even where these constraints do not apply, collateral is a poor protection against massive default due to covariant risks. However, other more appropriate instruments for managing covariant risks, such as crop insurance or hedging, are rarely available.

Classical microfinance techniques to cope with delinquency risks include highly standardized loan products based on small credit amounts, frequent (often weekly or bi-weekly) repayments without grace periods, short maturities, and collateral substitutes such as joint liability mechanisms. While these techniques still work rather well in peri-urban areas and for a few rural economic activities, they are difficult to apply in rural economies characterized by strong seasonality and low population densities, and they are unsuitable for the larger loan amounts and longer maturities that are typical for agricultural finance.

The above information is reproduced from the “Scaling Up Access to Finance for Agricultural SMEs – Policy Review and Recommendations” issued by IFC
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