A Financial Dilemma Threatening our Plates and Stomachs

Tenin Fatimata Dicko, Financial Sector Specialist at the World Bank, explores how increasing access to financial services can support smallholders and bolster development.

Agriculture remains the backbone of the economy in developing countries. It has an average contribution to GDP between 25–50 per cent, and it is a source of employment for more than 70 per cent of the population. On top of that, the sector is up to 3.2 times more effective in reducing the number of poor people in low-income countries compared to any other sector of the economy.

Financial services play an important role in agricultural transformation and development, as well as overall development. At the same time, access to financial services remains the main constraint for most stakeholders in the sector. Nearly 70 per cent of smallholders’ finance demand is unmet.

Closing the financial gap

Poor access to finance constrains investment in agriculture, limiting the sector’s development and transformation potential. Identifying and understanding the market failures that result in the weak supply of financial services to the agricultural sector is key. Closing the financing gap in agriculture is essential for improving the sector’s performance and requires implementing several simultaneous actions.

De-risking the sector to attract private finance and investments in agriculture. Systemic risks in agriculture (production, markets, and so on) impede private financial sector investment. In this context, the use of public resources must be optimised. Financial instruments, such as credit guarantee funds that have leverage effects or agricultural insurance whose payouts help compensate for the losses, can play important roles in de-risking and unlocking credit.

Thus, it is important to structure and implement these instruments well. In designing credit guarantee funds, careful attention is needed to limit moral hazard among credit beneficiaries and adverse selection within participating financial institutions. To ensure sustainability, other factors are equally important, such as the right level of risk-sharing between the guarantee fund and financial institution, the pricing, and the leverage ratio. In nascent markets, it is helpful to provide technical assistance to the guarantee fund manager and to financial institutions participating in the scheme.

Regarding agricultural insurance, the development of index insurance has helped protect smallholders against production risks by utilising climatic or area yield indices. Index insurance can be leveraged to increase producers’ access to credit and inputs. For instance, the government of Zambia bundles its inputs distribution program with index insurance to allow nearly one million producers to benefit from agricultural insurance coverage. However, the basis risk remains the Achilles heel of index insurance.

Large-scale and sustainable agricultural insurance programs are the result of a partnership between the public and the private sectors. The private sector carries the risk and the public sector provides the enabling environment (such as financial education, financial support, and so on). The development of the mobile phone and digital money further widens the reach of index insurance.

Leveraging digital financial services can reduce costs and improve the supply of agricultural finance, according to the author. Photo credit: Unsplash

Leveraging digital financial services to reduce costs and improve the supply of agricultural finance. Smallholders are highly dispersed, making transaction costs high for both the financial institution and the client. According to a McKinsey and Company study, the use of digital technologies can reduce the cost of providing financial services by 80–90 per cent. The loan process can be done fully via mobile phone, while money and fintech solutions use data that previously was not accessible. New credit scoring (for example psychometric tests or mobile phone usage data) can measure the probability that a borrower will repay his or her loan. Increasingly, smallholders use their mobile phones to conduct daily transactions, which – over time – build a rich transaction history that in theory could be used to assess repayment capacity and help guide lending decisions.

Strengthening understanding

Closing the financing gap will require also strengthening the skills within financial institutions in terms of agricultural client risk assessment, the development of adapted products and services, as well as the improvement of internal procedures. In addition, it is crucial to address constraints on the demand-side, since smallholders are not a homogeneous group, and their levels of organisation differ. Understanding their segmentation and in-group dynamics, level of producers’ organisation and professionalism, as well as the level of smallholders’ financial literacy, are as important as the development of agricultural finance and insurance instruments.

In agricultural finance and insurance, solutions need to be tailored to the local context. Photo credit: Unsplash

“One size doesn’t fit all” illustrates the reality in agricultural finance and insurance. Supply constraints call for a combination of risk management, credit enhancement instruments and technical assistance. While on the demand side, a recognition of the needs of different smallholders’ segments is required.

The dilemma “an important sector whose development and transformation is crucial, but which continues to suffer from limited access to finance” must be resolved in a way that fills our plates and our stomachs. Meeting the challenges of agricultural finance and insurance calls for a solid partnership of all actors, both public and private.