The Agricultural SME Finance Challenge
The Council on Smallholder Agriculture Finance (CSAF) is a pre-competitive alliance of 12 financial institutions that seek to expand the market and develop industry standards for lending to small and medium enterprises (SMEs) in the agriculture sector. In 2014, one of the CSAF members made a US$200,000 working capital loan to a sorghum processing enterprise in East Africa. The loan was made in local currency at the going market rate for loans of this size in other sectors. The borrower, in turn, used the loan to purchase drought-resistant sorghum from several thousand smallholder farmers, many of whom had lost their maize crop in prior seasons because of drought. The business successfully repaid the loan 13 months later and, by linking the farmers to a ready market, generated higher and more reliable incomes and food security for thousands of vulnerable families.
This seems to be exactly the kind of market-based approach that the development community craves, but there’s a catch: the loan was not profitable. Even though the loan was fully repaid, the lender lost almost seven percent of the original transaction value after factoring in its cost to make the loan. This example illustrates a dynamic that is common for many loans to SMEs in the agricultural sector. Simply put, the economics of lending to agricultural SMEs, particularly those requiring smaller loan sizes and operating in less developed value chains for food crops, do not add up.
We know that SMEs can play a vital role in agricultural-led development by aggregating otherwise dispersed smallholder farmers; facilitating access to agronomic training, farm inputs, credit, and markets; and creating formal employment in storage and processing. SMEs in these areas have the potential to increase and stabilize farmer incomes, support farmers in adopting more sustainable practices, and generate direct and indirect economic development (for example, through demand for services and money multiplier effects) in rural communities and along agricultural value chains. Yet agricultural SMEs typically fail to realize their potential, in large part because they have limited access to capital to fuel their growth.
There continues to be a “missing middle” in the financial markets between microfinance and commercial banks; this gap is particularly pronounced in the agricultural sector and the sorghum example illustrates why: the economics of lending to agricultural SMEs in developing markets are challenging. This was the central learning from a recently completed USAID-funded study. The financial benchmarking study, executed by Dalberg working with unique data provided by nine CSAF members, quantified the economics of agricultural SME lending. The database brought together information on nearly 3,600 individual loans, including transaction revenues, write-offs, operating costs and impact-adjusted costs of funds, allowing analysis of the conditions for profitability and unprofitability of lending in this market.
While over 50 percent of the CSAF loans analyzed were profitable, an average CSAF loan of US$665,000 lost about US$1,800, not including the cost of funds.
Further analysis showed that the economics of the loans analyzed varied substantially by certain characteristics, including loan size, value chain and geography:
- Agricultural SME loans in Latin America performed better than loans in Africa. Loans in Africa are twice as likely to end up in recovery and have operating costs 22 percent higher than loans in other regions.
- Larger loans performed better than smaller ones. The operating costs are similar across different loan sizes, but interest and fee income are proportional to loan size. In addition, smaller loans below US$500,000 have an approximately 80 percent higher risk of default than loans above US$500,000.
- Loans to existing borrowers were significantly more profitable than loans to new borrowers. New borrowers’ risk of default was twice as high as that of existing borrowers, and new borrowers’ loan origination costs were 50 percent higher as well.
- Loans in more formal coffee and cocoa value chains performed better than loans in other crop markets. Loans to crops other than coffee and cocoa were 2.5 times more likely to default. Several lenders also reported higher origination costs for crops other than cocoa or coffee owing to a self-perpetuating cycle in which lenders’ lower familiarity with the less developed value chains made them reluctant to take on the resulting higher-risk loans.
- Short-term loans (less than 12 months) performed better than long-term loans (12 months or more). Loans with tenors of more than 12 months were over four times more likely to fall into arrears than were loans with tenors under 12 months.
The study also found that most of the loans analyzed clustered within the relatively more developed value chains and at loan sizes where lenders could cover their costs or at least come close. Other segments of the market, particularly smaller loans to first-time borrowers in staple crop value chains, are even less served. A second phase of the study focused on local financial institutions in East Africa is under development and will provide a more comprehensive view of that regional market.
Much as donors support market development in the microfinance sector, the results from this first phase of analysis point to the need for interventions to support lending to enterprises with one or more of the risk factors noted above. Donors could play a critical role in bridging the financing gap for agricultural SMEs serving smallholder farmers by supporting initiatives to improve the sustainability of lending in high-impact segments through use of blended finance tools and other supporting mechanisms. Four types of blended finance instruments to unlock the flow of finance to agricultural SMEs serving smallholder farmers are recommended for exploration:
- Output-based incentives: A financial incentive facility might be used to encourage lending to segments that lenders find unprofitable to serve in the short-term but that demonstrate high-impact potential. Such incentives could be paid to lenders per loan, at origination, based on tiered scoring of loan characteristics and the likelihood of reaching certain impact goals, such as lending to smaller SMEs (with smaller financing needs).
- Risk mitigation: A risk-absorbing facility allows lenders to explore riskier segments. To encourage lending in new, underserved segments perceived to be high risk, such as first-time borrowers or long-term lending, facilities such as partial credit guarantees and/or “first-loss” buffers, appropriate for different segments, may be considered.
- Direct funding: Providing concessional funding to lenders to decrease their required rate of return can reduce the cost of lending to high-impact segments with higher perceived and real risk – costs that would otherwise need to be passed on to borrowers. Such segments could include loose value chains or frontier markets.
- Technical assistance: In addition to direct financial support to lenders, advisory support for lenders on risk management or the use of improved technology can help lower their operating costs. Advisory support to borrowers, especially in high-cost segments such as first-time borrowers and SMEs in less-developed value chains, can help them to reduce their risk profiles by improving their management, governance, or agribusiness skills.
A broader set of donor actions taken in concert could improve the attractiveness of agricultural SME loans. Other initiatives might include providing funding for disruptive technological innovations and/or promoting competition from new actors with potentially disruptive business models. Finally, donors could focus on providing highly coordinated value chain or enabling environment interventions to help lower transaction costs, increase scale, and/or reduce risk.