201411128 agricultural financing challenges and opportunities (1)

Agriculture Finance in Kenya

Equity Group Foundation

Unlocking Agricultural Productivity in Kenya

Concept Paper-Draft

Rural Finance in Kenya: What are the Challenges and Opportunities in the Agriculture Sector?

By Philemon K. Ronoh

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Introduction Agriculture Sector in Kenya

Agriculture is the backbone of the Kenyan economy. The sector directly contributes 24% of the Gross Domestic Product (GDP) and 27% of GDP indirectly through linkages with manufacturing, distribution and other service related sectors. Approximately 45% of Government revenue is derived from agriculture and the sector contributes over 75% of industrial raw materials and more than 50% of the export earnings. The sector is the largest employer in the economy, accounting for 60 per cent of the total employment. Over 80% of the population, especially living in rural areas derives their livelihoods mainly from agricultural related activities1 Given the importance of the sector, it should follow that significant resources are directed to the sector, whether by the government providing enabling environment or by the private sector investing significantly. The latter group includes banks. That is not the case, however, because of many bottlenecks, which impedes growth and hence development of the sector.

Agriculture Credit Overview

The agriculture loan portfolio in Kenya is still very small, and as of 2012, less than 3% 2 of total private sector loans in the country went to the sector.

Various financial institutions offer some kind of agriculture loans. Major commercial banks like Equity serve thousands of farmers with small loans. However, the amounts disbursed are dwarfed by lending to other sectors.

While the loans seem to cover major subsectors in agriculture, the numbers are still very low in terms of allocation. As of January 2014, the Business Daily reported that only Ksh. 1.6b3 out of 1.6 trillion shillings lent to the private sector by commercial banks. That is about 0.1% of the total and makes the earlier 3% figure a very high estimate. (See the appendix for the various agriculture loan products available in Kenya).

1 IFPRI/KARI , Policy Responses To Food Crisis In Kenya 2 Swedish Embassy in Nairobi, Launch of Agriculture Sector Guarantee for Kenya, 2012 3 “Banks shrink loans to farmers over default fears�, Business Daily, 23rd January 2014

3 Trends in Rural Finance (1990s-)

The recipients of agricultural finance are mainly rural dwellers. This means their access to financial services depend on the presence and proximity of bank branches in their location.

Before the advent of mobile technology and the subsequent roll out of the agency banking model in Kenya, lack of rural branches was an issue in rural finance. To make matters worse, banks moved to shut down their rural branches to reduce costs and improve profits in the late 1990s.This led to the emergence of non-traditional financial institutions moved in to fill the gap left by their departure4.

Since then the rural finance landscape has been dominated by Micro-Finance Institutions (MFIs).

These micro lenders advance credit to smallholders for things like school fees, input loans, financing purchase of water tanks etc. These MFIs include K-rep, Kenya Women Finance Trust, Juhudi Kilimo, which are national in character, and many more others which operate only in a few towns in a given region of Kenya.

In the past 10 years, however, bigger and medium-sized banks have expanded again to major upcountry towns and have resumed rural lending. Some of these banks have tried to tailor their offerings to certain crops and livestock. An example is Kenya Commercial Bank’s “Herd Improvement Loan” (See the appendix).

In addition, newer entrants changed the banking sector in Kenya in the same decade. The best example is Equity Bank which, throughout the 2000s, launched an aggressive expansion across the country and positioned itself as the ‘farmers’ bank. In the process, it rose to the top to be the biggest bank by customer base. These customers are mostly located in rural areas. Through its flagship agriculture lending program, Kilimo Biashara, Equity has tapped into agricultural finance in Kenya.

Risks in Agriculture Finance

Agricultural production is viewed as an inherently risky economic activity. This perception has resulted in little lending to the sector because of this fear and the subsequent increased scrutiny.

Some of the risks frequently cited include: o

Weather Changes and Variability

o

Production and Yield Risk

o

Price or Market Risk

4 Betty Kibaara and James Nyoro, “Expanding the Agricultural Finance Frontier: A Kenyan Case”, AAAE Conference Proceedings (2007) 287-290

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Two issues emerge out from this hesitation by banks to lend to the agriculture sector: 1. Agriculture Loan Book/Available Capital is Low: Capital allocation by banks to the

sector is not a priority because of the perceived risks and difficulty of lending to small scale 2. Interest rates are high to account for the risks and perceived risks of agriculture

production.

The first issue seems straightforward. On the one hand, banks’ resources are simply limited and this forces them to allocate capital to the sector modestly, taking into account other competing, easier to lend to sectors. On the other hand, agriculture sector performance is subject to prevailing climatic conditions and other natural forces. Apart from these relatively out of control risks, agricultural commodities are subject to price risks. During harvest seasons, there is oversupply of goods and prices are driven down. In a liberalized economy like Kenya’s, most farmers are price takers5 due to some circumstances they are in. They lack proper warehouses to store their produce until there are better prices in the market. Also, most of them simply do not have other sources of income to postpone sale of their produce when they have pressing financial obligations like paying school fees for their children. Thus, most financial institutions opt to allocate little money to be lent to the sector.

The second issue seems arises from an amalgamation of factors. Beyond the generalized risks cited by banks to justify the high interest rates, there are more specific factors that actually contribute to high interest rates in agriculture loans: •

Lack of data analysis by banks. There is little or no data analysis done by banks to understand each crop/livestock in the agricultural value chain. Is a particular crop volatile every year? What causes this volatility? How can it be mitigated? What shocks contribute to the risk profile of each crop/livestock?

•

Collateral/Loan security requirements. Banks prefer land or landed property as collateral.

Most farmers, however ironic this might be, do not have titles to their land. Some farm on land belonging to the extended family and as such they cannot use the title deed to secure loans. Family members normally do informal subdivision of land but don’t complete official transfer of titles. This has affected collateral options farmers have when they want to borrow loans.

•

Profit margins. This depends on crop selection by farmers. Most farmers hardly carry out profitability analysis of their activities as farming is mostly done to generate food for domestic consumption rather than for sale.

5 Land Bank, South Africa, “Ad333111dressing Challenges Of Financing Emerging Farmers”, P.5

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Agricultural practices of most farmers. Most farmers rely on outdated methods of production and are seen as unwilling to adopt innovative technologies that have been invented.

•

Little or no use of risk mitigation instruments. Tools like insurance cover and irrigation can greatly reduce farmers’ risk profile but there is little adoption of the same.

•

Cost of reaching the customer. Farmers live away from major urban centers, which have better bank coverage.

It is no surprise then that the sector gets little lending. There is no doubt farming is an inherently risky economic undertaking. There are challenges in the sector but a little analysis will show that the problem of little lending to the sector lies somewhere else. It has to do with the lack of risk mitigating strategies as well as lack of coordination between stakeholders who affect farmer risk profiles.

To scale up agriculture lending, stakeholders in the sector need to understand the need to coordinate their efforts towards the sector performance with the aim of mitigating perceived risks in agricultural production. In view of this proposition, this working paper uses a framework that examines issues at various levels of actors that affect farmer risk profile.

Agricultural Finance Ecosystem in Kenya Despite considerable financial inclusion that has taken place in Kenya, usually stated to be 67% 6, most farmers, with the exception of large scale ones, have little access to credit. Most banks hesitate to lend to farmers. As of 2012, bank lending to the sector stood at 3% of total loans given out. This is rather unjustifiable for a country whose economy is agriculture based, and most of its population is engaged in the sector. At the same time, little lending to the agriculture sector cannot be blamed on the banks alone. There is interplay of issues that need to be dissected and resolved so as to enable flow of funds to the sector. This calls for engagement at all levels of actors in the sector, starting with the government at the top all the way to the farmer in the village.

Problem Statement

6 FSD Kenya, FinAccess National Survey 2013 Report

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The agriculture sector accounts for less than 3 percent of all loans to the private sector yet its contribution to the country’s GDP are at 24% directly and 27% indirectly. As a result, the sector has experienced low productivity for a long time. To unlock agricultural productivity, flow of funds to the sector is a matter of priority. This review aims to initiate the first step through holistic examination of agriculture ecosystem actors to understand how each one of them affects risk profile of farmers.

Framework for Agriculture Finance Ecosystem Challenges To dissect issues contributing to farmer risk profile, this paper uses the framework 7 illustrated below:

This paper proposes this framework as a way to identify and find ways to deal with issues at each level. The factors to be examined include: •

Policy factors

•

Land policies

•

Product design

•

Credit requirements

Policies at the bank level mostly do not favor farmers. Banks • Loan Processing in Kenya, for example, have embraced group lending models • Climate/Weather risks to mitigate risks. However, these banks do not necessarily take time to assess whether group members actually have shared interests or were just grouping for the sake of getting loans and breakup thereafter.

• Experience/Skills Animosity may arise among group members and that will paralyze the functioning of the group. How does the bank • Crop choice deal with such a case? That is not clear in many banks’ policies. In many cases, things end up getting stuck and • Risk mitigation many farmers which had savings through the group end up incurring losses as the bank continues to hold the money as collateral for the loans taken out by some of the group members, who are no longer working together.

In addition, product designs fail to take into account real needs of the farmer. For example, banks would categorize some loans as products for small scale farmers and go ahead to set the maximum amount of money without necessarily taking into account a farmer’s project proposal or if his/her need was for developmental purposes.

7 Land Bank, South Africa , “Addressing Challenges of Financing Emerging Farmers”, P.5

7 •

Economic factors

The agriculture sector is part of the larger economy. Prevailing economic conditions directly affect the sector and so are the perceived risks associated with the sector. High inflation in the economy leads to high interest rates. Kenyan banks charge as high as 23% for most loans and during such situations, they cite high Central Bank Rate, which is a monetary policy tool applied by the Central Bank to control liquidity in the economy.

•

Institutional factors

This level refers to institutions, private and non-private that are involved in the agriculture sector either providing financial services. Issues that arise at this stage include long turnaround time, lack of tailored products to meet farmer needs and lack of flexibility in loans. Banks in Kenya mostly have fixed loan requirements and in the case of agricultural loans, a title deed is normally a requirement.

•

Industry factors

Agricultural production is affected by natural disasters as yields are determined by occurrences such as drought, floods, poor climatic conditions and hailstorms.

•

Farm Level Factors

Viability of the farm affects the performance of farmers. Assuming that a farmer is able to manage production and if given credit as well as extension services, the farmer will automatically increase his or her production. Skills and farm sizes are two big issues at this level and they greatly affect access to credit. Majority of Kenyan farmers are small scale farmers (about 3.5 million8). Many banks doubt commercial viability of small scale farms and indeed many small scale farmers just engage in subsistence production, with hardly any surplus for sale.

Thus, the ability of these farmers to repay the loans they might want to take is in question. The few who take the loans have to produce their title deeds as collateral. This has proven problematic as only few small scale farmers have titles to their holdings. Smallholders do not have individual titles as many just inherited the subdivided land but the title remains one, usually belonging to the person who actually acquired the land just after independence in 1963.

The Need for Multi-stakeholder Approach to Agriculture Finance

As stated earlier, agricultural production in Kenya face many challenges but none is more highlighted by the farmers themselves than the lack of affordable financing. Farmers, whether 8 Equity Group Foundation, Unlocking the Potential of Medium Sized Farms in Kenya, 2013

Farmers

A Government Agency

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small or medium need access to credit to acquire inputs, machinery and working capital. The grave agricultural productivity and food security implications of this little lending to the agriculture sector should be a cause for concern and call to action for both the government and other actors in the sector.

Figure 1: An example of multi-stake holder collaborative framework

As explained above, stakeholders need to and should work together to unlock agricultural lending. Deliberate undertakings to jointly improve the risk profile of farming can bore fruits if government efforts are directed towards risk mitigation strategies, capacity building for farmers through a robust extension system, commodity price stabilization on top of the usual policy issues. Thus, the government, through the Agriculture ministry, can coordinate the sector lending by assuming the role of trainer and risk mitigation.

Figure 2: Roles of Stakeholders

Farmers

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Financial Institutions • •

Provide financing

•

Targets of interventions

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To be trained on modern production methods

Insurance Government

•

Emphasis on making their farms viable production

•

Extension system

•

Credit guarantee system

•

Commodity price stabilization

•

Agriculture finance policies

Risk Mitigation Strategies To unlock agricultural finance, it is emerging that risk mitigation should be the centerpiece of any strategy to be pursued. Stakeholders need to think about issues around risk mitigation to lower the risk profile of farmers as perceived by banks. Reducing or eliminating perceived risks associated with the sector should be part and parcel of any strategies to scale up agriculture lending.

Insurance, irrigation, and commodity price stabilization are some of the options that can deal with a number of aforementioned risks.

Insurance

Guaranteed Minimum Returns, form of crop insurance aimed at addressing the main challenges that faced agricultural production through guaranteed market and accessibility to credit, existed until 1978 when it was abolished due to abuse by stakeholders. Between then and 2009, agriculture insurance was almost non-existent9. However, private insurance companies are now offering different insurance covers.

Agriculture insurance policies can serve to protect farmers from total loss of their investments.

Depending on the type of cover a farmer takes, one can have the cost of inputs or output insured and in case of drought, diseases, hailstorm or flooding, they are assured of some money to invest in the next season.

9 Kennedy O. Pambo and Denis O. Olila, Determinants of Farmers’ Awareness about Crop Insurance: Evidence from Trans-Nzoia County, Kenya , University of Nairobi and The National Treasury, 2007

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Recent technological innovations have also led to the development of novel insurance products.

In Kenya, Syngenta Foundation for Sustainable Agriculture, in partnership with UAP, has launched weather index insurance. Other insurance companies like APA have also followed with their own products.

The challenge with insurance as a risk mitigation tool is that farmers are unaware of various products available. Those who are aware mistrust or misunderstand these insurance products and this has led to declining uptake of insurance. There is need for insurance companies to educate farmers on various insurance products before selling policies, which farmers misunderstand in many cases and in case of non-compensation when a loss occurs, mistrust of the insurance industry takes a dip.

Nonetheless, combining insurance cover and training on modern production methods can serve to improve risk profile of farmers.

Irrigation

Majority of Kenya agriculture is rain fed. It is almost known that if rains fail, agricultural production dramatically reduces. By some estimates, a fifth of Kenya (semi-arid areas) can be turned into irrigation schemes, and in areas that receive rainfall but occasional droughts occur, farmers need to be enabled to drill boreholes and dams created to enable them continue conclude their production activities to prevent loss of investments.

These measures have the potential to reduce yield risks due to drought and financial institutions will likely the weighting of drought risk when assessing a farmer’s loan application.

Commodity Price Stabilization

A recurring problem in agricultural production is price instability. Farmers often complain that they are forced to sell their produce at throwaway prices at harvest time. Lack of proper storage facilities and pressures of money force many farmers to dispose their crops as soon as harvesting.

One way to potentially solve this problem is through commodity price stabilization. The government will come up with price support mechanisms to ensure farmers don’t sell at a loss.

Though some economists express doubt on long term10 usefulness of commodity price stabilization, for an economy like Kenya’s where prices for grains like maize can swing wildly, often within a matter of months, it makes sense to protect farmers who are vulnerable to brokers who take advantage of their helplessness. This will help reduce price risks and banks will be willing to lend more to farmers.

Role of Government in Other Countries 10 Jonathan R. Coleman and Chris Jones, Measuring Welfare Changes from Commodity Price Stabilization in Small Open Economies, The World Bank, 1992

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Unlike countries like United States and Brazil, Kenya has not developed a comprehensive rural financial services strategy. The rural financial sector is governed by the Banking Act, Building Society Act and the Post Bank Act 11. Apart from ad hoc budget programs and state lending through AFC, this lack of firm credit policy is in contrast with other countries like Brazil, United States and the EU members where agricultural subsidies play central role in stabilizing agricultural production.

In Brazil for example, the government intervenes via interest rate subsidies and the requirement that banks allocate at least 29% of their demand deposits to agricultural lending. In addition, Brazil implements price support to all farmers who are located far away from major markets and ports12. The United States on the other hand has an insurance subsidy program, which takes derisks farming. Though the program is causing controversies13, it has greatly enhanced agricultural production in the US.

Applicable Models and Innovative Financing Models in Agriculture Because of the unique challenges in agriculture sector, bank lending practices have to be innovative and directly respond to bottlenecks to agricultural lending.

A few agriculture finance literature have explored the agriculture lending landscape, and these reports have not only identified barriers to more lending but also on how to overcome those barriers by adapting some financial instruments to come up with more loan products for the sector.

In Agricultural Value Chain Finance, Tools and Lessons , Miller and Jones, explores some of thes innovative approaches, which include14: Holistic Approach to Agriculture Finance Chain

11 Betty Kibaara, “Rural Financial Services in Kenya: What is Working and Why?”, Tegemeo Institute of Agricultural Policy and Development, 2007 12 OECD, Brazil - Agricultural Policy Monitoring and Evaluation 13 David J.Lynch and Alan Bjerga, “Taxpayers Turn U.S. Farmers Into Fat Cats With Subsidies”, Bloomberg, Sept 9 2013 14Calvin Miller and Linda Jones, Agricultural Value Chain Finance, Tools and Lessons, Food and Agriculture Organization of the United Nations and Practical Action Publishing , 2010

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Agricultural value chain finance should involve systemic analysis of an entire value chain and the relationship amongst its actors. This holistic approach enables stakeholders to design financial interventions that may incorporate one or various financial instruments. The approach enables lenders to better evaluate creditworthiness of individuals or groups of businesses within the chain through identifying risks and analyzing the competitiveness of that chain. It should focus on the transactions throughout the chain which is quite dissimilar in approach to the majority of financial institutions which offer a relatively fixed set of loan products secured by the collateral of a specific borrower with little consideration given to the market system as a whole.

Banks should approach sector lending differently

•

Looking beyond the loan recipient by understanding the competitiveness and risks in the sector as a whole so as to craft products that best fit the needs of the businesses in the chain

•

Make the chain more inclusive by making resources available to integrate farmers to higher value markets

•

Understanding Value Chain Finance can improve the overall effectiveness of agricultural financing by: Identifying financing needs for strengthening the chain; Tailoring financial products to fit the needs of the participants in the chain; Reducing financial transaction costs through direct discount repayments and delivery of financial services; and o Using value chain linkages and knowledge of the chain to mitigate risks of the chain and its partners o o o

Physical Asset Collateralization

Warehouse receipts are the best example of this approach. A farmer will store his grains, of certain quality, in an agreed warehouse, which will then issue receipts. These receipts can be used to secure a loan, which can mean accessing 60-70% of the stored value immediately. When grain prices improve, the farmer can authorize the warehouse to sell the grains, deduct bank’s loan and other expenses before disburse the rest to the farmer.

Blending Insurance and Loans

Farming is a risky economic undertaking because of systemic risks like droughts, floods and hailstorms are always present risks. To reduce these risks, farmers need insurance policies that cover against these types of risks. A good example of innovation in risk mitigation is weather

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index insurance. Farmers are indemnified according to rainfall indices, and thus there is no moral hazard risks to the provider as payments are made according to information obtained from sources such as weather stations and satellites. Insurance will allow farmers to make more investments as they are guaranteed of getting back what they spent on inputs. Banks more likely to lend to farmers who insure their crops/animals Forward contracts

These arrangements can be thought of as a kind of a derivative finance instrument. It is a contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.

This is a potential way to solve price risk as the price is set today, unlike waiting for market prices which are unpredictable. These contracts are appropriate for horticulture but the challenge is whether exporters/buyers to sign a buying price in advance, especially if their markets too are unpredictable.

Alternative forms of collateral

Some banks are known to offer debenture loans secured by an aggregation of company assets, asset financing (up to 90%)15.

In an effort to steer financial institutions to lend more to the agriculture sector, United States Agency for International Development (USAID) came up with a toolkit which expounds the following loaning concepts16 Supply chain financing

A bank can design a product based on the relationships in the supply chain. For example, a trusted aggregator of agricultural goods can be financed so as to enable onward financing of producers. Banks will not only reduce labor costs associated with vetting hundreds of farmers but also get to lend more through one actor, who bulks produce from farms and markets the same. Loans amounts will be deducted by the aggregator before any money is paid to the supplier farmers who took the loan.

Institutional or Corporate leveraging

If a reputable corporate is sourcing supplies from farmers, banks can leverage their relationship with the company to tailor a product for farmers. Farmers will then be paid through the bank, which will just deduct borrowed amounts before disbursing the rest of the money to the farmers.

15 Hansen, Kimeria et al. Assessing Credit Guarantee Schemes for SME Finance in Africa, Dalberg Global Development Advisors, 2012 16 USAID, Lending to the Agriculture Sector- USAID Toolkit, 2013

14 Cash flow-based credit methodology

This requires an understanding of the relationships and opportunities within a wide variety of value chains, carrying out mapping exercises to clarify specific opportunities to finance clients within each value chain.

In addition, banks need to understand the specific agricultural crop, production cycle, yields, crop budgets, crop protocols, and other issues unique to agriculture so that loan products and terms can be tailored to farmer’s needs.

This approach requires active analysis of the agriculture value chain: • Agricultural value chain finance requires active interactions with clientele (thus higher level of monitoring) • Deeper understanding of how value chain finance can provide additional guarantees and access to supplementary resources and technical competencies More importantly, banks need to orient their lending policies as well as train their credit officers on agriculture value chain before these types of lending.

Agriculture lending not only requires expertise on agricultural production process on the part of the bank staff but also a proactive approach in developing and marketing loan products.

Banks can jumpstart this process by approaching the sector with a different loan development methodology. Rather focus on collateral or asset-based lending, banks should start focusing on the applicant’s capacity to repay.

Conclusion To improve agricultural productivity in Kenya, all agriculture stakeholders must work together to increase farmer loans. The current level of agriculture credit does not enable most farmers to invest in modern production systems and as such the low productivity that has characterized the sector is bound to continue. Farmer risk profiles must be improved through adoption of risk mitigation strategies, which are readily available if actors at various levels of agriculture production coordinate their efforts. It emerges that the government has a central role to play in agriculture to as the sector contributes significantly to the overall economy.

References: 1.

Equity Group Foundation, Unlocking the Potential of Medium Sized Farms in Kenya, 2013

15 2.

Hansen, Kimeria et al. Assessing Credit Guarantee Schemes for SME Finance in Africa, Dalberg Global Development Advisors, 2012

3.

IFPRI/KARI, Policy Responses to Food Crisis In Kenya

4.

J.Lynch, David and Bjerga, Alan “Taxpayers Turn U.S. Farmers Into Fat Cats With Subsidies, “Bloomberg, Sept 9 2013

5.

Kibaara, Betty “Rural Financial Services in Kenya: What is Working and Why?”, Tegemeo Institute of Agricultural Policy and Development, 2007

6.

Kibaara, Betty and Nyoro, James, “Expanding the Agricultural Finance Frontier: A Kenyan Case, “AAAE Conference Proceedings (2007) 287-290

7.

Land Bank, South Africa, “Addressing Challenges Of Financing Emerging Farmers”, P.5

8.

Miller, Calvin and Jones, Linda, “Agricultural Value Chain Finance, Tools and Lessons,” Food and Agriculture Organization of the United Nations and Practical Action Publishing, 2010

9.

Ngigi, George “Banks shrink loans to farmers over default fears,” Business Daily, 23rd January 2014

10. O. Pambo, Kennedy and O. Olila, Denis, “Determinants of Farmers’ Awareness about Crop Insurance: Evidence from Trans-Nzoia County, Kenya ,” University of Nairobi and The National Treasury, 2007 11. Swedish Embassy in Nairobi, Launch of Agriculture Sector Guarantee for Kenya, 2012 12. R. Coleman , Jonathan and Jones, Chris, “Measuring Welfare Changes from Commodity Price Stabilization in Small Open Economies,” The World Bank, 1992 13. OECD, Brazil - Agricultural Policy Monitoring and Evaluation 14. USAID, Lending to the Agriculture Sector- USAID Toolkit, 2013