Agricultural Finance

Agriculture Finance Revisited
No. 2
Agricultural Finance: Getting the Policies Right
Food and Agriculture Organization of the United Nations (FAO) Deutsche Gesellschaft fr Technische Zusammenarbeit (GTZ)
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AGRICULTURAL FINANCE REVISITED
AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT
ELIZABETH COFFEY
June 1998
Food and Agriculture Organization of the United Nations (FAO) Deutsche Gesellschaft fr Technische Zusammenarbeit (GTZ)
NO. 2
PREFACE
Policies are powerful tools. They are basic to governance and administration. They exist at several levels: national government, local governments, and within firms and institutions. They are so basic that they are often overlooked in the search for better ways of pursuing objectives. This applies in many spheres of human activity. It applies especially to the provision of banking services for low-income people in rural areas. Why is this the case? There may be several reasons, and many of these are specific to a given country, district or institution. But a common thread is that the policies which affect agricultural and rural finance belong to several different policy-making zones. Three in particular have an impact, namely: agricultural sector policy, financial sector policy and macroeconomic policy. Since many different groups are involved there is the danger that the special needs for rural banking could be overlooked, or, as is more likely, that policies will be developed which are partially in conflict with one another, rather than being mutually supportive. What are the inputs to policy making? The essence of successful policy making is that it captures the views of all the stakeholders in the delivery of the policy, backed up by relevant analyses of key data. This is not as easy as it might seem, for a further requirement for an efficient policy-making system is that it is able to do this on a continuing basis. Policy-making is an ongoing responsibility, not a single event. Because a range of ministries, institutions, firms and individuals should be involved, there are bound to be significant differences in the extent to which influences can be brought to bear on the policy making process. Creation, and maintenance of a level playing field is a further requirement for an efficient system. This publication sets out to clarify the process of policy making for agricultural and rural finance, and dwells especially on the mechanisms involved. It is addressed to those responsible for formulating, managing
Preface
and tending the rural financial system, namely, policy makers, donors and managers of rural financial institutions. It lists some of the key issues, and provides a Diagnostic Methodology which can be used as an aid in the evaluation of the comprehensiveness of a given policy-making system at national level. Case study examples are presented throughout the document to highlight the importance of some key issues when formulating an agricultural finance policy. FAO and GTZ see the Diagnostic Methodology as an evolving tool, and welcome suggestions for its improvement. This publication is the second in the series produced under the joint FAO/GTZ Initiative: Agricultural Finance Revisited. Publications in this series comprise of the following: Agricultural Finance Revisited: Why? Agricultural Finance: Getting the Policies Right Better Practices for Agricultural Finance - Doing it Right Sources of Funds for Agricultural Finance Prudential Regulation and Supervision for Agricultural Finance Improving Farmer Bankability and Financial Management Skills
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R.A.J. Roberts Chief Marketing and Rural Finance Service FAO
A. Hannig Lead Financial Economist Financial Systems Development & Banking Service GTZ
INTRODUCTION
Numerous changes have occurred in rural financial markets during the past few years1. This includes the collapse of traditional institutions that once were the backbone of these markets, overall contraction in the volume of agricultural credit due to hostile economic environments, repressed financial sectors, and a shift in donor interest to financing rural poor and small enterprises. These changes have been accompanied by a switch in the dominant development paradigm from one emphasising central planning to one that relies on market forces. Dissatisfaction with the results of traditional agricultural credit policies and the inconsistencies between these policies and the use of market forces are forcing policy reassessments in many countries. Although numerous new or reformed financial institutions have emerged, substantial gaps persist in many rural financial markets2. These gaps relate to scarce provision of formal agricultural credit to small farmers, a paucity of medium- and long-term lending, and few deposit facilities in rural areas. The absence of these financial services have important implications for agricultural development and for small farm households. Major segments of agriculture cannot modernise without the support of a strong financial system; an increasingly capitalintensive agriculture requires access to working capital and seasonal loans along with medium- and long-term credit for on-farm investments. Likewise, many poor people in rural areas are disadvantaged by financial markets that perform poorly. They have less opportunity to climb out of poverty by accumulating financial savings and they have no access to formal credit because the financial system is not innovative or sufficiently efficient to reduce transaction costs and to provide small clients with access to affordable and durable financial services. A more efficient financial system would help accomplish the dual objectives of boosting production and easing rural poverty. Recent experience provides useful lessons about rural finance policies, both positive and negative. These lessons are summarised in the first
1 The term rural finance covers agricultural lending, loans made to non-farm rural firms, and deposit services in rural areas. 2 These institutions include non-governmental organisations, credit unions, private banks, village banks, and reformed agricultural development banks.
Introduction
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part of the discussion that follows. This includes negative lessons learned from past errors and more recent positive lessons derived from experiences with new policies and approaches. This is followed by a second section where the process of policy formulation is discussed and an outline is presented of a framework that might be useful in formulating and implementing policies that strengthen rural financial markets. Specific country examples are presented in boxes that support the two segments of the paper.
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ACKNOWLEDGMENTS
The author wishes to extend thanks to the many people who made this publication possible. The contribution of Dale Adams to Part I of the document is particularly acknowledged as are his comments on various drafts. Thanks to Richard Roberts and Anthon Slangen for their continual support and contributions, in particular for their respective inputs to the Key Issues in the paper. Special thanks to Brigitte Klein for her valuable contribution to the Diagnostic Methodology, her comments on various drafts and to her boundless enthusiasm. The author also thanks colleagues Pekka Hussi, ke Olofsson and Thorsten Giehler in FAO, and Alfred Hannig, Sylvia Wisniwski and Michael Fiebig in GTZ for their inputs, constructive criticism and editorial advice in the production of this document.
Acknowledgments
TABLE
OF
CONTENTS
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v
PART I: LESSONS LEARNED 1. 2. Performance of Agricultural Credit . . . . . . . . . . . . . . . . . . . . . 1 Directed Credit and Financial Market Development: Difference between Concept and Reality . . . . . . 7 2.1 Problem Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 2.2 Role of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . 8 2.3 Users of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . 9 2.4 Sources of Loanable Funds . . . . . . . . . . . . . . . . . . . . . . . 10 2.5 Role of Subsidies and Taxes . . . . . . . . . . . . . . . . . . . . . . 10 2.6 Credit Information and Evaluation Systems . . . . . . . . . . 12 Transition to the New Approach . . . . . . . . . . . . . . . . . . . . 13
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3.
PART II: THE POLICY FRAMEWORK 4. Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.1. Policy Fields Affecting the Formulation of Agricultural and Rural Finance Policy 4.1.1 Macroeconomic Environment . . 4.1.2 Agricultural Sector Policy . . . . . 4.1.3 Financial Sector Policy . . . . . . .
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4.2. Essential Elements of Policy Making . . . . . . . . . . . . . . . . . . . 28 4.2.1 Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 4.2.2 Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Table of Contents
4.2.3 4.2.4
Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Donor Co-ordination . . . . . . . . . . . . . . . . . . . . . . . . 34 . . . . 34 . . . . 36 . . . . 37 . . . . 38 . . . . 40
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4.3. Policy Making Process . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Summary of Key Issues to be examined in Policy Making . . . . . . . . . . . . . . . . . . . . . . . 4.3.1.1 Main Objectives of Agricultural and Rural Finance Policy . . . . . . . . . . 4.3.1.2 Main Policy Makers in Agricultural and Rural Finance . . . . . . . . . . . . . . . 4.3.1.3 Policy Areas that affect the Provision of Agricultural Credit . . . . . . . . . . . . . 4.3.1.4 Different Opinion Leaders and Stakeholders and their Participation in the Policy Making Process . . . . . . . . . 4.3.1.5 Role of Information and Research in Policy Formulation . . . . . . . . . . . . . 4.3.1.6 Policy Monitoring and Evaluation . . . . 4.3.1.7 Role of the Government in Agricultural and Rural Finance . . . . . . . . . . . . . . .
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Case Study Boxes: Box 1: Box 2: Box 3: Box 4: Box Box Box Box 5: 6: 7: 8: Increased Outreach to Thai Farmers: BAAC . . . . . . . . . 3 Directed Credit Leading to Institutional Collapse: BAP in Peru . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Social Concern versus Institutional Viability: India . . . 14 Lessons Learned from the Collapse of an Agricultural Bank: BAP in Peru . . . . . . . . . . . . . 16 Mistrust in the Policy Dialogue: Zambia . . . . . . . . . . 24 The Importance of Leadership: Indonesia . . . . . . . . . . 29 Stakeholder Participation in Policy Dialogue: India . . 30 Non-Governmental Organisations (NGOs) and Agricultural and Rural Finance . . . . . . . . . . . . . . 39 Rural Finance Policy Dialogue: Uganda . . . . . . . . . . . 41
Box 9:
Figures Figure 1: Figure 2: Policy Fields Affecting The Formulation of Rural and Agricultural Finance Policy . . . . . . . . . 22 Diagrammatic Outline of the Diagnostic Methodology: Guidelines for the Formulation of an Agricultural Finance Policy (Annex 2) . . . . . . . . 26 Rural Finance Policy Making Process . . . . . . . . . . . . . 35
Figure 3:
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Annex 1 The Difference between the Directed Credit Paradigm and the Financial Market Paradigm. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Annex 2 Diagnostic Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
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Table of Contents
PART I
LESSONS LEARNED
1. Performance of Agricultural Credit
Since the early 1950s governments and donors have spent large amounts on agricultural credit programmes. The World Bank alone committed over US$16 billion to these efforts from the mid-1950s to the late 1980s and other donors also spent substantial amounts. In several countries, such as Brazil, India, Indonesia, Mexico, and Sri Lanka, supply-led and directed credit programmes were the dominant tool used to spur agricultural development during the three decades prior to the 1990s. In centrally planned countries directed credit was likewise a prominent instrument used to implement agricultural production plans. However, directed agricultural credit programmes continue to play a strong role in some developing countries, e.g. the Philippines (see section 3). The assumption behind these efforts was that many farmers faced liquidity constraints that limited their ability to make farm investments and to use additional modern inputs. Relaxing these constraints by providing them with loans, therefore, was thought to be an easy way of stimulating farm investment, boosting the use of modern inputs, and augmenting farm production. It was further assumed that most farmers were too poor to save, that informal financial markets were dominated by monopolist money lenders who charged usurious interest rates, and that commercial bankers were too conservative to lend to most farmers. Based on these assumptions governments and donors developed and funded numerous directed credit programmes around the world that focused on overcoming these problems. Most of these efforts were heavily subsidised by charging concessionary interest rates or tolerating loan defaults. A common arrangement for providing rural financial markets with donor or government funds was to open concessionary rediscount windows in the countrys central bank to disburse funds to selected groups, regions, or activities. Banks and other financial institutions were stimulated to grant targeted lending by making concessionary funds available from the rediscount window. The interest rates on these funds were typically lower than the rates lenders were paying for alternative sources
Part I: Lessons Learned
of funds. In the later 1970s, for example, the central bank in Indonesia administered nearly 200 directed credit lines, many of which were aimed at agricultural activities, and most of which were subsidised. In some cases, the availability of rediscount funds was augmented by imposing loan portfolio requirements on commercial banks. These requirements were intended to compel banks to either make more loans for purposes targeted by the government, or to lend on concessionary terms to other institutions, especially agricultural development banks that were doing targeted lending. In Thailand, for example, during the 1970s and 1980s the government required all banks to lend an increasing percent of their total loan portfolio to farmers. If they were unable to comply directly with this requirement, they were allowed to fulfil their obligation by lending money at concessionary rates to the Bank for Agriculture and Agricultural Co-operatives (BAAC, see p. 8). In some countries subsidised loan guarantee schemes were also established to further encourage agricultural lending. The assumption behind these schemes was that by transferring part or all of the loan recovery risk to the insurance programme, lenders would be induced to do more of the lending preferred by policy makers. As part of this process, many countries formed or expanded agricultural development banks to handle the bulk of the targeted lending. Ministries of agriculture typically played a dominant role in these banks, and in the formulation and implementation of associated policies. In some cases, especially in Latin America, these banks and ministries formed supervised credit programmes that tied technical assistance and training to subsidised lending, especially during the 1960s. In many countries political considerations were involved in loan approval and loan recovery decisions. Government-mandated loan forgiveness in Bangladesh and Loan Melas (fairs) in India during the 1980s being examples of such political interventions in financial sector operations. Shifts in political priorities and donor preferences have often resulted in substantial changes in roles assigned to rural financial markets. Sometimes farm production and farm investments were stressed, while at other times poverty alleviation, pacifying the countryside, or disaster relief were the primary objectives of directed credit efforts. In several countries such as the Philippines and Indonesia, major segments of the
Box 1 Increased Outreach to Thai Farmers: Bank for Agriculture and Agricultural Co-operatives, BAAC Thailand has been characterised by stable macroeconomic and open market policies for the past decades. In 1997 before the currency and financial sector crisis, the Thai government estimated an annual economic growth rate of 7-7.5%, while maintaining inflation at 5%. Economic growth and stability are expected to result in a more equal distribution of income, alleviate poverty and improve the quality of life of the Thai people. In an attempt to achieve these objectives, clear targets are set by the Ministries of Finance, Commerce, Communication, Central Bank, Budget Bureau, Office of National Economic and Social Development and private sector bodies. In the economic development process, the agricultural sector is expected to play a major role. Past government policies have emphasised the accessibility of farmers to agricultural credit at affordable costs. The government created the Bank for Agriculture and Agricultural Co-operatives (BAAC) in 1966 with the objective of attending small farmers, agricultural co-operatives and farmers associations. However, despite government concerns, directed credit failed to meet the total farmer demand. This led to a mandatory requirement for commercial banks to lend a minimum fixed percentage of their total lending to the agricultural sector (lending directly to farmers or lending money to the BAAC at concessionary rates) and this measure has had a significant impact on increasing the volume of lending to farmers. In 1997, 80% of all Thai farmers are registered as borrowers with BAAC, either individually or through membership of co-operatives and associations. The charter of BAAC sets the framework for its credit operations, where lending is possible only to farmers and until recently, exclusively for agricultural purposes. Restricting lending to farming activities affects BAACs ability to attend the financial needs of small-scale farmers who, due to the small size of their holdings, are also dependent on off-farm employment and non-farm activities for additional income. A proposal to amend the charter to allow all-purpose rural lending, thereby allowing a diversified loan portfolio, is under consideration at parliament and is an essential precondition for the profitability and continued viability of BAAC. BAAC is under pressure to enhance the scope of its lending to cover an increasing proportion of the poor farming population, while at the same time, it is required to operate in a viable way. It receives support from the government for specific lending programmes, while effective management and use of appropriate financial technologies have enabled BAAC to meet the challenge of viability and equity.
rural financial system were attached to crop production programmes. In other countries such as Egypt and Brazil large subsidised credit efforts were justified on the basis of compensating farmers for other economic distortions in the economy, such as food price controls or over-valued foreign exchange rates. The support for these traditional directed agricultural credit efforts began to wane in the 1980s and by the end of the decade most donors and some governments sharply reduced their support for agricultural credit. In part, this decline in support was due to the unsatisfactory performance of these efforts. Critics increasingly argued that relatively few of the credit subsidies were captured by poor people and that subsidised and directed credit had a weak effect on farm production and investment. Serious and chronic loan recovery problems, dependency on outside funding, and overall costs eroded the support for these efforts. Poor performance and the lessening of donor and government support led to the collapse of many public agricultural development banks and rural (government directed) co-operatives in the 1980s. In some countries such as Peru and Bolivia traditional agricultural banks were closed (see p. 6). In other countries such as The Gambia and ex-USSR all or part of the development banks were sold or privatised. In still other countries these development banks and rural credit co-operatives persist but their financing activities have been sharply reduced, such as in Guatemala, Nicaragua, and Uganda. Several major forces led to the collapse of many of these directed credit efforts and to the general disillusionment with the directed-credit approach. With the benefit of hindsight, it is clear that many of these programmes operated in hostile economic environments that were not conducive to the development of healthy financial markets. Cheap food policies, subsidised food imports, farm price controls, unfavourable terms of trade for agriculture, and distorted foreign exchange rates all contributed to this hostile environment. In addition, little investment in rural infrastructure, lack of law and order, and failed land reform efforts further dampened economic incentives in some rural areas. Rural financial markets cannot thrive and grow if their clients lack creditworthiness, lack the ability to repay loans, and are unable to save because their incomes are depressed.
Box 2 Directed Credit Leading to Institutional Collapse: Banco Agrario del Peru (BAP) The predecessor of the agricultural development bank in Peru (Banco Agrario del Peru, BAP) was formed to provide loans (directed credit) to cotton, sugar and rice producers in the coastal region. Shifts in focus occurred throughout subsequent decades and were pronounced with changes in political power. Throughout the 1970s and early 1980s the number of employees and BAP branches rapidly expanded to provide an increasing number of subsidised loans to remote areas (e.g., from early 1975 to late 1979, the number of employees increased by 46 percent). The adverse effects of this expansion on the administration costs was compounded by hefty inflation that substantially exceeded the nominal interest rates charged on BAP loans. In the late 1980s the government instructed BAP to disburse loans to disadvantaged areas at zero nominal interest rates with the promise to reimburse BAP the interest rate subsidy, a promise that was not kept. During this period, BAP did achieve considerable outreach, growing from 4 percent of all farmers to 25 percent. By the late 1980s, BAP extended loans to farmers who cultivated approximately half of the total land area. The growth of BAP caused a crowding out of commercial banks. In the 1950s, BAP provided about one third of all formal agricultural credit, the remainder being provided by the commercial banks. However, by the late 1970s, BAP captured more than 90 percent of the formal agricultural loan market and 80 percent thereafter. In addition, the importance of savings mobilisation as a source of funds declined rapidly throughout the 1980s when BAP became increasingly dependent on donors and Central Bank funding. It was cheaper for BAP to utilise external funds than to mobilise deposits from rural households. In addition, such dependency increased the vulnerability of BAP to political intrusions and donor fads. BAP faced both internal and external problems. Among the external forces, which were beyond the control of BAP, were an unstable macroeconomic environment, poor financial sector policies (forced interest rate ceilings, limiting the ability to price financial products according to their costs and risks) and forced political directives (sometimes loan approval and loan repayment decisions were made outside the bank). Among the internal problems were lack of deposit mobilisation, dependency on external funding, non-banking culture and huge administrative and transaction costs. Close ties with the Ministry of Agriculture resulted in BAP recruiting individ-
Box 2 (Cont.) Directed Credit Leading to Institutional Collapse: Banco Agrario del Peru (BAP) uals with a knowledge of agriculture rather than banking. Success was measured by the number of loans disbursed, crops planted, investments funded and size of the organisation. Little or no attention was paid to transaction costs, to administrative costs, to quality of service, or to financial innovation. In some cases the bank was required to charge the least for loans that were the most costly to administer. BAP was constructed and operated in line with the old directed credit paradigm, compatible with subsidies, suppression of market forces and central planning. As in many other countries with the onset of market liberalisation, BAP collapsed and left a void in servicing small farmers and rural households. Source: Dale W. Adams and Juan Jose Marthans., Benefits and Costs of Liquidating an Agricultural Bank in Peru and The Rise and Fall of an Agricultural Bank in Peru, 1997.
Development of rural financial markets was further impeded by repressive financial sector policies. Interest rate ceilings were common on both loans and on deposits. This limited the ability of lenders to charge costrecovery rates on their loans and limited their ability to mobilise deposits by paying attractive interest rates. Excessive legal reserve requirements were effectively a tax on deposit-taking and further lowered the rates of interest that could be paid on deposits. Limits on bank branching and on the formation of new financial institutions restrained competition and efficiency improvements in the sector. In addition, design flaws in what has been called the traditional directed credit paradigm contributed to the problems encountered in many rural financial markets. Support for the directed credit paradigm was further undermined by the world-wide shift in development philosophy from one that stressed central planning to one that stresses free markets. Credit planning, credit directing, and credit subsidies are inconsistent with allowing free markets to allocate scarce resources.
2.
Directed Credit and Financial Market Development: Difference between Concept and Reality
The directed agricultural credit programmes proved to be subsidy dependent, prone to disasters, and ineffective in helping to achieve important goals. Instead of building a sustainable financial infrastructure, many of the directed credit programmes undermined the development of a viable financial market. Critics of the old paradigm increasingly claimed that cheap credit was ineffective in alleviating rural poverty, in stimulating agricultural investments and in spurring agricultural production. The flaws of directed credit in the 1990s led to the formation of a new paradigm, labelled the financial market approach. This new paradigm is markedly different from the directed credit approach3. For purposes of differentiating old policies from new policies it may be useful to briefly outline six major features and to compare the two paradigms on the basis of these features.
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2.1 PROBLEM DEFINITION
The existence of market imperfections is often used to justify directed credit. These imperfections may be seen as too few loans being made to poor people or to small farmers in general, exploitation of borrowers by moneylenders, lack of loan collateral, or monopoly power in rural financial markets. Other more sophisticated statements may include concerns about asymmetric information between lenders and potential borrowers that may limit the ability of lenders to determine accurately the creditworthiness of some individuals, thus creating a so-called market imperfection. In the past, there has been an over-emphasis on credit as the cure for all small farmer ills. At the same time, there was little or no consideration given to high transaction costs and to new financial technologies that would reduce these costs. It is generally recognised that
3 The new financial system approach covers all financial institutions, financial markets and instruments, the legal and regulatory environment and financial norms and behaviour (BMZ, 1994).
providing banking services to farmers is more costly and difficult than attending urban clients. With traditional banking practices, dispersed small farm households will, as a result, have limited access to financial services. This problem definition suggested three general policy avenues to overcome the observed imperfections. The first was to expand the formal financial system as rapidly as possible to fill some of the gaps in rural financial markets. Second, this expansion, combined with regulation of informal finance might be instrumental in tackling the supposed monopoly power of local moneylenders, thus forcing them through competition to lower their loan charges. Third, efforts to overcome market imperfections were directed explicitly at specific areas, activities and disadvantaged population groups. In contrast, the new financial market approach focuses on the high costs and risks associated with rural lending and on ways to overcome these problems. Since many of the financial transactions in rural areas are smallboth for loans and for depositsthe transaction costs per unit of money involved are necessarily high compared to larger transactions. Distances between clients and financial intermediaries, transport and communication difficulties, and the risky nature of agriculture that is vulnerable to natural disasters boost these costs. Weak land titling and cumbersome and costly court procedures also compound the problems of providing conventional collateral for loans in rural areas, thereby further increasing the risks of rural lending. Reducing these costs and risks is the focal point of the new financial market development approach. These issues are dealt with in greater detail in another publication in the Agricultural Finance Revisited series; Better Practices: Doing it Right.
2.2
ROLE
OF
FINANCIAL MARKETS
Those supporting the directed credit approach assign numerous duties to financial markets. These include poverty alleviation, stimulating production and investments, boosting production, moderating the effects of disasters, helping to implement central planning, and providing employment opportunities. Directed credit programmes were a major feature
of government and donor efforts to solve many development problems. It is paradoxical that proponents of the directed credit approach assign many tasks to financial markets on the one hand, but on the other hand pay little attention to maintaining the financial infrastructure needed to carry out these assignments. The extensive use of agricultural development banks during the 1960s through the 1980s to administer large numbers of targeted credit lines and their subsequent debilitation or liquidation being examples of this paradox. In contrast, the new market approach assigns a more modest role to financial markets. Instead of involving financial institutions in distributing subsidies and directing credit, the new approach stresses the importance of the process of financial intermediation. The primary goal in improving this process is to enhance the efficiency of resource allocation in the economy. This is done by efficiently mobilising deposits from savers who, otherwise, have only low-return options for investing their surplus funds, and then efficiently allocating loans to creditworthy borrowers who have too few funds to capitalise on viable investment opportunities. Critics of the old paradigm argue that using financial markets to direct credit weakens the ability of these markets to efficiently intermediate between savers and creditworthy borrowers. However, the transition from the old to the new paradigm continues to encounter strong political resistance in many countries, as outlined in section 3.
2.3
USERS
OF
FINANCIAL SERVICES
Under the directed credit approach the recipients of targeted loans are often called beneficiaries. They are seen as benefiting from the efforts of credit planners or providers of subsidised loans, for example, for people who merit sympathy and special attention. Such altruistic views may be later engaged to justify slack loan recovery procedures, thus further expanding the magnitude of the credit subsidy. It is a short step from justifying an interest-rate subsidy on loans for people because they are poor, to justifying loan forgiveness because poor borrowers later turned out to be too poor to repay their loans.
Under the new financial market approach there are no subsidies associated with loans so there are no favours associated with lending. Financial intermediaries must treat their borrowers and depositors as valued clients if they are to stay in business. This forces intermediaries to be attentive to the quality of services they provide, to the transaction costs they impose on their clients, and to financial innovations that reduce these costs.
2.4
SOURCES
OF
LOANABLE FUNDS
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Financial institutions that provide directed credit usually rely on outside funding: government funds, donor resources, or concessionary loans from other financial institutions. In some cases, institutions that provide subsidised loans are not involved in the mobilisation of their own internal funds, and in other cases they do capture some deposits, but without much enthusiasm because using external funds is less costly. Likewise, subsidised interest rates on loans force deposit-takers to offer even lower rates of interest on savings, thereby weakening the incentives of savers to deposit surplus funds in banks. Financial institutions that are heavily involved in channelling subsidised credit tend to become left handed-the left-handed portion of finance being lending and the right-handed portion being deposit mobilisation. The users of financial services in a system strongly influenced by directed credit tend to be borrowers rather than depositors; the system is borrower dominated. By contrast, the new financial market approach stresses the importance of mobilising local deposits, and efficiently intermediating between savers and borrowers.
2.5
ROLE
OF
SUBSIDIES
AND
TAXES
Subsidies play an important role in directed credit and are, perhaps, its distinguishing characteristic. There is little logic in attempts to direct credit without subsidies. These subsidies can take the form of conces-
sionary interest rates on funds provided to lenders, subsidised interest rates on loans made to beneficiaries, implicit subsidies involved in loans that are not repaid and written off, government or donor grants to cover costs of institutions involved in directed credit, and subsidies for supporting loan guarantee schemes. The old adage that there is no free lunch applies to credit subsidies. For every subsidy there is a tax. Someone must pay for subsidies through explicit or implicit taxes. The incidence of the tax associated with directed credit subsidies will vary from case to case, but is likely to involve some or all of the following: explicit taxes on the citizens of the country that are used to fund government subsidies, explicit taxes on people in foreign countries that fund donor aid programmes, implicit taxes on holders of financial assets imposed by inflation caused by monetary issuance to finance credit subsidies, and implicit taxes on depositors who receive low rates of interest on their savings as a result of subsidised credit programmes. An important objective of the new financial market approach is to eliminate subsidies in rural finance, especially those related to low lending rates, that do not cover all financial intermediation costs, or loan default. Market forces, instead of subsidies, are relied upon to mobilise funds from savers and enforce financial intermediaries to improve their loan allocation and loan recovery. Any subsidies should be temporary and transparent and not linked to lending activities but rather to institution building. To help reduce transaction costs, for example, training for bank staff in new lending practices or for banking operations and automation may be subsidised. The absence of subsidies allows financial institutions to focus on financial intermediation. Since financial institutions are not processing subsidies under the new system, they are much less susceptible to rent seeking and corruption, common features of the directed credit approach.
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2.6
CREDIT INFORMATION
AND
EVALUATION SYSTEMS
Typically, the volume of information associated with directed credit programmes is substantial. Each directed credit line typically has its own idiosyncratic data requirements, including collecting extensive information about characteristics of final borrowers and measuring the impact of credit on beneficiaries. Each credit line may require lending organisations to submit periodic reports to the providers of funds. It is not uncommon for the ample amounts of direct-credit information to crowd out other information flows that might be more useful to managers of the financial institutions. Managers of directed credit programmes may be able to provide detailed information on data required by funds providers, but be unable to generate critical up-to-date management information, such as the status of loan recovery. Concerns about meeting lending targets may also deflect policy makers from monitoring the overall performance of rural financial markets. To justify the subsidies associated with directed credit programmes, it is also common for credit planners to require that credit impact studies be done on these programmes. These studies usually require collection of costly primary data that is not ordinarily assembled by lenders. The costs of managing the dense volume of information generated by directed credit activities typically augments loan transaction costs for both lender and borrower. In contrast to the dense information systems in the directed credit approach, the financial market approach generates less but more useful data. The absence of numerous directed credit lines eliminates the need to process data for each sub-programme. Since the new approach stresses making loans based on creditworthiness, rather than on the basis of need, there is likewise much less data processed on the characteristics of borrowers and the impact of these programmes. The focal point of data gathering and processing under the new approach is to provide information that is essential to manage financial intermediaries efficiently and prudently. The performance of financial institutions is measured by indicators such as deposit mobilisation, transaction costs, loan recovery, number of clients, and financial and
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operational sustainability. In sharp contrast to the costly data that are collected to measure the credit impact at the borrower level under the old approach, performance under the new approach is largely measured using information normally collected by well-managed financial institutions. Annex 1 summarises the difference between the old and new paradigms.
3.
Transition to the New Approach
World-wide, the switch from directed credit to financial market development is only partial. In countries such as Chile, El Salvador, Indonesia, Peru, and Uganda only a few remnants of the old directed credit approach remain. In many other countries the conversion to the new approach has been less complete. Typically, partial conversions involve interest rate deregulation and a reduction of subsidies and fewer facilities in central banks providing concessionary funds to lenders. The International Monetary Fund and the World Bank have played key roles in prodding this conversion as part of the economic reforms under structural adjustment programmes, that aim at creating economies that are less planned and more market driven. Understandably, these conversions usually encounter strong resistance. Directed credit programmes were put in place for powerful reasons (see Box 3). Various interest groups pushed for their formation and these groups often argue for their continuance. These interest groups include donors who have found it easy to move relatively large amounts of money through directed credit programmes, politicians who are able to quickly respond to crises by announcing a directed credit initiative, managers and employees of development banks who benefit from handling directed credit programmes, and the beneficiaries who are able to capture the subsidies involved in these programmes. Since the benefits (subsidies) from these programmes are usually concentrated and the costs (taxes) diffused, it is much easier to mobilise defenders of the benefits than to organise those who bear the costs of these programmes.
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Box 3 Social Concern versus Institutional Viability: India The National Bank for Agricultural and Rural Development (NABARD) was created as an apex level financial institution in 1982 to provide guidance and focus on rural finance. It has also been given a mandate to co-ordinate, supervise and build the capacity of rural financial institutions. It sets down policies on lending rates, institutional development and regulation and supervision of rural financial intermediaries. It also provides finance to primary lending institutions for on-lending to the rural population and supplies a substantial part of the credit demand in rural areas through refinancing. An economic reform package was launched in 1991 and to date the response of the different sectors to a market oriented private sector economy has been positive. Agriculture, however, has been subject to limited reform in the ongoing liberalisation process. The main government objectives of agricultural policy continue to be of a social and political nature. It is now recognised that subsidised directed credit programmes to the rural and farming sectors and to selected beneficiary groups within the rural population have not achieved their objectives. The social objective of poverty alleviation through subsidised credit has not been achieved and the creation of a strong rural financial system has been undermined. Policy in the past, while it concentrated on subsidised credit, also supported an expanded outreach, but financial deepening and widening and viability and sustainability of financial institutions was not part of this policy framework. New policies in the financial sector are implemented by institutions, therefore changes at policy level in the financial sector determine the shape and nature of rural financial institutions. As the government owns 85% of rural financial institutions, government interventions continue, particularly in the areas of promotion of different types of financial institutions and disbursement of credit to priority sectors.
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Many policy makers and politicians continue to support directed credit. They believe that subsidised credit is an effective tool for alleviating poverty, stimulating technological change, promoting desirable investments and boosting production. It often takes time for policy makers who have been steeped in the visible hand of central planning to overcome the directed-credit habit and develop confidence in the workings of the invisible hand of the market. The mixed signals that policy makAGRICULTURAL FINANCE: GETTING THE POLICIES RIGHT
ers may receive from donors further complicates the move away from directed credit. It is still common for some donors to tie their assistance to credit lines that aim to support specific target groups such as women, small farmers, and microentrepreneurs4. Events in the Philippines over the past two decades illustrate the problems associated with attempts to shift from the old to the new paradigm. In the early 1980s the financial system in the Philippines was severely stressed and the government initiated substantial financial sector reforms. This included deregulation of interest rates, allowing more competition in banking, and closing most of the discount lines in the Central Bank that had provided large amounts of subsidised and directed credit. On the surface, at least, the Philippines appeared to have largely adopted the new financial market approach. Recent analysis, however, showed that directed credit is still common in the country. Research has documented about 90 directed credit programmes in the Philippines, most of which involved substantial implicit or explicit subsidies. Many of these programmes resulted from political mandates to satisfy the demands of special interest groups and a number of the directed credit programmes were supported by donors. Although the notion of charging market interest rates has been widely accepted, there are often substantial differences between interest rates charged on targeted loans and the rates that are required to cover all financial transaction costs and credit risks. Experience suggests that rapid conversion to the new financial market paradigm only occurs when policy makers are faced with a collapse in their financial sector and/or when political leaders are not subject to strong democratic forces. Even in these cases, there are periodic calls for a return to subsidised directed credit. The more typical cases are in countries where economic crises are less intense and where leadership is more subject to democratic forces. In these cases it is common for policy makers to straddle the new and old views. This typically involves charging less subsidised interest rates on loans, but not stimulating
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4 Most donors have not adjusted their rural or microfinance strategy so that it reinforces deposit mobilisation, a vital component of the new financial market development approach.
deposit mobilisation and reduction of transaction costs, which are other vital elements in the new approach. The issue of whether to restructure or abolish state-owned agricultural development banks in the shift from directed credit to financial market development needs to addressed in many countries (see Box 4). In order to survive, such banks must first emphasise their role as financial intermediaries rather than attempting to promote the adoption of particular
Box 4 Lessons Learned From the Collapse of an Agricultural Bank: Case: Banco Agrario del Peru (BAP) When attempting to transfer lessons learned from one country to another, one needs to be cautious. Nevertheless, lessons learned from the collapse of the Banco Agrario del Peru (BAP) provides some useful pointers for governments that have to address bank liquidation. In many cases in the past, closing a specialised agricultural development bank has proven to be an easier option rather than assessing the reasons why the bank performed poorly and trying to resolve this. Forcing development banks to manage large numbers of directed credit lines diminishes transparency and masks useful information. In addition, banks that provide highly subsidised directed credit discourage other financial institutions from expanding rural operations and, when they are liquidated, they leave a large void in rural areas. Governments must recognise their role in the creation and maintenance of a financial infrastructure that supports rural development. At least they should direct prudential regulation and supervision, especially for those institutions handling deposits, demanding information that clarifies the financial performance of banks, thereby ensuring transparency. Governments may also provide seed capital for start-ups or temporary subsidies to strengthen existing financial institutions. Correct policies include allowing lenders to charge market interest rates that fully cover their costs plus allowing a reasonable profit margin. Changing public and private sector roles and economic environment requires both incentives and time. The incentives include changes in the role assigned to new and existing organisations. The changes involved in successfully developing new finan-
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Box 4 (Cont.) Lessons Learned From the Collapse of an Agricultural Bank: Case: Banco Agrario del Peru (BAP) cial institutions may be similar to the changes needed to successfully reform existing development banks. If policy makers cannot effect these changes through reforming development banks, they may be unable later to effect similar changes in promoting successful new financial institutions. Indeed, policy makers may be later forced to establish new institutions using remnants from the old development bank. Conditions necessary to successfully reform a traditional agricultural development bank or to create efficient and durable alternative rural financial institutions are essentially the same. They both require favourable macroeconomic and financial sector policies that reinforce rather than destroy financial institutions, free them from political interference and instil financial discipline. Source: Dale W. Adams and Juan Jose Marthans., Benefits and Costs of Liquidating an Agricultural Bank in Peru and The Rise and Fall of an Agricultural Bank in Peru, 1997.
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crops or the adoption of specific technologies. The most difficult constraint facing these banks if they are to operate in a liberalised, competitive market is to overcome the deficiencies arising from state ownership. If policy makers wish to accelerate the pace of the conversion from the old directed credit to the new approach of rural financial intermediation, experience shows that there are systematic ways of doing this. The manner in which policies can be harnessed in this task is explored below.
PART II
THE POLICY FRAMEWORK

4. Policy Framework
A policy can be best described as a framework or strategy, giving a broad outline of the direction and overall strategy for the development of a particular sector. It is formulated by central government, from within a particular ministry to regulate the performance of individual sectors (OECD, 1988).
Policies often focus on creating a strategy which will arrest the decline of a specific sector or redress the imbalances which have occurred as a result of market forces. It is usually possible to identify a number of different functional sectors which normally correspond with the division of the government into ministries or departments. However, the formulation or re-definition of an effective policy for rural finance does not refer to a single sector, but rather to three main policy spheres which are closely interconnected and include the prevailing macroeconomic parameters, the agricultural sector and the financial sector (see Figure 1). Moreover, during rural finance policy analysis and formulation, international and regional trade should be considered in view of the current increasing globalisation of the world economy. All three policy areas have their own impact on the effective provision of financial services. Generation of an effective agricultural and rural finance policy depends on the definition of a clear overall rural finance policy framework and strategy. Tensions and contradictions do occur between each of these policy areas, which need to be debated and addressed through effective and continuous policy dialogue. Often, however, an effective policy dialogue platform does not (yet) exist, as is the case in Zambia (see Box 5), with a lack of confidence between the public and private sectors.
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Part II: The Policy Framework
Figure 1: Policy Fields affecting the formulation of Agricultural and Rural Finance Policy
4.1
AND
POLICY FIELDS AFFECTING THE FORMULATION RURAL FINANCE POLICY
OF
AGRICULTURAL
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The existence of a favourable and stable macroeconomic environment is imperative for the development of a countrys economy. 4.1.1 Macroeconomic Environment The macroeconomic policy conditions and legal framework that exist in a developing country can either enhance or impede the development of agriculture and the financial sector. Governments and donor agencies presently acknowledge the necessity of an enabling environment for private sector development, but all too often in the past they have supported direct government interventions and supply-led credit programmes to achieve short-term social equity objectives, which in most cases have performed poorly through inefficient management and political interference.
The sequencing of structural adjustment measures in a liberalised market environment has strong implications for the development of both the agricultural and financial sector. In the standard model of structural adjustment, demand management stabilisation measures should precede conventional structural production adjustment measures. More specifically they argue that domestic financial markets must be liberalised before product markets are reformed, otherwise limited access to effective financial services will hamper the performance of scheduled privatisation programmes. Inefficiencies in the financial sector, if not addressed and corrected in time, will arrest, in this case, the development of the non-financial sectors.
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Box 5 Mistrust in the Policy Dialogue: Zambia
The Agricultural Sector Investment Programme (ASIP) was launched in Zambia 1992, and constitutes the basis for the agricultural policy. Its main weaknesses are: the absence of a comprehensive policy and planning framework; delays in implementation of the restructuring of the Ministry of Agriculture; lack of donor interest in supporting an appropriate rural finance strategy, lack of effective government support to private sector development and lack of confidence between the public and private sector. The Ministry of Agriculture as key player in the field of agricultural finance supported directed agricultural credit programmes until 1997. The national Agricultural Credit Management Programme (ACMP), was characterised by high credit administration costs, lack of accountability and dismal loan recovery rates. Seasonal fertiliser credit to farmers, based on fertiliser donations, seriously distorted private sector fertiliser marketing operations. A strong contradiction existed between the government interventions in fertiliser marketing and fertiliser credit for maize production, alongside the rapid overall privatisation of the economy. In these circumstances, it is hardly surprising that the private sector, in particular, is not convinced that the government commitment to privatisation and reform is real and permanent. In view of the strong mutual mistrust between the public and the private sector, there is a definite need for establishing an effective policy dialogue platform, where all stakeholders, ranging from government to farmer organisations, private sector and donor agencies can discuss main issues and thus influence sound decisions concerning the development of an effective agricultural finance policy.
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Appropriate government policy support measures that facilitate the role of the private sector, and in particular, provide favourable investment opportunities for small-scale farmers, should recognise the interdependence of the financial and non-financial sectors. While measures to create a favourable policy environment for agricultural and rural finance are necessary, they may not be sufficient in themselves. Development of rural financial markets requires a supportive legal and regulatory framework, and direct interventions may be needed to accelerate the building of robust rural financial markets. Formulating appropriate prudential banking laws, financial contract laws and procedures for the effective enforcement of these contracts are important areas for policy interventions in developing countries and countries in transition, in view of the recent changes in the macroeconomic environment as a result of liberalisation and globalisation. Financial institutions cannot depend solely on agricultural lending, which faces high risks; indeed the trend is to restructure agricultural banks into universal rural banks. The banking legislation should specify the contractual form for agricultural loans and strengthen their enforcement mechanisms. Under the joint FAO/GTZ programme Agricultural Finance Revisited, a separate publication entitled Prudential Regulation and Supervision for Agricultural Finance will be produced in the planned series of documents.
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Figure 2: Diagrammatic Outline of the Diagnostic Methodology: Guidelines for the Formulation of an Agricultural Finance Policy (Annex 2).
4.1.2 Agricultural Sector Policy
Governments must sincerely work for the removal of pricing and supply distortions in agricultural products so that activities supported by credit may be sufficiently remunerative for small farmers (Chowdhury and Garcia 1993, p. 43).
The crucial issue in agricultural sector policy is the profitability of farming. As long as this remains low, then lending for agricultural production will be risky. It is important that the agricultural sector becomes as profitable as other sectors if it is to attract funds for viable investments. While no simple solution exists, the formulation of effective policies for agricultural sector development is imperative. Appropriate macroeconomic policies and the provision of essential rural infrastructure and support services such as roads, markets, agricultural research and extension are crucial to making farming more profitable in developing countries and countries in transition. Favourable agricultural policies create an environment in which private financial institutions are willing to service farmers. Governments should avoid undue taxation of agriculture. Instead, policy makers should liberalise agricultural trade and product prices, thus making on-farm investments more profitable and attractive, as well as benefitting the national economy. While accessible credit and deposit facilities may help poor rural people to smooth their production and consumption needs, there may be limited opportunities for farmers and microentrepreneurs to use these facilities productively, unless accompanied by a broader set of non-financial support services and investments in rural infrastructure. There are different interests at stake in an attempt to address this issue (see Figure 2), which are further investigated in the Diagnostic Methodology (Annex 2).
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4.1.3 Financial Sector Policy
In all cases, government should be guided by the principle that any intervention should only be directed to improving the workings of financial markets (Stiglitz, 1994).
Rural financial reforms should be a vital part of financial sector reform. The challenge is to promote a variety of viable financial institutions that are client oriented, that mobilise deposits efficiently, and that provide access to loans to a broad spectrum of farmers, agribusiness entrepreneurs and other rural clients. Policies should facilitate the experimentation and adoption of new financial technologies and development of attractive financial products. The new financial market approach does not ignore the important role of government in reducing risks and increasing confidence, by improving information and providing incentives to improve the performance of financial intermediaries. In particular, the government has specific powers regarding taxation, subsidization, regulation and enforcement that can influence the direction of desired developments. Successful financial intermediation, in particular, is dependent upon transparency and accountability. Financial institutions should have updated and accurate information systems in place, that are readily available not only to management and bank supervisors but also to policy makers, to assist them in policy revision for improved delivery of agricultural and rural financial services (see Section 4.2.3).
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4.2
ESSENTIAL ELEMENTS
OF
POLICY MAKING
Although policy making is more an art than a science, at least five common elements are involved in the formulation of rural finance policies: exerting leadership, forging coalitions, providing essential information, promoting donor co-ordination and establishing a framework that allows the interaction of these four elements.
Box 6 The Importance of Leadership: Indonesia It should be recognised that the expansion of rural banking and the success of Bank Rakyat Indonesia (BRI) and Badan Kredit Kecamatan (BKK) with rural village bank units in Indonesia can be attributed to location specific factors. These include: strong and continuous government support without government interference in bank management; social sensitivity and cohesion and in particular a conducive macroeconomic environment. Supportive decentralisation and market-based savings and lending strategies together with technical and financial support have filtered down from the Ministry of Finance through the local government structure to villages. Most of the government support has been at policy level and has not resulted in bureaucratic interference in day-to-day operations of banks. The growth and continued evolution of the rural banking system in Indonesia is the direct result of the presence of a determined leader, the Minister of Finance, committed to the promotion and strengthening of rural financial intermediation.
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Of significant importance is that external donor assistance was offered to the Ministry of Finance and the Bank of Indonesia while technical assistance was provided within an already existing strategy context. This situation contrasts with many rural banking programmes in other countries where the order is reversed. In this case the government has little or no involvement in the policy design and implementation process. Source: Patten, H.P., and J.K. Rosengard, The Development of Rural Banking in Indonesia. A copublication of the International Centre for Economic Growth and the Harvard Institute for International Development, 1991.
4.2.1 Leadership One of the results of dismantling traditional directed agricultural credit programmes and institutions is that it creates a leadership vacuum in rural finance. The Minister of Agriculture and the head of the agricultural development bank were typically responsible for tending the agricultural credit system. In many countries that leadership has been disPart II: The Policy Framework
Box 7 Stakeholder Participation in Policy Dialogue: India For many years now, a reasonably effective policy dialogue platform for agricultural finance has existed in India. The participants in this platform include: Members of Parliament, especially those representing rural areas; Central Bank; Ministries of Agriculture, Finance; Commercial and Co-operative Banks; National Bank for Agriculture and Rural Development (NABARD); Others: e.g. Farmers Unions
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Ideas for policy amendments generally come from Members of Parliament. Their role is that of spokesmen for their constituents, rather than as legislators, per se. Government ministries and the banking sector attempt to accommodate required changes within existing regulations wherever possible. Any new legislation, of course, requires a much longer period of time than if changes can be accommodated under the existing laws. The policy dialogue platform exists at two levels. Firstly, formal meetings are held at frequent intervals. Secondly, informal contacts take place between various partners in the policy dialogue process on a more or less continuous basis. Despite the comprehensive nature of policy dialogue, there have been a number of problems, such as the fact that some institutions come under State legislation and/or co-operative legislation, which may lag behind national (All-India) banking legislation in terms of suitability following structural adjustment reforms. In addition small farmers experience difficulty in having a voice in the policy making process, where participation is based on crop commodity associations, such as sugarcane, cotton, tobacco, cashew nuts and plantation crops. The intensive lobbying by various interest groups means there is potential to distort credit policies. Information is essential in the policy making process and feedback from the various interest groups should be organised in a systematic way, with increased emphasis placed on the effective participation of grassroots farmer organisations in the policy making process. Additionally, there is a need for a legal framework and supervisory body for NGOs operating in India.
solved as agricultural development banks have collapsed, governments and donors are reducing their agricultural credit funding, and ministries of agriculture, under structural adjustment programmes are increasingly isolated from decisions that affect rural finance. Rural finance policy decisions are typically unattended in ministries of finance as they are engaged in addressing overall problems in the economy and the financial sector, and are not familiar with agricultural and rural development. Policy makers often implicitly assume (or hope) that the private sector will automatically rebuild or develop a rural financial system once macroeconomic and financial sector reform measures have been implemented. Experience in many other countries, however, strongly suggests that the high transaction costs and risks involved in rural finance require special government attention. This attention, in turn, requires strong leadership. At least two leadership forms have emerged in low-income countries engaged in structural adjustment. The first form is where a single individual, such as a dynamic minister of finance or a new head of a reformed government-owned agricultural development bank takes charge. This was the approach used in El Salvador, Indonesia, (see Box 6) Malaysia and Thailand. In the last-named country one large and relatively efficient public agricultural bank (BAAC) continues to play a dominant role in agricultural finance. The other model is to appoint an inter-ministerial and inter-agency consultative policy committee on agricultural and rural development that takes charge of formulating rural finance policies (see Box 7, India)5. The committee is comprised of all the stakeholders that are involved in rural finance. This model also exists in the Philippines and in Uganda (see Box 9), where a variety of organisations are involved in rural finance policy formulation.
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5 An inter-ministerial inter-agency committee appears to work best if it is chaired by a high level official from the financial sector, rather than someone representing agriculture.
4.2.2 Coalitions Under the directed credit approach, various coalitions of interest groups were formed. They included farmer groups whose members were able to capture sizeable amounts of subsidised credit, labour unions in government-owned banks whose employees depended on directed credit programmes, politicians who built their reputations by dispensing subsidised credit, and donors who were able to fill lending quotas through directed credit programmes. The configuration of these coalitions is disrupted when attempts are made to switch support to the new financial market approach. Farmer organisations protest that their members are unable to pay higher interest rates, government-owned bank employees go on strike when their organisations are down sized or threatened with liquidation, politicians continue to pass laws that encourage subsidised and directed lending and some donors may fund programmes that are inconsistent with the new approach. Sustaining policies that support financial market development necessitates defending new policies against these old coalitions, and likewise developing new coalitions that support the new views. New coalitions might be fostered among some of the following groups: opinion makers who are concerned about creating a more efficient and durable rural financial infrastructure, savers who would benefit from more attractive deposit services in rural areas and higher interest rates, non-farm rural entrepreneurs who wish to have access to formal finance, and farmers who, previously, were unable to access subsidised credit. Policy workshops or seminars may be useful tools to build support for the new view of financial market development and also to co-ordinate donor and NGO efforts (see Section 4.3.1.5: The Role of Information and Research in Policy Formulation). 4.2.3 Information Information is an essential element in policy formulation and relevant data pertaining to agricultural finance must be collected. The diagnostic methodology which has been developed by the FAO/GTZ team (see Annex 2) may assist governments and donors in the task of data collection and analysis.
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Once a policy has been formulated, monitoring of key indicators is of great importance. Bank data constitute a key element in the assessment of the effectiveness of current policies. In particular, data that relate to the volume, composition and performance of agricultural and rural loan portfolios, as well as savings deposits, provide valuable assistance in policy review. Presently, bank data are believed to be insufficiently used in policy generation and revision, while in many cases existing data which are unreliable and not up-to-date need to be improved. The use of aggregate data (to ensure confidentiality), is recommended. Clear standards need to be set for the collection of consistent bank data, and where necessary, management information systems (MIS)6 need to be put in place, implemented and maintained. Applied research that addresses concerns raised by key policy makers, study tours to successful examples of agricultural and rural finance in other countries and careful diagnosis of traditional directed credit programmes that failed in the country, are extremely useful in building support for the new approach.
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6 The use of computerisation, e.g. the FAO MicroBanking System, designed for automation of bank records, such as loan and savings accounts of small and medium size financial intermediaries, caters for accurate and reliable record keeping. Benefits from such a system are enjoyed not only by bank management and supervisors but also by customers.
4.2.4 Donor Co-ordination As discussed in Part I agricultural credit has attracted substantial donor attention in the past. More recently, donors have backed away from agricultural credit projects and have placed greater emphasis on lending programmes for poverty alleviation, women and microfinance. Although many of these new programmes are concentrated in urban areas, it is not uncommon to find them also in rural areas of developing countries and countries in transition. Some of these donor-funded programmes adhere to most of the tenets of the new financial market approach: cost-recovery interest rates are charged on loans, loans are made on the basis of creditworthiness and repayment capacity of borrowers, bank managers focus on reducing transaction costs, and sustainability has become a major concern. Other donor-funded programmes, however, still largely operate under the old paradigm: loans are heavily subsidised and are made on the basis of assumed needs, transaction costs are ignored, loan recovery is given scarce attention, and financial viability is not a major concern. Understandably, where programmes that do not provide subsidies operate in areas where other subsidised credit programmes operate, conflicts arise. Heavily subsidised credit programmes unfairly compete with lending programmes that are market based, and loan discipline is undermined by intermediary organisations that accept low loan-recovery rates and defaults. A principal part of the task of leadership for the development of rural financial markets is co-ordinating the efforts of donors so that these types of conflicts are avoided
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4.3
POLICY MAKING PROCESS
Exercising strong leadership, building coalitions, assembling appropriate information, and co-ordinating donor efforts are effective if they are focused on clearly specified goals. To be consistent with the new approach to rural financial intermediation, these goals should include: reducing transactions costs, accelerating rural deposit mobilisation,
increasing the number of people who have access to rural financial services, building viable and durable rural financial intermediaries, and reducing risks that affect their performance. The process that is used to achieve these goals will vary from country to country. The determining factor is the extent to which an economy has been liberalised. If the process is successful, it will accomplish two major tasks: the first is to build a broad base of support among stakeholders in formulating new policies for developing rural financial markets. The second is to address the concerns of those who oppose the new approach and continue to promote directed credit activities. There are different stakeholders at national, sectoral, institutional and farmer levels (see Figure 3). Policy makers should ensure that all these stakeholders are consulted. The success of a concerted rural finance policy depends on the interactions of all stakeholders, who will inevitably have different goals and interests.
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Figure 3: Rural Finance Policy Making Process
The dominant government player in the agricultural and rural finance policy making process varies from country to country (see Section 4.2.1) and can be the Ministry of Agriculture (associated in the past with the directed credit paradigm), the Ministry of Finance or the Central Bank (that will support the new financial market paradigm) and in exceptional cases an inter-ministerial committee. The need for a co-ordinating committee is outlined in Section 4.3.1. The essence of policy making is politics. Politics has been defined as the art of the possible, the art of compromise and the art of who gets what; policy formulation is a key determinant. It is therefore important to have a clear understanding of the policy making process and of the main stakeholders who attempt to influence the direction and contents of rural finance policies. The stakeholders that should be engaged in policy making for agricultural and rural finance include: government ministries (particularly Agriculture and Finance/Central Bank, but also trade and commerce may also have an important role to play), financial institutions, farmer organisations and co-operatives, NGOs and private sector representatives.
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Conflicts and differences of opinion will arise among the different interest groups which should be debated and resolved through dynamic policy dialogue and leadership. 4.3.1 Summary of Key Issues to be examined in Policy Making When devising a policy for agricultural and rural finance, there are particular key issues that must be considered, but each country is a specific case and must be dealt with accordingly. However, the issues outlined below are broad questions applicable to any country that attempts to formulate or update its agricultural and rural finance policy. what are the main objectives of agricultural and rural finance policy? who are the main policy decision makers in agricultural finance? what are the policy areas that affect the provision of agricultural credit? who are the different opinion leaders and stakeholders and how do they participate in the policy making process? what is the role of information and research in policy formulation?
how best are policy monitoring and evaluation effected? what is the role of the government in agricultural and rural finance? In Annex 2, a diagnostic methodology7 is presented to assist policy makers in examining and analysing their specific country situations and in answering questions such as the key issues addressed above. Those engaged in the policy making process may include governments, donor agencies, financial experts/consultants and project designers.
4.3.1.1 Main Objectives of Agricultural and Rural Finance Policy
Traditionally, finance for agricultural and rural development has been a part of the agricultural sector policy falling under the umbrella of the Ministry of Agriculture. It has often been used as a tool for achieving other government development objectives, such as social, political and equity objectives. Even when a specific policy on agricultural credit did exist, the main focus in most cases was on increasing the access of small farmers to institutional credit, often at subsidised rates of interest and without requiring collateral.
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Conventional wisdom is that the overall objective of agricultural and rural finance policy is to secure the availability of appropriate and affordable financial services to rural households. This involves a shift in emphasis from the supply of predetermined financial products to the provision of demand-led financial services. For this, it is essential that bank management and staff understand and respond to the needs of their clientele and focus on a demand-driven approach that cultivates durable bank/client relations and provides effective rural financial intermediation services. This topic is covered in greater detail in another publication in the Agricultural Finance Revisited series; Better Practices: Doing it Right.
7 The policy checklist which has been developed by the FAO/GTZ team (see Annex 2) has been used as a conceptual framework guide while conducting case studies in various countries throughout Africa, Asia and Latin America. Examples from these case studies (see boxes) are presented in this chapter to highlight the importance of the key issues outlined when formulating an agricultural and rural finance policy.
4.3.1.2
Main Policy Makers in Agricultural and Rural Finance
Using the directed agricultural credit approach, the Ministry of Agriculture was mainly if not solely responsible for agricultural finance policy formulation, while the public agricultural banks that executed this policy were regulated by special legislation, different from the banking law, and controlled and overseen by government officials under the direction of the Minister of Agriculture. As previously stated, the financial market approach focuses on the development of viable and durable financial intermediation based on the provision of demand-led financial services, including savings and deposit facilities and lending for both on-farm and off-farm or non-farm rural enterprises. It recognises, however, that the provision of rural financial services may not always be the most urgent and cost-effective way of improving the incomes and alleviating the poverty of the rural population and should be complemented by other important government support measures.
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The potential tensions and contradictions between overall financial sector and agricultural sector policies, should be noted in this connection. In order to formulate, co-ordinate, direct and review the agricultural and rural financial sector policies, it is considered essential to establish a national level body, such as an Agricultural or Rural Finance Policy Committee. An inter-ministerial and inter-agency committee should preferably work under the guidance of the Ministry of Finance, with representatives of the various ministries and institutions like the Central Bank that are directly involved in agricultural and rural development and the financial sector together with the various stakeholders of the private sector such as financial institutions, agribusiness and representatives of farmer organisations. (see Indian example, Box No. 7). There is an urgent need to establish such a committee, particularly in larger countries, where all stakeholders (government, donor community, NGOs, financial institutions, farmer organisations and other private sector actors) should participate in effective policy dialogue and policy formulation.
Box 8 NGOs and Agricultural and Rural Finance
With the change in focus from directed credit to financial market development, the type and role of financial institutions has changed. To overcome the high transaction costs and risks associated with rural finance, increasing efforts are made to involve various types of decentralised financial intermediaries and grassroots level organisations. The rapid increase of NGOs in developing countries has occurred alongside market liberalisation and privatisation and the emphasis by donor agencies on grassroots development and poverty alleviation. NGOs are now a preferred channel due to their proximity to the rural population. Most NGOs have not been established for the purpose of providing financial services in general and even less so for financing agricultural production. Therefore, the provision of financial services by NGOs is not always satisfactory and is further complicated by the fact that NGOs display a great diversity of form and generally lack legal personality. NGO staff generally have a good knowledge and understanding of poor communities, but often lack the necessary professional experience to operate financial services. Accounts of NGOs are often not presented or audited. In their activities, welfare and business goals often get muddled, impacting negatively on performance and loan recovery. Financial authorities in many countries prohibit NGOs and other unregulated financial intermediaries to accept savings deposits. Projects run by NGOs tend to be expensive, highly subsidised and of limited duration. However, NGOs may have an important role to play in promoting grassroots level financial intermediaries, training managers and group members to establish proper accounting and management procedures and pave the way for building links between grassroots financial intermediaries and formal financial institutions. In general, NGOs should be considered a transitional mechanism in financial intermediation and due consideration needs to be given to their regulation and supervision in the case of intended continued financial intermediation. Note: The term NGO does not refer to/include registered co-operatives.
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There is often a dichotomy between the setting of agricultural and rural finance policies and their implementation and monitoring. Therefore, the constitution of a National Level Policy Advisory Committee should, in large countries, coincide with the formation of decentralised committees at regional and local level to facilitate a two-way flow of information, from national to grassroots level and vice versa, thus facilitating participation in policy making and providing feedback on the impact of policy delivery.
4.3.1.3 Policy Areas that affect the Provision of Agricultural Credit
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Agricultural credit policy should take into account the objectives of the three inter-linked policy areas, i.e. macroeconomic, agricultural sector and financial sector policy, as far as they relate to and influence agricultural finance (see Sections 4.1.1, 4.1.2 and 4.1.3). It should capture the dynamic interactions between these three areas. In particular, it is important to assess the different pace and sequencing of reforms in each sector, and to identify the strengths and weaknesses of current policies, the presence or absence of complementary policy measures and the existence of major policy inconsistencies that have a direct impact on the provision of cost-effective and durable agricultural credit services. Some specific policy areas which should be addressed and which are dealt with in greater detail in the Diagnostic Methodology (Annex 2) include: the role of formal financial institutions in agricultural finance; state ownership of agricultural financial institutions; the role of second tier financial institutions in agricultural refinance; the role and supervision of NGOs (see Box 8) and the various types of grassroots level rural financial intermediaries and their linkage with the formal banking sector; the role of central bank in monetary policy, prudential regulation and supervision of non-banking financial institutions.
Box 9 Rural Finance Policy Dialogue: Uganda In the early 1980s international donor agencies, initially FAO, were active in supporting the establishment of an Agricultural Credit Unit, later the Agricultural Secretariat in the Development Finance Department in the Bank of Uganda. The principal objective was to facilitate an improved flow of loanable funds to priority sectors of the economy, in particular agriculture and agro-related industries. In the late 1980s the government of Uganda, by establishing district and village level councils, attempted to decentralise political powers and increase the support for economic reform and peace. As a result of this, grassroots organisations engaged in intensive dialogue with the government. In addition, Village Resistance Councils were established to provide a political platform for the small-scale farmer to voice their interests. However, rather than exerting influence on policy decisions, these councils have been used as a channel to move the population in favour of government reforms. A National Forum was established in 1992 which brought government officials and private sector stakeholders around the table, creating a platform to discuss policy issues impinging on restructuring the financial sector. However, this platform focused on medium to large scale companies, neglecting smallholders. In the absence of a clear policy in favour of microfinance institutions servicing the needs of smallholders and microentrepreneurs, an Association of Microfinance Institutions, with the membership comprised of NGOs and the co-operatives, was established in 1997. The department of supervision within the Central Bank has established close links with this Association in order to promote an innovative regulatory framework that supports microfinance institutions. In 1997, the government of Uganda, in agreement with the World Bank, decided to establish an Agricultural Policy Committee (APC) under the umbrella of the Ministry of Finance and the Ministry of Planning and Economic Development (MPED) with the responsibility to rationalise policy making in pricing, marketing structure and resource allocation within the agricultural sector. This development resulted in the Agricultural Secretariat being moved from the Bank of Uganda to an Office for Rural Finance (ORF) in the Ministry of Finance and Ministry of Planning and Economic Development.
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Box 9 (Cont.) Rural Finance Policy Dialogue: Uganda ORF has been established to formulate rural finance policies, to monitor and evaluate credit programmes, to co-ordinate and maintain a dialogue with donors and commercial lenders as well as to mobilise financial resources. Agreement exists on the fact that the role of Central Bank is one of establishing an appropriate monetary policy and, a regulatory and supervisory framework for rural financial intermediaries, but that it should not set policy objectives for the development of the agricultural and rural sectors. However, strong political pressure continues to exert influence on APC and ORF, resulting in little participation from the private sector. Source: FAO Report, 1997: N.S. Shetty, End-of-Assignment Report; UTF/UGA/029/UGA and UTF/UGA/032/UGA and GTZ Financial System Development Division.
4.3.1.4
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Different Opinion Leaders and Stakeholders and their Participation in the Policy Making Process
Policy making is a dynamic and continuous process. Sustaining and implementing policy reforms under structural adjustment programmes is a question of building a consensus and setting the right priorities and strategies. Governments not only need to institute right reforms in the right order, but they also have to make them stick. This sometimes means compensating losers and providing the right type of incentives to promote certain behaviour. For this reason it is important to strengthen the participation of all stakeholders (financial institutions, farmers, other private sector actors such as traders and agribusiness as well as donor agencies and NGOs) in the process of agricultural and rural finance policy formulation. The following are some areas of concern: institutional and organisational set-up for policy making; relation of stakeholders with national level policy makers; effective participation of all stakeholders in policy making; organisation of mechanisms that promote transparency and openness in the policy making process; opportunities for effective small farmer participation in policy formulation.
These areas have emerged as important aspects to be investigated in the Diagnostic Methodology (Annex 2), where agricultural sector and financial sector policies are examined in relation to agricultural finance policy formulation. An important measure of the effectiveness of policy dialogue is the degree of mutual trust between the public and private sectors. This is demonstrated by the government providing for equal terms of participation between all pressure and interest groups and institutionalising a policy dialogue platform with all stakeholders at different levels (see Box 9). All stakeholders should be involved in the policy formulation and revision processes, while the government is ultimately responsible for the policy decision making.
4.3.1.5 Role of Information and Research in Policy Formulation
Building support for the financial market approach often requires additional information. Many of the costs involved in the directed credit approach and benefits of the new approach are not readily apparent. A well-meaning politician, for example, may not recognise the extent to which subsidies attached to directed credit are captured by unintended beneficiaries, how weak an effect these subsidies have on production and investment decisions, and how detrimental directed credit programmes are for effective financial intermediation. Likewise, wellmeaning donors may overlook the effects their directed credit programmes have on the transaction costs of rural financial services or on the incentives to mobilise rural savings and deposits. Similarly, policy makers may be unwilling to stress savings mobilisation until they are convinced that the propensities to save in rural areas are significant. In several countries, small research groups have been formed to assist those who are formulating policies associated with the introduction of the new financial market approach. Research is necessary for underpinning new policies and designing financial technologies that reduce transaction costs and results should be available to all those who wish to benefit from them. In the Philippines research staff reported to an inter-agency committee and later to the Minister of Finance. In Indonesia much of this type of research was carried out by a small techPart II: The Policy Framework
43
nical advisory group associated with the Ministry of Finance. In both cases, researchers gathered information on issues raised by supporters of the old directed credit approach as well as by advocates of the new financial market view.
4.3.1.6 Policy Monitoring and Evaluation
Policy monitoring and evaluation both at financial institution and farmer levels are essential for assessing the effects of policy. In particular, policy delivery should be evaluated in terms of effectiveness, efficiency, equity and enforceability against stated policy objectives, and provide feedback to policy decision makers. Some specific areas where the effects of agricultural finance policies need to be monitored at institutional and farm level are: (i) Institutional Level improved commitment towards sustainability, target group orientation and outreach of agricultural financial services; increased independence from governmental/political interference; increased availability of loanable resources from savings/deposit mobilisation; improved access to refinance facilities, if available; improved access to training facilities and improved management and staff capabilities of rural financial intermediaries; increased availability and use of appropriate internal management information systems in rural financial institutions; improved mechanism for the flow of feedback information to national level policy makers; lower transaction costs; better performance of loan portfolio. (ii) Farmer-Borrower Level improved access to appropriate and durable financial services at an affordable cost; increased availability of opportune and demand-led financial services; improved access to essential training facilities;
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improved feedback flow of information to national level policy makers. These two levels are examined in greater detail in the Diagnostic Methodology (Annex 2). In monitoring and evaluating the effects of policy implementation on financial institutions, the issue of risk management should not be overlooked. Risk management is an essential element in building a sound loan assets portfolio and needs to be incorporated into the agricultural and rural finance policy, along with capacity within the lending institution to collect and analyse information on agricultural risks which confront small farmers and influence their loan repayment capacity.
4.3.1.7 Role of the Government in Agricultural and Rural Finance
Government interventions in agricultural and rural finance should always be guided by the fundamental objective of complementing or facilitating the workings of the market. All interventions should aim to reduce direct government involvement over time, while increasing private sector provision of financial services and competition among financial intermediaries. Governments should focus on enhancing information and providing incentives necessary to promote efficient private sector operators thus paving the way for sound financial intermediation. Inadequate information is a major cause of increased risk. In policy formulation there is a need for a clear definition of what are considered to be indirect and direct government interventions in rural finance. According to Yaron et al (1997) indirect refers to the policy environment (macroeconomic and sectoral policies, legal and regulatory framework) and direct refers to interventions which normally involve the direct application of public funds for targeted credit and financing of technical assistance to rural finance intermediaries. While a consensus is developing among policy makers regarding accepted indirect interventions, the appropriate role of governments in direct interventions is still much debated.
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The current approach of rural financial market development assigns a different role to the government with limited direct interventions in rural financial markets. It proposes, however, a pro-active support role of the government in the following fields: creating a favourable macroeconomic environment (prudent monetary and fiscal policies, trade liberalisation, encouraging domestic savings); developing a suitable legal framework for market transactions (clear contract and property rights, a proper regulatory and supervisory framework for rural financial institutions, contract enforcement mechanism) and institution and capacity building of rural financial intermediaries. The importance of the macroeconomic environment and related policies are outlined in sections 4.1.1-4.1.3 and are examined in the Diagnostic Methodology (Annex 2). The legal framework and supervisory framework for financial institutions will be dealt with in another publication in the Agricultural Finance Revisited series; Prudential Regulation and Supervision for Agricultural Finance.
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Government interventions in rural finance can be of a different nature, but they should be based on the principle of removing the causes of market failure in a cost-effective way. Ultimately, they should facilitate the effective working of market forces. This may include grants or subsidies for information generation and institution and capacity building, providing seed capital for capital enhancement of new rural financial intermediaries, providing rural financial intermediaries with access to refinancing facilities, in particular, to be used for term lending. Subsidies and grants, however, should always be transparent and temporary and provide incentives to strengthen the role of private sector operators in rural financial markets.
REFERENCES
NOTE: Citations are marked in the text only where material has been heavily drawn upon. Adams Dale W. & Marthans Juan Jose. 1997. Benefits and Costs of Liquidating an Agricultural Bank in Peru. Unpublished paper prepared for the Agency for International Development by IMCC, Washington D.C. Adams Dale W. & Marthans Juan Jose. 1997. The Rise and Fall of An Agricultural Bank in Peru. Abstracted from Benefits and Costs of Liquidating An Agricultural Bank in Peru. Unpublished paper prepared for the Agency for International Development by IMCC, Washington D.C. Adams, Dale W. et al. (eds.). 1984. Undermining Rural Development with Cheap Credit. Westview Press, Boulder CO. Agency for International Development (A.I.D.). 1991. Mobilizing Savings and Rural Finance: The AID Experience. Washington, D.C.: USAID Science and Technology in Development Series, Agency for International Development. Agency for International Development (A.I.D.). 1973. Spring Review of Small Farmer Credit. 20 Volumes. A.I.D.,Washington D. C. Bauer, Elizabeth K., ed. 1952. Proceedings of the International Conference on Agricultural and Cooperative Credit. Vols. I and II. University of California Printing Department. Berkeley, California. Besley, Timothy. 1994. How Do Market Failures Justify Interventions in Rural Credit Markets? The World Bank Research Observer. Vol. 9, p. 27-47. Bundesministerium fr wirtschaftliche Zusammenarbeit und entwicklung (BMZ). 1994. Policy Paper. Financial Systems Development Promotion of Savings and Credit. Referat Presse und ffentlichkeitsarbeit, Bonn.
References
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Buttari, Juan J. 1995. Subsidized Credit Programmes: The Theory, the Record, the Alternatives. USAID Evaluation Special Study No. 75. Center for Development Information and Evaluation. Washington, D.C: U.S. Agency for International Development, June. Chowdhury, A.H.M.N. & Garcia M.C. 1993. Rural Financial Institutions in Bangladesh and Nepal: Review and Agenda for Reforms. Occasional Papers Number 3. Asian Development Bank, November 1993. Cuevas, Carlos E. & Graham Douglas H. 1984. Agricultural Lending Costs in Honduras. In Undermining Rural Development with Cheap Credit. Edited by Dale W Adams et al. p.96-103. Westview Press, Boulder CO. Darling, M. L. 1925. The Punjab Peasant in Prosperity and Debt. Oxford University Press, London. Donald, Gordon. 1976. Credit for Small Farmers in Developing Countries. Westview Press, Boulder, CO. FAO. 1997. Financial Advisory Services to the Agricultural Secretariat, Uganda. Project Findings and Recommendations. FAO, Rome. FAO. 1996. The State of Food and Agriculture. Food Security: Some Macroeconomic Dimensions. FAO, Rome. FAO. 1994. Rural Finance in FAO. Position Paper by the Rural Finance Group, Marketing and Rural Finance Service. FAO, Rome. FAO. 1994. Structural adjustment and the provision of agricultural services in sub-Saharan Africa. FAO, Rome. Gonzalez-Vega, Claudio (ed.). 1992. Republica Dominicana: Mercados Financieros Rurales y Movilizacion de Depositos. Santo Domingo, Dominican Republic: Amigo del Hogar.
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Gonzalez-Vega, Claudio & Douglas H. Graham. 1995. State-Owned Agricultural Development Banks: Lessons and Opportunities for Microfinance. Rural Finance Program, Department of Agricultural Economics, Ohio State University, Colombus, Ohio. Knutson, R.D., J.B. Penn & W.T. Boehm. 1995. Agricultural and Food Policy. Prentice-Hall, Inc., Englewood Cliffs, New Jersey, USA. Kuiper, K & van Rijn Fr. 1996. Financial Services. Sectoral Policy Document of Policy Co-operation, Ministry of Foreign Affairs. The Hague, The Netherlands. Krahnen, Jan Pieter & Schmidt Reinhard H. 1994. Development Finance as Institution Building: A New Approach to PovertyOriented Banking. Westview Press Boulder, Colorado. Lieberson, Joseph M. 1985. A Synthesis of AID Experience: Small Farmer Credit, 1973-1985. USAID Special Study No. 41. Agency for International Development, Washington, D.C.
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Llanto, Gilberto M. et al. 1997. Directed Credit Programmes in The Philippines: The Experience and Policy Reform Issues. Unpublished Working Paper No. 1 in two volumes prepared by the Credit Policy Improvement Programme for the National Credit Policy Council, Department of Finance, Manila, Philippines, July. McKinnon, Ronald I. 1973. Money and Capital in Economic Development. Brookings Institute, Washington D.C. Meyer, Richard L. & Nagarajan Geetha. 1995. Evaluating Credit Guarantee Programmes in Developing Countries. Unpublished paper. Columbus, OH: Department of Agricultural Economics, The Ohio State University, November. Organisation for Economic Co-operation and Development (OECD). 1988. New Trends in Policymaking. OECD, Paris.
References
Patten, Richard H. & Rosengard Jay K. 1991. Progress with Profits: The Development of Rural Banking in Indonesia. ICS Press, San Francisco, California. Rice, E. B. 1973. History of A.I.D. Programmes In Agricultural Credit, 1950-1972. In Spring Review of Small Farmer Credit. Volume 8. Agency for International Development, Washington D.C. Roberts, R.A.J. 1995. Agricultural Services: their Role in Development. Paper presented at the Annual Agricultural Economics Society Conference, Cambridge, UK. 1995. Robinson, Marguerite S. 1992. Rural Financial Intermediation: Lesson from Indonesia. Unpublished discussion paper. Harvard Institute for Development, Cambridge MA. Sacay, Orlando J. et al. 1985. Small Farmer Credit Dilemma. National Publishing Cooperative Inc. Manila, Philippines.
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Sandiford, Frances and Rossmiller Ed. 1996. Many A Slip: Studying Policy Delivery Systems. Paper presented at the Agricultural Economics Society Conference, University of Newcastle-upon-Tyne, 27-30 March. Schmidt, Reinhard H. & Kropp Erhard. 1987. Rural Finance - Guiding Principles. GTZ, Eschborn. Shaw, Edward S. 1973. Financial Deepening in Economic Development. Oxford University Press, New York. Shetty, N.S. 1997. FAO Report, End-of-Assignment Report; UTF/UGA/029/UGA and UTF/UGA/032/UGA. FAO, Rome. Smith, L.D. & Spooner N.J. 1990. The Sequencing of Structural Adjustment Policy Instruments in the Agricultural Sector. Centre for Development Studies Occasional Paper No.6. University of Glasgow, UK.
Stiglitz, J.E. 1994. The Role of the State in Financial Markets. Proceedings of the World Bank Annual Conference on Developments Economics 1993. The World Bank, Washington. Stiglitz, Joseph & Weiss Andrew. 1981. Credit Rationing in Markets with Imperfect Information. American Economic Review. Vol. 71, p. 393-410. Thillairajah, S. 1994. Development of Rural Financial Markets in SubSaharan Africa. World Bank Discussion Paper, No. 219. Africa Technical Department Series, The World Bank, Washington D.C. Vogel, Robert C. 1984. Savings Mobilisation: The Forgotten Half of Rural Finance. In Undermining Rural Development with Cheap Credit. Edited by Adams Dale W. et al. p. 248-265. Westview Press, Boulder, CO. Vogel, Robert C. & Adams Dale W. 1997. Old and New Paradigms in Development Finance: Should Directed Credit Be Resurrected? CAER Discussion Paper No. 2 Harvard Institute for International Development, Cambridge, Massachusetts, April. Vogel, Robert C. et al. 1997. Approaches to Rehabilitating Insolvent Banks: Benefits and Costs of Liquidating an Agricultural Bank in Peru. Unpublished paper prepared by IMCC, Washington, D.C., October. Von Pischke, J. D. 1991. Finance at the Frontier: Debt Capacity and the Role of Credit in the Private Economy. The World Bank, Washington D.C. World Bank. 1993. A Review of Bank Lending for Agricultural Credit and Rural Finance (1948-1992). The World Bank, Operations Evaluation Department, Washington D.C. World Bank. 1991. World Bank Policies Guiding Financial Sector Operations. Memorandum to the executive directors, April 15. The World Bank, Washington, D.C.
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References
World Bank. 1989. World Development Report 1989. The World Bank, Washington, D.C. Yaron Jacob, McDonald Benjamin & Piprek Gerda L. 1997. Rural Finance: Issues, Design, and Best Practices. No. 14 in the World Banks Environmentally and Socially Sustainable Development Studies and Monographs. The World Bank, Washington. D.C. Zeller, M., Schrieder G., von Braun J. & Heidhues F. 1997. Rural Finance for Food Security for the Poor. Implications for Research and Policy. Food Policy Review 4. International Food Policy Research Institute (IFPRI), Washington, D.C.
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ANNEX 1
THE DIFFERENCE BETWEEN THE DIRECTED CREDIT PARADIGM AND THE FINANCIAL MARKET PARADIGM
ELEMENTS
DIRECTED CREDIT PARADIGM
FINANCIAL MARKET PARADIGM
1. Primary Problem
Market Imperfections
High transaction costs Financial intermediation
2. Role of Financial Markets
help the poor stimulate production offset distortions implement plans
3. Users
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4. Sources of funds
Beneficiaries (borrowers)
Valued clients (borrowers and depositors) Mainly deposits
Governments and donors Many (persistent) Dense, mainly for planners. Focus on credit impact
5. Subsidies and taxes 6. Information systems and evaluations
Few (Transitory) Less dense, mainly for managers. Focus on performance of financial intermediary and system
ANNEX 2
DIAGNOSTIC METHODOLOGY
Modules for Analysing Agricultural Finance Policy
This is essentially a checklist of questions designed to serve as guidelines to governments in formulating and updating agricultural finance policy, in an effort to ensure that important aspects are not overlooked8. It is not essential that each point be examined in detail and in certain cases some points may not be relevant to the country in question. Although the focus is on agricultural finance policy, it cannot be regarded as a single sector analysis since three inter-related policy areas are involved, i.e. the macroeconomic environment, the agricultural sector and the financial sector. Institutions and procedures for setting policy objectives and instruments at different levels, and for monitoring policy performance, are key elements to be examined. A thorough analysis of the overall agricultural and financial sectors is not required, but only in so far as agricultural finance policies are affected. While the emphasis in each given country is on the current situation, a concise review should be undertaken of the recent changes in policies, the motives and forces behind these changes and their impact on the financing of on-farm production and the marketing of primary produce. It is of particular importance to identify the tensions and contradictions between the different policy fields and to describe the stated objectives and strategies of agricultural sector and financial sector development. The analysis is designed as follows:
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8 It should not be viewed as a questionnaire but a conceptual framework guide during the policy formulation process.
Annex 2: Diagnostic Methodology Modules for Analysing Agricultural Finance Policy
General Background Information Examination of Agricultural Finance Policy using three modules: Macroeconomic policy with relevance to agricultural finance Agricultural sector policy related to agricultural finance Financial sector policy related to agricultural finance
Module 1: Module 2: Module 3:
General Background Information

The analysis needs to be undertaken in the context of general background information, including demographic, social and cultural issues; rural infrastructure; agricultural production; the socio-economic situation at farmer level. This component will provide a sound basis for examination of the remaining three modules.
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Module 1 Macroeconomic Policy with relevance to Agricultural Finance

This module outlines general macroeconomic policy and macroeconomic policy as it relates to both the agricultural and financial sector.
Modules 2 & 3 Agricultural Sector Policy and Financial Sector Policy as they relate to Agricultural Finance
Agricultural and financial sector policy are examined separately but in a similar manner as follows: (a) relationship to macro level, (b) sector level, (c) institutional level, (d) farmer level.
This is to allow for vertical analysis within each sector and horizontal analysis between the agricultural and financial sectors in order to gain a comprehensive picture of complementary policy measures, as well as possible policy inconsistencies. The policy analysis at institutional and farmer levels are intended as a reference point for feedback purposes, i.e. they are examined to highlight: (i) the degree of participation in policy decision making; (ii) the effect and realisation of policy at each level. Examination of the three policy levels will serve to pinpoint the strengths and weaknesses in the policy formulation and delivery of agricultural financial services, to provide lessons and to identify gaps and contradictions in policy formulation and in the delivery of agricultural financial services.
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GENERAL BACKGROUND INFORMATION

Demographics, Social and Cultural Issues
Agricultural/rural/urban population; Social and human development indicators; Income distribution; Role of formal and informal economy; Ethnic issues; Religion (Islamic banking).
Rural Infrastructure
Roads, transport; Electricity and power; Telecommunications, water supply; Irrigation; Marketing infrastructures.
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Agricultural Production
Agricultural production structure and traditional practices (main crops/livestock enterprises); Natural resources (suitability of specific food and cash crops, output variability, seasonality, current threats to sustainability); Regional peculiarities; Agricultural input and output markets (general structure and performance, local accessibility, transaction costs and profit margins).
Socio-economic Situation on Farmer Level

Farmer categories (small, emergent, large); Family structure (size, age, gender of head of household); Level of farming technology (productivity, profitability and sustainability and obstacles to further expansion of these technologies); On/off farm income diversification; Motivation to improve living standards through increased agricultural
productivity versus investment in general education for off farm employment or investments in trading and other service activities.
Political Climate
Political stability; Recent reforms; Ethnic, religious conflicts.
MODULE 1: MACROECONOMIC POLICY WITH TO AGRICULTURAL FINANCE

General Macroeconomic Policy
RELEVANCE
Macroeconomic situation and reforms GDP/capita, sectoral and regional distribution of GDP, economic growth, inflation & exchange rates; Overview of stabilisation and structural adjustment policy liberalisation, decentralisation, privatisation, role of government, fiscal policy: progress, sequencing and status of reforms; Role of foreign aid and debt principal donors and influence at macro level; Social equity policies rural vs urban development, basic needs, poverty alleviation, employment.
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Macroeconomic Policy relating to the Financial Sector

Status, sequencing and progress of structural adjustment in the financial sector: - market orientation; - privatisation of governmental financial institutions; - promotion of private sector; - intervention, subsidies.
Monetary policy: - monetisation of the economy; - interest rate policy and recent developments; - inflation rate policy and recent developments; Influence of Donors.
Macroeconomic Policy relating to the Agricultural Sector

Status, sequencing and progress of structural adjustment in the agricultural sector: - agricultural market liberalisation; - privatisation of government institutions; - promotion of the private sector; - import/export policy (external trade policy). Agricultural subsector development plans; Food security policy; Influence of donors.
62 MODULE 2: AGRICULTURAL SECTOR POLICY AGRICULTURAL FINANCE

1. Relation to Macro Level (Link to Module 1) Identification of Policy Decision Makers, Actors in the Field of Agricultural Finance Policy
Relevant actors formulating policy (financial and non-financial support) in the agricultural sector - Ministry of Agriculture, Ministry of Commerce, Ministry of Trade. RELATED TO
Identify Policy Objectives

Food security (plus 10% by the year 2005?); Commitment to privatisation; Do agricultural policy objectives comply with overall economic and
sectoral development policies? (conflicts with financial sector policy; rural versus urban development).
Identify Policy Measures and Instruments

Further analysis of Module 1 in regard to structural adjustment: - pricing policy and price stability measures (removal of price controls, government minimum price setting); - trade policies (domestic (food crops); import/export (cash crops), tariffs; - controls on marketing; - provision of agricultural inputs and equipment; - changes in the role of government and degree of intervention; - government Land Tenure Policy; - decentralisation of public agricultural support services; - taxation of agricultural inputs (fertiliser, seeds, chemicals, farm machinery, spare parts).
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2. Agricultural Sector Analysis
Overview of the Agricultural Sector

Current situation and recent reforms in the agricultural sector (liquidation of parastatals and emergence of new private sector players; involvement in lending activities (quantitative data); extent of market liberalisation, e.g. move from single channel marketing system to competitive market environment.
Identification of the Role and Participation of the Main Interest Groups/Pressure Groups/Stakeholders in the Formulation and Execution of Agricultural Policy related to Agricultural Finance
Common concerns of the Main Interest Groups include: Risk management/Risk mitigating measures (public/private sector); Freedom from political interference; Provision of financial and non-financial support services; Link between financial and non-financial support services. Ministries of Agriculture, Trade and Commerce: - role in the policy making process for agricultural finance (if any); - organisational structure and flow of decisions; - current agricultural sector policy framework (existence of an agricultural sector development or investment plan?); - policy towards state-run agricultural institutions (input supplies); - capability to provide effective support services (e.g. relevant expertise and sufficient resources), staff expertise in agricultural finance; - existence of effective marketing information systems for agriculture; - relief measures in the event of a natural disaster; - arrangements for (a) a crop insurance scheme and (b) land tenure/land registry.
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Extension service: - public/private; - performance and role (if any?) with regard to agricultural credit. Parastatals: - steps towards privatisation; - organisational structure and governance. Farmer and Womens Associations and Farmer Pressure Groups: - representative of which farmer groups/categories? Agricultural Co-operatives and Chamber of Commerce: - organisational set-up and governance structure; - interest in developing into formalised financial institutions? Agribusinesses, Outgrower Schemes, Input (public and private) Suppliers: - ownership structure.
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Regulatory Framework
Existing legislation and its impact on the agricultural sector - laws, regulations, factors impinging on farmer profitability (e.g. extent that agricultural sector is being taxed); To what extent are public and private services bound by regulations, to provide financial and non-financial services to the agricultural sector?; Government land tenure policy (land reform package); certification of ownership rights; land mortgage required by banks for collateral.
3. Institutional Level (reference/control group)
Role and Participation in Policy Decision Making

See 2 above and select principal actors for further analysis; What extent does a policy network exist in the field? (Platform for policy dialogue); Actors perception of their role in policy formulation vs their actual involvement.
Effect and Performance of Policy at Institutional Level

Performance of government institutions to provide necessary expertise and resources (financial and non-financial); Degree of policy dialogue and information flows (collection and use of information); Government incentives to ensure timely and reliable financial and nonfinancial support services to farmers; Environment to enable e.g. agricultural co-operatives to become formal financial institutions; Access to refinance facilities; Access to training facilities (management and staff); Identified gaps in the policy framework.
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4. Relationship with Farm Level (as a reference group)
Role and Participation of Farmers in Policy Decision Making

Degree of farmer representation in policy dialogue: Role and participation in policy decision making at farmer level (small farmers, women, self-help groups, emergent and commercial farmers, village opinion leaders); Two-way information flows.
Effect and Performance of Policy Instruments and Measures on Farmers

Profitability of agricultural production; Farmers access to yield and price increasing technologies; Farm management capabilities (repayment capacity) / Risk management; Availability and access to financial and non-financial support services (are financial services provided appropriate?); Level of education / Existence of farm management training programmes.
MODULE 3: FINANCIAL SECTOR POLICY AGRICULTURAL FINANCE
RELATED TO
1. Relation to Macro Level (link to Module 1)
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Identification of Policy Decision Makers, Actors in the Field of Agricultural Finance Policy
Ministry of Finance, Central Bank, Ministry of Agriculture etc.
Identify Policy Objective

Promotion of private sector; Commitment to market, target group; Links, conflicts to agricultural sector policy; etc.
Identify Policy Measures and Instruments

See structural adjustment in Module 1; Changes in legislative framework; New institutions (e.g. Apex Institutions); Changes in the organisational structure of decision making procedures; etc.
Annex 2: Diagnostic Methodology
2. Financial Sector Analysis Identification of the Role and Participation of Main Stakeholders, Interest and Pressure Groups in the Formulation and Execution of Agricultural Finance Policy
Common Concerns of the Main Actors: - degree of political interference; - risk management; - coverage of the agricultural sector. Government Institutions (Ministry of Finance, etc.): - policy towards the promotion of the efficient performance of financial institutions in the field of agricultural finance; - organisational structure of policy decision making; - policy towards state-owned agricultural finance institutions; - policy towards NGOs and Co-operatives, respectively, their formalisation or linking to the formal financial market, access to refinancing facilities, training and assistance; - staff expertise in agricultural finance. Role of Central Bank: - role of central banks (tasks, reforms); - degree of political independence, interference; - information basis on the agricultural financial sector for policy decisions; - staff expertise in agricultural finance; - organisational structure of policy decision making. Banking Supervision Authority: - relation to central bank; - objectives, measures regarding financial institutions in the area of agricultural finance; - supervision coverage; - performance criteria for financial institutions in rural areas; - enforcement mechanisms to ensure that regulations are adhered to; - staff expertise in agricultural finance.
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Apex Institutions9: - Apex Institutions: deposit and loan insurance, credit guarantee facilities, risk information offices, training institutions etc. (see also module 2); - measures and services with regard to financial institutions in the area of agricultural finance (e.g. refinancing, training); - organisational set-up, ownership and governance structure; - performance criteria for financial institutions in rural areas. Other Interest and Pressure Groups: - influence of non-financial private or public institutions in agricultural policy decisions, e.g. commercial producers of certain products as political pressure group; - (see also module 2). Role of International Donors: - involvement in agricultural finance policy; - programmes in the field of agricultural finance: vision , measures, procedures; - networking on donor level in the field of agricultural finance, conflicting positions - etc.
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Regulatory Framework for Financial Transactions

Legislative Framework relevant for Agricultural Finance: (e.g. private law, banking law, capital market legislation, co-operative law); Selective Issues with relevance for Agricultural Finance: - law of property, land tenure, creditor protection; (informal and implied contracts); - controls or limits on lending; - reserve and capital requirements;
9 APEX: A financial institution that provides banking services to other financial institutions. Used often when donor agencies channel money into developing countries through financial institutions.
Annex 2: Diagnostic Methodology
- licensing standards; - capital requirements; - deposit insurance; - usury legislation; - etc. Recent Changes in the Regulatory Framework: - reasons for reforms; - actors of the financial sector addressed, (dis)advantaged by the regulatory framework and its reforms.
3. Institutional Level (as a reference group) Role and Participation in Policy Decision Making
Representative types of financial institutions which offer agricultural financial services: commercial bank, state owned bank, (formalised) NGO (financial/non-financial), (non)financial co-operative, other semi- or informal financial institutions (e.g. ROSCA), agricultural input supply and marketing enterprise, etc.: - form of involvement in policy decision taking; - existing dialogue platforms; - need for further involvement in policy decisions; - influence from donors on financial institutions; - actors perception of their role in policy making, their main interest.
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Effect and Performance of Policy at Institutional Level

- Commitment and incentives towards sustainability, target group orientation and outreach in agricultural finance, formalisation; - independence from political/governmental interference; - access to refinancing facilities; - access to training facilities at management and staff level; - identified gaps in policy framework from institutional point of view; - information delivery exchange system; - performance of policy dialogue platform.
4. Relationship with Farm Level (as a reference group)
Role and Participation in Policy Decision Making

Representatives at farmer level: small (landless) farmers, women, self-helpgroups, commercial farmer, leading persons of village: - form and extent of participation in policy decision taking; - existing dialogue platforms; - need for further involvement in policy decisions.
Effect and Performance of Policy Instruments and Measures on Farmers

Changes in access to financial services; Appropriateness of financial services; Performance of policy dialogue platforms; Changes in access to financial support facilities; Changes in access to training facilities; Policy shortcomings identified by farmers.
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Agriculture Finance Revisited

Agricultural Finance: Getting the Policies Right

AGRICULTURAL FINANCE REVISITED

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

R.A.J. Roberts Chief Marketing and Rural Finance Service FAO

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

PART II: THE POLICY FRAMEWORK 4. Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4.2. Essential Elements of Policy Making . . . . . . . . . . . . . . . . . . . 28 4.2.1 Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 4.2.2 Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Donor Co-ordination . . . . . . . . . . . . . . . . . . . . . . . . 34 . . . . 34 . . . . 36 . . . . 37 . . . . 38 . . . . 40

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Annex 2 Diagnostic Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

Part I: Lessons Learned

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part I: Lessons Learned

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part I: Lessons Learned

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part I: Lessons Learned

Transition to the New Approach

Part I: Lessons Learned

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part I: Lessons Learned

THE POLICY FRAMEWORK

Part II: The Policy Framework

POLICY FIELDS AFFECTING THE FORMULATION RURAL FINANCE POLICY

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part II: The Policy Framework

Box 5 Mistrust in the Policy Dialogue: Zambia

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part II: The Policy Framework

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

4.1.2 Agricultural Sector Policy

Part II: The Policy Framework

4.1.3 Financial Sector Policy

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

POLICY MAKING PROCESS

Figure 3: Rural Finance Policy Making Process

Part II: The Policy Framework

Part II: The Policy Framework

Main Policy Makers in Agricultural and Rural Finance

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Box 8 NGOs and Agricultural and Rural Finance

Part II: The Policy Framework

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part II: The Policy Framework

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Part II: The Policy Framework

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

DIRECTED CREDIT PARADIGM

FINANCIAL MARKET PARADIGM

High transaction costs Financial intermediation

2. Role of Financial Markets

help the poor stimulate production offset distortions implement plans

Valued clients (borrowers and depositors) Mainly deposits

5. Subsidies and taxes 6. Information systems and evaluations

AGRICULTURAL FINANCE : GETTING THE POLICIES RIGHT

Module 1: Module 2: Module 3:

General Background Information

Module 1 Macroeconomic Policy with relevance to Agricultural Finance