Agriculture Microfinance : Changing Face of Indian Farming

Agriculture Microfinance Rural finance, as defined by the World Bank, is the provision of a range of financial services such as savings, credit, payments and insurance to rural individuals, households, and enterprises, both farm and non-farm, on a sustainable basis. It includes financing for agriculture and agro processing. Agricultural finance is defined as a subset of rural finance dedicated to financing agricultural related activities such as input supply, production, distribution, wholesale, processing and marketing. Microfinance is the provision of financial services for poor and low income people and covers the lower ends of both rural and agriculture finance as seen in the diagram below.

Microfinance loans are fungible and are often already used for agricultural activities, microfinance products are often a poor fit with agricultural cashflows and as a result can be more risky for lenders and borrowers alike. Where rural financial services have reached poor households, these have tended to be households with diversified non-farm income sources or income from non-seasonal agricultural activities. Specificity of Agriculture Finance The agricultural sector is different from other economic sectors in a number of ways. Activities are generally located in isolated areas with low population density and poor infrastructure. They are dependent on weather and production cycles; income is seasonal and monetary income is limited.

Agricultural prices are notoriously volatile and few farmers can offer guarantees that are legally or financial acceptable. These specificities demand financing mechanisms adapted to the diverse needs and services of rural households (Wampfler and Lapenu, 2002): Short-term: input financing at the beginning of the crop year (seeds, fertilizers, pesticides), additional labor, feed, storage facilitates, processing, etc. Medium and long term: equipment for intensification, commercialization (transportation), storage (buildings), perennial crops (investment, renewal, maintenance), (re)constitution of herds, land purchase. Family needs: personal, durable goods, housing. Savings Non-financial services: monitoring demand, technical assistance and extension. Understanding how to best meet these financial needs and finding ways to mitigate the risks associated with them are added challenges that further hinder the expansion of financial services for agriculture. Moreover, as microfinance is increasingly integrating into conventional financial markets, the sector has no choice but to apply cost-covering interest rates. Such rates often contradict the expansion of rural coverage and agricultural finance due to the low profitability of the activities financed. All these factors explain the relative lack of interest in agriculture on the part of urban and peri-urban zones. Consequently, liberalized markets coupled with contractual innovationselements promoted under the new paradigmhave not fulfilled their promises vis a vis rural and agricultural finance. Need for Agriculture Microfinance in India Agriculture plays a crucial role in the development of the Indian economy. It accounts for about 19 per cent of GDP and about twothirds of the population is dependent on the sector. The importance of farm credit as a critical input to agriculture is reinforced by the unique role of Indian agriculture in the macroeconomic framework and its role in poverty alleviation. Recognising the importance of agriculture sector in Indias development, the Government and the Reserve Bank of India (RBI) have played a vital role in creating a broad-based institutional framework for catering to the increasing credit requirements of the sector. Agricultural policies in India have been reviewed from time to time to maintain pace with the changing requirements of the agriculture sector, which forms an important segment of the priority sector lending of scheduled commercial banks (SCBs) and target of 18 per cent of net bank credit has been stipulated for the sector. The Approach Paper to the Eleventh Five Year Plan has set a target of 4 per cent for the agriculture sector within the overall GDP growth target of 9 per cent. In this context, the need for affordable, sufficient and timely supply of institutional credit to agriculture has assumed critical importance. The evolution of institutional credit to agriculture could be broadly classified into four distinct phases - 1904-1969 (predominance of co-operatives and setting up of RBI), 19691975 [nationalisation of commercial banks and setting up of Regional Rural Banks (RRBs)], 1975-1990 (setting up of NABARD) and from 1991 onwards (financial sector reforms). The genesis of institutional involvement in the sphere of agricultural credit could be traced back to the enactment of the Cooperative Societies Act in 1904. The establishment of the RBI in 1935 reinforced the process of institutional development for agricultural credit. The RBI is perhaps the first central bank in the world to have taken interest in the matters related to agriculture and agricultural credit, and it continues to do so (Reddy, 2001). The demand for agricultural credit arises due to

i) lack of simultaneity between the realisation of income and act of expenditure; ii) lumpiness of investment in fixed capital formation; and iii) stochastic surges in capital needs and saving that accompany technological innovations. Credit, as one of the critical non-land inputs, has two-dimensions from the viewpoint of its contribution to the augmentation of agricultural growth viz., availability of credit (the quantum) and the distribution of credit. In this paper, the trends in agricultural credit are analysed in Section I; Section II covers Statewise distribution of institutional credit; Section III deals with recent policy initiatives; issues and concerns are dealt with in Section IV; Section V draws implications for the future followed by the concluding observations in Section VI. The new development challenge Andhra Pradesh, which witnessed a spate of suicides, especially by cotton farmers in recent years, saw the biggest drop in agricultural workers -- from 56% in 1991 to 43% in 2002, according to a report in the Hindustan Times dated December 5, 2005. The figures for Kerala and Tamil Nadu are 50% (from 78%) and 35% (from 43%) respectively. The new states, Chhattisgarh and Jharkhand, with little industrial activity, have the largest numbers of farm workers -- 75% and 76% respectively. Himachal Pradesh fits into the same category, with 75% of its population dependent on agriculture for their livelihood. The national average for people engaged in cultivation is around 60%. It was 76% in 1971 and 66% in 1991. This trend poses a challenge for the development sector, especially those in micro-finance, in terms of retaining the involvement of people with their landholdings and strengthening the tentative linkages of micro-finance with agriculture. More importantly, as people struggle to move out of the ambit of agriculture in search of newer avenues, there is a need to extend support to non-farm activities and also help resolve the problem of migration. To address these issues, sessions on self-help initiatives and the micro-finance sector formed part of the National Conference on Empowering Livelihoods organised by the PACS Programme in New Delhi on October 24-26, 2005. Micro-finance: New look required Over the past decade or so, the micro-finance sector has made significant progress in fostering savings and extending credit to small groups, especially women, in rural India (only 20% of the Indian populace has access to credit from the formal sector). The sector has spawned over 2 million self-help groups (SHGs) and 1.6 million have been linked with banks since 1992. Total SHG-bank linkage lending over 2004 alone was over Rs 3,000 crore (Source: Andhra Pradesh Mahila Abhivradhi Society, or APMAS).

Although growth in the Indian micro-finance sector has been exceptional, concern is being expressed over issues like internal control systems, fund management, accounting and governance. In recent years, SHG federations have been mushrooming all over the country. Andhra Pradesh alone has over 30,000 federations, informal and formal. The question now is how to tweak and mesh this growth into the development process. There is need for a new understanding and structure for micro-finance, one that looks beyond credit, offering solutions to the multifarious issues germane to rural economies such as micro-finance and agriculture, livelihood security, migration, insurance, rural entrepreneurship, technology infusion, market linkages, the role of agribusiness, etc. This requires a certain degree of restructuring and innovation of approach, which is happening. The faint contours can already be seen. At a time when interest in agriculture is waning, can micro-finance rekindle and sustain livelihoods around agricultural activities? Can micro-finance undertake this task by continuing with the present mechanism or does it call for a radical change in approach? Can we learn from global trends and tailor a model suitable for India? What are the trends, and which model is right for us? A new model The Consultative Group to Assist the Poor (CGAP), supported by the International Fund for Agricultural Development (IFAD), recently examined over 80 providers of micro-finance across the developing world. The idea was to pin down sustainable approaches to providing financial services to farming-dependent households. While the focus of the CGAP analysis was on lending, it nevertheless recognised and explored the importance of deposits, insurance, and money transfer services. It also addresses the need to look at markets and market linkages seriously, to ensure agricultural sustainability, and recommends a collaborative or contractual approach to problem solving. The new model is described plainly as agricultural micro-finance by the CGAP. It combines the most relevant and promising features of traditional micro-finance, traditional agriculture finance (bank/institutional), and a host of other approaches including leasing and area-based insurance. The area-income-based Farm Insurance Income Scheme was tried out for the first time in India across 19 districts, during the rabi season in 2003-04, by the Agriculture Insurance Company of India. In 2003, ICICI-Lombard experimented with rainfall insurance, based on a composite index. AIC followed with Varsha Bima in 2004. These schemes harnessed technology and existing infrastructure and contracts with processors, traders and agribusiness. This forms an agriculture micro-finance model characterised by 10 principal features. Ten principal features of the model The CGAP analysis stresses that successful agricultural micro-finance lenders rely on a judicious mix of the 10 features, but that it is not necessary for an effective model to incorporate all ten.

Most of the features, naturally, are specific to financing agriculture; some address the common challenges of operating in a rural setting, and some are basically good practices in delivering small, unsecured loans. In India, bits and pieces of these features are already being tried out. The features: 1. Repayments are not linked to loan use: Under this model there is a conscious effort to de-link loan uses from repayment sources (traditional lending is a medley of production loans narrowly designed for varieties of crops or livestock-rearing). The new approach says that even if a loan is given to raise a certain crop, the borrowers entire household income is taken into account when judging repayment capacity. Deploying this approach has apparently worked remarkably well in increasing repayment rates. The approach is based on detailed studies on how poor households earn, spend, borrow and accumulate assets. Farming households often engage in a number of activities that align with agriculture cycles -- petty trading, rudimentary processing, labour, livestock, temporary migration, etc. (Non-farm income of a typical farming household in Asia is around 32%; the non-farm part of rural full-time employment is 25%.) 2. Character-based lending techniques are combined with technical criteria in selecting borrowers, setting term loans, and enforcing repayment: This feature emphasises the principles that most self-help groups adhere to -- group guarantee, peer pressure, follow-up on late payments, etc. It also stresses on infusing the credit mechanism and process with specialised agricultural knowledge. The few micro-finance programmes that have entered into full-scale agricultural activities have agronomists and vets to support loan decisions and methodologies. 3. Saving mechanisms provided: However poor an individual or household may be, there still exists the need to manage liquidity, conduct transactions and accumulate assets. When rural financial institutions offered deposit accounts to farming households, which enabled them to save funds for lean periods and handle life events, the number of such accounts quickly exceeded the number of loans. 4. Portfolio risk is highly diversified: Diversification has been one of the primary riskmitigation strategies in financing. A number of micro-finance institutions with stable lending portfolios have minimised risks by lending to households or groups that have a diverse crop mix and also earn from other sources such as livestock-keeping. Organic farming undertaken by small, marginal farmers would therefore be an ideal plank, for organic principles encourage diversity, inter-cropping, buffer, companion crops, etc. Most organic farmers are also adept at livestock-keeping, for it is integral to the system. Dung, urine and other on-farm resources are vital ingredients in the bio-composting and pest management techniques adopted by farmers practising sustainable agriculture. 5. Loan terms and conditions are adjusted to accommodate cyclical cash flows and bulky investments: Successful agricultural micro-lenders, keeping in mind that farming cash flows are highly cyclical, have modified loan terms and conditions to track these cash flows more closely. All this without compromising on the principle that repayment is expected regardless of the success or failure of an individual productive activity, even that for which the loan was used. Promoting flexible repayment has worked well. For instance, Caja Los

Andes in Bolivia has tuned its repayment options with the agricultural activities of its borrowers. The options include:

One-time payment of capital and interest. Periodic payments of equal amounts. Periodic interest payments with payment of capital at the end of the term loan. Plans with differing, irregular payments (for clients with several crops).

PRODEM, another micro-finance institution in Bolivia, has expanded this tenet to embrace rural non-farm enterprises as well. Cash flows of rural grocers, for instance, were found to be significantly higher in the months when the local dominant crops were harvested. To adapt financial products to fit agriculture cycles, monitor uptake and performance and improve their design over time, micro-finance institutions have to plug into better management information systems. Long-term lending is also an area that bedevils the micro-finance sector. However, this need too can be addressed successfully as shown by the Small Farmers Cooperative of Prithvinagar, a tea-growing area in Nepal. Earlier, its loans were not big enough or sufficiently long-term to encourage tea-growing. Therefore, an eight-year-long loan that covers three-fourths of the average cost of starting a small tea farm (0.6 hectares), with a three-year grace period, was introduced. Interest payments are made every three months between the third and fifth years of the loan term, while principal instalments are made every six months between the sixth and eighth years. Most importantly, the cooperative goes beyond credit. It offers tea farmers marketing services to help ensure loan repayments, and higher prices for harvests. Tea from individual farms is pooled and marketed collectively. The sale proceeds are given to the farmers after deducting loan payments. 6. Contractual agreements reduce price risks, enhance production quality and help guarantee repayments: Because of the complexity of production risks, many lenders feel that small farmers require far more support than simply receiving loans, especially if they are engaged in the production of a complex crop. Such lenders offer technical assistance and other types of support directly to farmers, either because they seek to improve farm practices as part of an integrated development programme, or to guarantee minimum yields and quality of commodities for processing or resale. Traders, processors, other agribusinesses, and individuals reduce the production and operational risks associated with lending to farmers, by linking credit to the provision of technical advice (such as on input use or what crop variety to grow to meet market demand), or timely delivery of appropriate inputs (seeds, etc). Or by building relationships with farmers over one or more years. Many also tie credit to subsequent sales of produce, a practice often called interlocking or interlinked contracts because it provides inputs on credit based on the borrowers expected harvest. Operating costs for providing credit can be low because credit is built into crop purchase and input supply transactions with farmers, for which agribusinesses may have existing physical infrastructure (warehouses), agents, processing facilities, information technology systems, farmer networks and market knowledge.

This approach has already taken root in India. For instance, Rallis with ICICI Bank/SBI and Picric of the UK worked quite successfully with basmati rice farmers in Haryana. Rallis provided all the inputs for growing, ICICI Bank extended loans for the inputs, and Picric bought the produce. Such instances now abound across the country. Mahindra Shubhlabh runs a similar initiative. Many models of contract farming are being practised. Pepsico was one of the pioneers when it started work with tomato and chilli farmers in Punjab, in the 1990s. Basix, an Andhra Pradesh-based micro-finance institution that has over the years disbursed over Rs 355 crore, has been propagating the collaborative/contractual approach to livelihood solutions. Basix has replicated what the commercial banks have been doing. Its drip irrigation experience is an eye-opener. Under this initiative, the Delhi-based NGO International Development Enterprises provided the technology, and Sowbhagya Seeds did the marketing. Demonstration trials were carried out by the Andhra Pradesh governments District Poverty Initiative Programme (DPIP) together with the UNDPs South Asia Poverty Alleviation Project (SADAP). Similar initiatives have been undertaken by a variety of operators in other sectors including dairying. A host of crops -- potato, soybean, paddy, red gram, lac and even seaweed -- have been covered by contractual arrangements. The only apprehension often aired about contract farming as it is practised today is the inherent potential of big players to be exploitative. Therefore, farmers and farmers groups have to be educated and enabled to stand up and negotiate fair terms. Collective bargaining and arbitration mechanisms must be in place. Contractual arrangements have tremendous potential to secure livelihoods. A host of corporates are already engaged with, or are entering the agricultural sector in a big way. They include Mahindra & Mahindra, Hindustan Lever, ITC, Reliance, the Tata Group, Venkateshwara Hatcheries, Pepsico, Nestle, McDonalds and now even Airtel. The challenge is in establishing lasting linkages between agribusiness and micro-finance and, most importantly, reaching out to the small and marginal farmer. NGOs can play a role as pivotal intermediaries in capacity-building and monitoring, as, for example, Banco Wiese in Peru and the NGO CES Solidaridad. 7. Financial service delivery piggybacks on existing institutional infrastructure, or is extended using technology: Increasing the supply of agricultural finance requires creating institutional capacity. One way to do this is by building on existing institutional infrastructure and networks such as post offices, agribusiness agents or collection centres, and state-run banks, and using technology appropriate to rural areas such as mobile banking units. All rural lenders need to invest in techniques and technologies that deliver financial services sustainably, in areas characterised by poor transportation and communications infrastructure, low client density and low levels of economic activity. NABARD and the Department of Posts are all set to launch a pilot project in Tamil Nadu for disbursing loans to SHGs through post offices. The project will be tried out in three districts, from December 2005, and then scaled up across the country. NABARD has decided to take all the credit risks, while the post offices act as agents on a fee basis.

The challenge of devising new channels of delivery to 70% of the Indian populace living in rural areas is daunting. Harnessing technological innovations such as kiosks and smart cards could reduce transaction costs considerably and improve access. ICICI Bank is already piloting the use of smart cards, in association with SEWA Bank in Ahmedabad. The bank is also working on a high quality shared banking technology platform that can be used by MFIs, cooperative banks and regional rural banks. Wipro, Infosys, I-Flex and 3iInfotech are spearheading this initiative. 8. Membership-based organisations can facilitate rural access to financial services and be viable in remote areas: Lenders generally face much lower transaction costs when dealing with an association of farmers as opposed to numerous individual, dispersed farmers. Associations or groupings of farmers can also administer loans more effectively. Membership-based organisations can be viable financial service-providers themselves. According to Y S Nanda, former chairman of NABARD, 20 lakh SHGs was too great a number for banks to be interested in. He would like to see newer structures emerging, such as a collection of groups. The challenge now is in creating and sustaining producer/farming SHGs. Experiences with producer/farmer associations have been mixed, with problems of lack of member motivation and association capacity. Smaller and more marginal farmers need considerable handholding and training in order to establish effective associations. The upfront costs may be more than what private sector actors are willing to pay. Therefore, the situation merits donor support through specialised intermediaries/NGOs that can provide training, systems support and other assistance to existing associations and to farmers wishing to set up producer associations. Creating a second-tier institutional support structure for small rural financial organisations, such as a network or federation of savings and loan cooperatives, could address some of these challenges. Audits and benchmarking are also key to the success of initiatives in this area. They promote transparency and performance standards. In addition, services can be offered that make it easier for member organisations to negotiate funds from banks and donors, lobby for policy and legal reform, monitor performance and meet short-term cash flow needs. A refinancing facility, for instance, would help in this regard. 9. Area-based index insurance can protect against the risks of agricultural lending: Area-based index insurance, which can be applied to both production and price risks, is a promising approach. Such insurance is defined at a regional level and provided against specific events that are independent of the behaviour of insured farmers. Examples include weather-related insurance policies linked to rainfall or temperature in a defined area, offering indemnity payments if the relevant index falls or rises above a certain level, and price-related policies with payouts based on crop prices. Such policies enable providers to insure against a specific risk rather than all agriculturerelated risks, and being defined at a regional level makes them more viable and attractive to private insurers because they reduce administrative costs and risks of fraud and moral hazard.

Index-based insurance has the potential to reduce both the risks of losses for individual farmers and the operational risks of lenders. The basic difficulty for insurers in extending such coverage to small farmers is the same as that faced by micro-finance institutions: how to profitably service small contracts and transactions. Governments and donors can adopt or support measures that enhance the potential for indexbased insurance from the private sector to include small farmer clients. They can, for example, ensure the existence and availability of accurate, timely and comprehensive databases -- for example, on national or regional rainfall levels and commodity prices -- that private insurers can use to value instruments for weather and price risks. 10. To succeed, agricultural micro-finance must be insulated from political interference: Agricultural micro-finance cannot survive in the long term unless it is protected from political interference. Even the best designed and best executed programmes wither in the face of government moratoriums on loan repayment or other such meddling in wellfunctioning systems of rural finance. Some Key Issues in Agricultural Microfinance The issue at hand is not about the straightforward application of microfinance technologies to agriculture in order to provide small farmers and other agriculture-based economic agents with access to sustainable finance services. The case at hand is much more complex and challenging than can be imagined. Christen and Pearce (2005) have documented the problems faced by lending institutions in the agriculture sector. In Uganda a bumper maize harvest in late 2001 and early 2002 caused maize prices (and farmer incomes) to fall, significantly affecting loan repayment in four branches of the Centenary Rural Development Bank. In Mali, Kafo Jiginew, a federation of credit unions suffered a deteriorated portfolio at risk (over 90 days) from 3% of the total in 1998 to 12% in 1999 due to a slump in cotton prices. Cotton loans had a very a large share of the credit unions loan portfolio. It is, thus, necessary to have a keen understanding of (a) agricultural conditions, (b) the configuration of risks in the rural areas, the availability of riskmitigation instruments and how to use those instruments, and (c) the incentives that will affect the design of the finance (loan) product, including mechanisms for recoveryin the case of a loan product, the loan recovery methods. These issues can be largely understood in terms of three significant characteristics of rural credit markets identified by Besley (1994), which shape the nature of appropriate credit policy and program responses, namely: 1) the scarcity of collateral, 2) the absence of complementary institutions to reduce risks, and 3) covariant risks and market segmentation. Scarcity of Collateral Traditional collateral may be scarce because borrowers may be too poor to have significant assets that can be pledged as collateral. The scarcity of collateral may also be attributed to the relatively small sizes of farm lands and the lack of secure titles to those small pieces of

land. In the case of the Philippines, the fragmentation of farm lands and the demise of land markets because of agrarian reform have imposed an additional constraint (Estanislao and Llanto 1995; David et al. 2003; and Llanto and Ballesteros 2002). Certain provisions of the Comprehensive Agrarian Reform Law such as: (a) the prohibition against mortgaging/selling of the land within 10 years of its award and upon full payment by farmer- beneficiaries to the Land Bank of the Philippines; (b) the setting of a ceiling on the ownership of agricultural lands at five hectares; (c) the designation of government as the sole buyer of awarded lands; and (d) the prohibition against share-tenancy arrangements, have eroded the collateral value of land. This has hampered the small farmers access to credit in the formal financial markets. The World Banks Land Administration and Management Project (LAMP) in Thailand and the Philippines underscores the severity of land titling and administration problems in the two countries, particularly in the rural areas of the latter country. Llanto and Magno (2002) note that the inefficient land administration system has resulted in high transaction costs in securing, registering and transferring property rights. There is no efficient mechanism to resolve land disputes, and the land administration system does not generate the reliable information needed by the courts to hear land cases. Also, the high cost of registering land discourages registration and consequently investments on land. Poor land administration can erode public confidence and trust in the titling and land registration system, and this puts especially the poor at a great disadvantage. Secure property rights, which are a fundamental requirement for a collateral-oriented banking system, may be poorly developed or even absent. Of course, MFIs have long ago shown that microenterprise loans, including loans to poor individuals (mostly women), do not necessarily require the traditional land collateral as security. MFIs have lent to asset-less individuals and have successfully recovered the loans. However, one may argue that the context of urban micro-lending is quite different from that of rural and agri-based lending, where borrowers may demand bigger and longer-term loans. The size of the loan may be larger and the loan maturities are typically longer than the usual micro-loans that have to be repaid within a 90-day period in view of the rural borrowers different consumption and investment requirements. Both rural borrowers and lenders face the challenge of discovering alternative mechanisms such as contractual arrangements, contract farming and others, viewing rural households as integrated business and family units with multiple sources of income, and adjusting loan repayment schedules to the households cash flow and to the agriculture cycle. Thus, rural lenders have to adopt a business unusual approach and innovate because the constraint imposed on rural credit markets by the scarcity of collateral seems to be a myth. Christen and Pearce (2003) gave the example of Banco del Estado de Chile, which spent two years improving its micro-enterprise lending techniques before expanding into farming activities. It also improved agricultural finance techniques, for example, by integrating cropbased analysis into its wider client analysis and by having flexible loan repayment schedules based on seasonal income cycles. The Economic Credit Institution, a microfinance institution in Bosnia and Herzegovina, uses spreadsheets for key agricultural products compiled by an agronomist as an aid to cash-flow analysis.

Risks, Risks and More Risks Skees (2003), Ibarra (2003), Bryla (2003), and Christen and Pearce (2005) provide a neat summary explanation of the risk issues faced by rural borrowers such as small farmers and their rational behavior toward risks. Bryla cites a 1999 World Bank study showing how price volatility significantly impacts on the incomes of farmers and the macroeconomic health of their countries. From 1983 to 1998, the prices of many commodities fluctuated from below 50 percent to above 150 percent of their average prices. Facing a spectrum of risks, the most frequently cited of which are price, weather and health risks, farmers respond by adopting low-risk and low-yield crop and production patterns to ensure a minimum income at the expense of rural growth and accumulation of capital. Alternatively, in the absence of insurance markets, farmers try to cope with price and other risks by: (a) asset accumulation, savings, and access to credit; (b) income diversification; and (c) informal insurance arrangements. Ibarra (2003) views the increased labor market participation by small farmers, the reduction of consumption, the resort to interest-free loans or donations from relatives and friends, and the sale of assets such as livestock, as risk-coping strategies, and not risk management strategies. Successful agricultural microfinance as indicated by the experience of Banco del Estado de Chile is about pooling and managing risk. But how well can rural lenders cope with the correlated risks in agriculture? Traditional agriculture loans portfolios, especially those of government banks or development finance institutions, show a concentration of production loans to certain crops, e.g., rice, maize, cocoa, and livestock. The concentration of production loans creates concentrated risks for the rural lending institution. There seems to be no major problem if the risks involved are individual and are not correlated. However, the reality is that risks in agriculture are correlated. When agricultural commodity prices decline, everyone faces a lower price for their crops. Natural disasters such as widespread flooding that destroy crops, livestock, shelter and rural infrastructure, severely impact rural households in many contiguous areas. Price and yield risks are spatially correlated and this poses a major challenge to agricultural microfinance. On their own, small rural lenders, e.g., rural banks, cooperatives or credit-granting NGOs, are simply not capable of pooling and managing correlated risks. Worse, they may have no experience whatsoever in dealing with these different types of risks. Because of this, many rural lenders, which may have experienced the adverse effects of correlated risks in agriculture on their loan portfolios or which may be aware of the negative experience of other lenders in this regard, would tend to avoid agricultural lending or drastically limit their loan exposure to smallholder agriculture. Anecdotal evidence from the authors interviews with rural bankers in Mindanao, Philippines shows that the wary rural lenders have nonetheless practiced rational decisionmaking through loan diversification to minimize credit risks. This is evident, for instance, in their moves to cap their agricultural lending, shift their target clientele to teachers and other government employees who they provided with salary loans, and focus on urban microlending. In Latin America, diversification is one of the primary risk-mitigation strategies of rural lenders. The MFIs tend to limit agricultural lending to less than one third of their portfolios, e.g., about 25% of the portfolio for Confianza (a rural finance institution in Peru),

but only 6% for Bolivias Caja Los Andes, with a similar level for Ugandas Centenary Bank. Some Latin American MFIs, e.g., PRODEM of Bolivia and Calpia of El Salvador do not lend to rural households without non-farm income or those dependent only on one or two crops, as a strategy to contain risks in agricultural microfinance (Christen and Pearce 2005). Box 1 is an illustration of the experience of a Latin American financial institution with concentration and diversification in the loan portfolio. Observing local rural economies, Vogel and Llanto (2005) pointed out that there seems to be a parallel diversification of risks among rural householdsmirroring a risk management strategy as opposed to an ex post coping strategy such as liquidation of households assets in response to, say, a catastrophe like flooding that wipes out standing crops. Rural households have tried to diversify their risks through family members engaging in non-farm activities. Rural income still largely comes from farm production, although income from non-farm activities is becoming significant in Asian countries, as pointed out earlier. Philippine data show that in 1987, on-farm income contributed 56 percent to total rural income, while offfarm incomes share was 7 percent. This means that 63 percent of the rural income came from both on-farm production and off- farm activities, e.g., livelihood projects. By 1990, farm incomes (on-farm and off-farm incomes) had declined to 57 percent while income from non-farm and other sources has increased to 43 percent (Agricultural Credit Policy Council, 1992). Incomes from non-farm activities and other sources such as remittances have become a significant source of rural incomes. Remittances from overseas Filipino workers (OFWs) and relatives based abroad have also become an increasingly important source of income for many rural households. They contributed 32 percent of the total income generated within the period 1991-2000 and helped keep the economy afloat. With the decline in incomes from agriculture and agriculturerelated activities, remittances have become an alternative and significant source of income for rural families. Although a large number of OFWs are from urbanized areas, such as the National Capital Region (NCR) and Southern Tagalog, many of them also come from mainly agricultural regions with high poverty levels. Some families depend entirely on these remittances as their main source of income while others have used a portion of these funds to pursue informal lending activities that provide external financing to farmers and entrepreneurs. Thus, these remittances either directly or indirectly provide the rural areas with the necessary liquidity that formal institutions cannot supply. The significant increase of overseas remittances has contributed to the growth of business and economic activities in the rural areas. In sum, it is important for formal rural lenders to be equipped with accurate information on the agricultural crop cycle; the pattern of risks; how rural households earn, spend, save and borrow money; what risk management and risk-coping strategies and instruments are used by those households; the variety of farm and non-farm activities; and attempts to diversify local economies, among others. In short, rural lenders must have a thorough understanding of their potential clients and the milieu or context of their daily lives and economic and business activities.

The challenge of Liquidity Management The main unrecognized challenge in rural finance is the problem of overcoming the systemic risks arising from the undiversified nature of local economies. Notwithstanding the diversification efforts of small-scale farmers and most other rural residents, especially lowincome ones, rural areas themselves remain largely undiversified economies. In fact, the typically undiversified nature of rural areas presents a major challenge to most rural residents even shopkeepers in a rural town will be adversely affected if the major product (e.g., rice) suffers a decline in price or loss of output due to adverse weather or insect pests. Thus, a rural lender does not escape this lack of diversification by lending to shopkeepers rather than to farmers. In finance, risks are dealt with by portfolio diversification, but for a local lender the opportunities for loan portfolio diversification are sharply limited, so the lender is likely to be left with the alternative of holding relatively large amounts of liquid assets and thereby curtailing local lending. Realizing the absence of effective demand, one type of lender woulddecide to park the excess liquidity in commercial papers, bills and securities, e.g., government bonds and securities. On the other hand, there is the lender who has lending opportunities but is pressed with temporary lack of liquidity and has to abandon the likelihood of lending. In the Philippines, there is no institution dedicated to providing a much-needed liquidity service, i.e., providing short-term loans to rural lenders that are temporarily short of liquidity but fully solvent in the longer run if the liquidity problem can be overcome. Rural banks can potentially access liquidity from the Bangko Sentral ng Pilipinas (BSP), but conditions surrounding access are appropriately rather draconian, based on the usually correct assumption that lack of liquidity indicates potential insolvency. Government financial institutions such as the Land Bank of the Philippines or the Development Bank of the Philippines or a federation of credit cooperatives could perhaps fulfill the function of providing liquidity to local lenders with temporary liquidity problems, but in general, government entities and cooperative federations do not exhibit the appropriate degree of toughness in separating temporary liquidity shortages from pending insolvency. An obvious solution to this problem of systemic risks in local areas could be to rely more heavily on nationwide financial institutions (e.g., large banks) to provide most rural loans. However, recent experience in the Philippines shows that even slightly adverse financial conditions could trigger a reduction in rural lending by commercial and universal banks. Clearly, these banks view rural lending as a relatively risky undertaking not unlike most banks worldwide that have failed to develop effective mechanisms to delegate lending decisions adequately to small branches while maintaining appropriate systems of internal audit and financial controls. Absence of Risk-reducing Institution As pointed out earlier, risks are correlated in agriculture, and this can potentially ruin a rural lender who does not have an effective risk management strategy and who may not have access to risk-reducing instruments or institutions. Insurance markets are important institutions for overcoming systemic risks but complementary institutions, such as insurance

markets and credit information bureaus, that may help to reduce those risks may be lacking or underdeveloped in developing countries in Asia. The absence of such risk-reducing mechanisms to manage correlated risk and insulate lenders from its adverse impact constrains agricultural microfinance (Skees 2003; Ibarra 2003; Bryla 2003). In this regard, a comment on the performance of the Philippine crop insurance is in order. Where crop insurance has been implemented, the costs have typically been extremely high, in part because of the difficulties of administering large numbers of small contracts spread over wide areas, but more often because of problems of adverse selection and moral hazard (Vogel and Llanto 2005). The experience of the Philippine Crop Insurance Corporation (PCIC) can be seen in this light. The number of farmers covered by crop insurance exhibited a declining trend from 108,512 in 1995 down to 54,093 in 2004. At the peak of its operation in 1991, the PCIC provided some 336,000 farmers with rice and corn insurance amounting to over 3 billion pesos and covering more than half a million hectares of land. Crop insurance coverage has since declined. Crop insurance coverage for the period 1995-2004 exhibited a declining trend although it showed improvement toward the later years. Insurance coverage decreased by 18 percent during the period 1997-1998. It improved only slightly in 1999 by 1.6 percent, but this was negated by a decrease of 1.3 percent in 2000. The largest decrease happened in 2001 when insurance coverage dropped by 31.5 percent from P1,274 million in 2000 to P874 million. The governments crop insurance scheme was simply no match to covariant risks. There is insufficient diversity in the risk pool to deal with covariant risks. Brazil, India and Morocco also have crop insurance schemes but the overall verdict, it seems, is that crop insurance schemes failed because of moral hazard and adverse selection problems and high transaction costs. Systemic risks brought about by insufficient diversification in local rural economies, changing weather patterns, seasonality of supply, and fluctuations in global markets have discouraged not only private investments but also the participation of private banks in agriculture finance. Both crop insurance and credit guarantee schemes have failed to expand private bank lending to agriculture. A better package of risk-reducing instruments could consist of the following: efficient infrastructure, access to technology and information, credible regulatory regimes, and recently developed marketbased instruments designed to address price- and weather-related risks. The problem of correlated risks is not insolvable. Innovations in global financial markets, which can deal with correlated risk and reduce the rural lenders exposure to local risks, e.g., drought, have been developed. These are the futures exchange markets to shift price risk; and weather-based, index-based insurance products to shift natural disaster risk. Price risk management instruments tacked in loan agreements can lower default risks arising from falling commodity prices. An example of such price risk management instrument is a put option, a hedging instrument for price risk. A simple put option may be purchased at

international exchanges. Combined with physical sales, it will guarantee a minimum price level based on an international price for a given commodity over a number of months. When price rises during the option contract period, the producer receives no payout from the contract but can still sell his physical product at the prevailing market price. In this situation, the producer benefits from rising prices. When price falls during the option contract period, the producer receives a payout equal to the difference between the price the producer chose to insure with the put option contract and the international market price on the last date of the option coverage. The problem faced by the small producer may not necessarily be the market-based premium paid for such price risk management instrument but access to the international exchanges. On the other hand, weather risks are covariant and typically shock entire regions and entire farming communities at one and the same time. Weatherbased index insurance has been developed as a risk management instrument. Under this scheme, a farmer can insulate himself from production risk by purchasing an index insurance that pays in case rainfall falls below a certain threshold. Farmers can elect coverage for a given period, taking into consideration the crop cycle. Farmers who have bought such an index insurance receive a payment if the rainfall index level falls below an agreed rainfall threshold. The farmer receives more protection the higher is the rainfall threshold but this is bought at a higher premium. A farmer wishing to minimize the cost to him of this index insurance may go for a lower rainfall threshold but at the price of lower protection. He, thus, has to evaluate the trade-off and make a decision. Missing Opportunities in the Agriculture Supply Chain Understanding the agriculture supply chain may create profitable opportunities in agricultural microfinance for rural-based economic agents. Research (Boehlje, Hofing and Schroeder, 1999a; 199b) on value chain in agriculture indicates that 21st century agriculture is likely to be characterized by: 1) adoption of manufacturing processes in production as well as processing, 2) a systems or food supply chain approach to production and distribution, 3) negotiated coordination replacing market coordination of the system, 4) a more important role for information, knowledge and other soft assets (in contrast to hard assets of machinery, equipment, facilities) in reducing cost and increasing responsiveness, and 5) increasing consolidation at all levels raising issues of market power and control. As the raw produce goes through each link of the chain, it undergoes varying degrees of value adding, such as processing and packaging, before it is distributed to consumers, thus ultimately increasing the original value of the good. The supply chain can also be loosely referred to as a value chain. The added valuation to a raw product is a result of the increasing stratification in consumer tastes and the need to be more efficient, which is an offshoot of competition in global markets. The agriculture supply chain offers scope for small farmers to participate but they have to deal with the problem of aggregation of the produce from a large number of small farmers and the associated distribution and marketing of the accumulated bulk product.

According to Kaplinsky (2000), the importance of the value chain lies in the concept that the chain is a repository for economic rents, i.e., each link in the chain carries a premium from which profits can be made. Increasingly, primary economic rents in the chain of production are to be found in the areas outside of production. Globalization has highlighted the need for an effectively functioning supply chain to meet diverse consumer needs. As world markets converge, inefficient local agricultural producers are pitted against competitive producers in the global arena. Due to insufficient capital, inadequate infrastructure, and weak institutions, small farmers and other rural producers in developing countries may find it quite a challenge to cope with the demands of global markets for competitively priced goods and commodities (Van Roekel, Willems, and Boselie 2002). Local producers sometimes find it hard to match the significantly lower production costs and lower transport and handling expenses of other countries. Consequently, the cost of domestic goods, which is already higher relative to those from other countries due to higher input costs, is further driven up by high processing, marketing, and distribution costs. One of the most important links in the value chain is the provision of transport and storage facilities. It links primary producers to processors and packagers and finally to marketing and distribution units for the consumption of end-users. Costales and Macapanpan (2004) stressed the need for transportation and storage systems as important factors of productivity and competitiveness in agro-industry. There is therefore a very great need for an efficient transport infrastructure, which includes road, ship and air transport, and adequate storage capacity. Rural linkage with domestic and global markets depends to a great extent on the availability, quality, and location of transport and storage systems, which will help dispersed rural communities to overcome their isolation. Understanding the great potential of supply chains will enable rural producers/clients to position themselves strategically in the different subsystems of these chains. Subsystems in the agriculture supply chain have their respective value-added activities and banks could provide financial services for those value-adding activities. In crafting appropriate responses, policymakers should learn lessons from the prominent role played by traders in the supply chain and rural financing systems. Traders act as moneylenders at the start of the cropping season and as buyers during the harvest season. They are available to rural borrowers at the time and place where their help is needed. Their access to rural information brought about by close association to rural clients and their keen understanding of rural networks and economies have served them well in plying their loan products (based on simple, timely, accessible, and flexible loan terms) and in creating interlinked contracts. Traders may act as independent buyers of local produce or as middlemen between major integrators, wholesalers or processors and farm producers. In any of these major roles, they add value and provide timely financing that otherwise would not be provided by formal financial institutions. Government-directed credit programs have found it very difficult to compete with the interlinked contracts, timely access to financing, and storage and transport facilities that traders have effectively provided to rural-based clients for many, many years.

Regulation and Supervision Issues Microfinance has developed and expanded generally because of the permissive (within bounds) attitude of the regulators, who are aware of the vital task of finding an appropriate regulatory framework for microfinance. The pioneering efforts of the Philippine central bank to develop such framework can be cited. The Philippine Congress recently revised the General Banking Act, which recognized the peculiar nature of microfinance and tasked the central bank to develop an appropriate regulatory framework. Regulators in many developing countries seem to recognize that microfinance promises to be a sustainable mechanism for providing financial services to poor households and microenterprises. However, there should be prudence in the way a regulatory framework is crafted and in the manner of supervising banks engaged in microfinance. As stressed by Valenzuela and Young (1999), regulation that comes too early can hamper innovation in financial service and institutional forms. On the other hand, an overly strict approach would suffocate innovative microfinance practices. In general, regulatory authorities are still developing anunderstanding of the microfinance phenomenon, making sincere attempts to flesh out an appropriate regulatory framework, and building the required capacity for effective supervision (Llanto 2006). The same observations may be said of agricultural microfinance. Regulators should bear in mind that the timing of the introduction of regulation is important (Christen and Rosenberg 2000) and that microfinance cannot be simply placed in the category of conventional credit categories, that is, consumer loan, commercial loan or mortgage credit (Jansson 2001). The key challenge is finding the appropriate regulatory framework for agricultural microfinance which would recognize the different risks faced by rural lenders (that is, the regulated lenders such as banks) and which would ensure the soundness of those rural lending institutions, including the protection of deposits. Recent literature shows that poor rural households and micro-enterprises demand different types of financial services and products, including savings deposits with (regulated) banks. Successful methods for delivering financial products and services to poor households and micro-enterprises have grown and matured outside conventional banking and conventional regulatory frameworks. The Holy Grail of regulation and supervision is developing an appropriate regulatory framework that ensures the soundness of financial institutions and protects depositors without dampening innovative impulses. Fine-tuning existing regulatory frameworks may not be sufficient. On the contrary, it may create a false sense of complacency on the part of tradition-minded regulators that all is well with the approach when in reality the innovative financial impulses that are so important in microfinance and in this case, the more challenging phenomenon of agriculture microfinance, are either constrained or dampened. Van Greuning et al. (1998) point out that the approaches to regulation and supervision of microfinance can range from non-existent to full regulation, either through the existing prudential regulatory framework or by modifying the existing regulatory requirements to fit

the organizational and operating characteristics of microfinance institutions. Such retrofitting of traditional regulatory frameworks should be taken with great caution. In contrast to this approach is risk-based supervision, a relatively new approach to supervising regulated financial institutions, which is preferable to traditional bank supervision (Vogel et al. 2000). Under risk-based supervision, most financial products and services share a common set of risk factors but can have very different risk profiles. The difference lies in the risk profiles and not in the set of risk factors (Vogel et al. 2000). Thus, risk-based supervision concentrates on the lending institutions ability to manage risks and not on the collateral required to secure the loan, nor on the number of unsecured loans, nor compliance with tedious documentation, and other factors that are the concerns of traditional bank supervision In sum, the jury is still out, so to speak, on the search for an appropriate regulatory framework or approach for microfinance. There is no onesize-fits-all approach to regulation and supervision but on balance, the rationale and arguments for risk-based supervision seem to outweigh those favoring more traditional approaches. Designing regulatory mechanisms and building effective institutional frameworks are never easy tasks, but these may be facilitated by a constant dialogue and interaction between regulators and microfinance institutions and other types of (regulated) financial institutions.