PART A: AGRICULTURAL TERM INVESTMENTS

1. Main Issues and Challenges

Agricultural term investments are investments in production assets used from one production cycle to another, usually over several years^[4]. Term investments are characterized by long amortization of the invested capital or by long gestation periods before revenues are produced. For example, the purchase of farm machinery and equipment requires a large initial lump-sum payment compared with the annual cash flow generated by the investment. Thus the invested capital only amortizes over a period of several years. Perennial crops take several years to mature, while staggered expenditures for land preparation, weeding, fertilization, etc. accrue during the immaturity period. Investments in irrigation systems or farm buildings may require considerable engineering and construction work before they are ready for use.

Term finance can be categorized in different ways. Depending on the time horizon, a distinction can be made between medium-term finance (from one to five years) and long-term finance (above five years). According to the source of funds, internal or self-finance through retained profits or other income sources of the farm household can be distinguished from external finance using funds owned by third parties. External finance can be provided through different financial instruments such as term loans, leasing or the temporary investment of third-party equity (equity finance), whereas self-finance strategies may use deposit instruments.

Figure 1: Dimensions of Term Finance

The crucial role of external term finance

There is a trade-off between profitability and risk in the use of internal versus external finance. On the one hand, external term finance allows farmers to ‘save down’ by anticipating future income, including the incremental cash flow generated by the investment, in order to finance present investment costs. This has two main advantages over selffinance:

• It allows farmers to carry out profitable investments earlier by leveraging their equity and existing cash flow.

• Investment costs can be spread over a period of several years, enhancing the affordability of ‘lumpy’ and larger (but often more profitable) investments.

On the other hand, external term finance and particularly term loans increase the risk exposure of farmers. Agricultural activities are affected to a significant extent by risks beyond the control of the borrower, and the uncertainties increase over time. If the investments fail, farmers lose not only their capital and the labour invested, but also any physical asset pledged as collateral or any ‘social capital’ such as access to future loans. Thus term loans are a double-edged sword for farmers, and their feasibility and benefits have to be weighed carefully against their costs and risks.

Term finance may not always be required in order to finance agricultural term investments. For example, smaller or divisible investments that can be gradually expanded (e.g. small livestock) may to a certain extent be financed out of existing cash flow or - in the case of lumpy investments - through the ‘saving up’ of funds^[5] (Rutherford, 2000). This, of course, presupposes that farmers dispose of sufficiently large and diversified income sources. Financing investments in new activities or technologies through term loans is quite risky, and farmers often prefer enterprise diversification on a limited scale using their own funds, while seeking loan finance only to expand proven and successful activities. However, self-financing of lumpy assets or larger investments may be difficult if investment costs are high in relation to the existing farm household cash flow. Financing long-term assets out of current operations may take a long time and will reduce the funds available for working capital or consumer needs. To accumulate funds faster, farmers may cut consumption or save on proper maintenance of productive assets (inputs, repairs, etc.), which in turn reduces the profitability and economic life of the investment. Also, claims from immediate family members, relatives and friends often make it difficult to save larger amounts of cash. The use of short-term borrowing to finance long-term assets exposes the farm household to high liquidity risk, and in the case of major adverse events, the household may have to sell assets.

Thus entrepreneurial but poor farmers, who have to rely completely on their own funds for financing lumpy investments, may face considerable difficulty in scaling up profitable operations, adopting new technologies and reaping economies of scale. Access to well-designed external term finance can have a catalytic effect on the ability of entrepreneurial farmers to realize profitable investment opportunities, allowing them to grow faster and to exploit promising market opportunities. Financial institutions (FIs), which are able to assess the risk and profitability of investment opportunities and provide appropriate term finance products, make an important contribution to growth and value adding in the rural economy.

Understanding structural constraints: risks and transaction costs

The scarcity of examples of successful term finance arrangements in agriculture points to the intrinsic difficulty of this activity compared with other fields of banking. Providers of agricultural term finance have to address the general constraints of agricultural finance together with those related to longer time horizons. Most of these constraints are related to risks and transaction costs.

Many risks and transaction costs affect both farmers and financial institutions and are major determinants of the sustainable supply of and effective demand for term finance^[6]. Moreover, there are specific risks affecting the supply of term finance. Some risks can be managed by farmers and FIs, while others are beyond their control and require access to specific risk-management instruments or may have to be addressed by governments through policy reform and other measures. Financial institutions considering agricultural term finance need to have a good understanding of the impact of specific risks and transaction costs on the feasibility of term finance, as well as of the scope for designing appropriate financial products and technologies to manage risk at a reasonable cost. The feasibility of term finance has to be assessed carefully from the perspectives of both the financier and the investor in order to avoid default and the associated costs. Such assessment is also important to governments and donors in designing appropriate policies and programmes that support the expansion of sustainable supply and effective demand for term finance in rural areas.

Past approaches have often been skewed towards expanding the supply of term finance, without paying sufficient attention to the underlying structural factors related to risk, transaction costs and asymmetric information affecting both the supply and effective demand. All too often, access to credit, particularly long-term credit, was perceived as the main bottleneck inhibiting the growth of small farmers. The failures of targeted and subsidized credit lines, which have been widely analysed elsewhere, illustrate that agricultural term finance cannot be used as a shortcut to rural and agricultural development^[7]. Measures aimed at enhancing the supply of term finance should be part of a broader and longer-term strategy, framed by coherent, enabling macro and sectoral policies, and closely coordinated with other policies and programmes to promote rural development, commercial agriculture and rural financial services.

Given the crucial importance of risk to the feasibility of term finance, the following section discusses major types of risk and classifies them either as risks common to investors and financiers or as risks faced specifically by term finance providers. The costs of providing term finance will be analysed and compared with the costs of short-term finance.

1.1 Risks of Financing Agricultural Term Investments

Any investment appraisal is based on certain assumptions about technical and production parameters, future demand for and prices of agricultural products, cost and availability of inputs, and investor management practices. However, uncertainty about the future development of these parameters increases with longer time horizons, as does the likelihood that unforeseen external events will affect the feasibility and profitability of the investment. Thus, appraising risk and profitability becomes more difficult as amortization or gestation periods lengthen.

An important distinction can be made between idiosyncratic and systemic risks:

• Idiosyncratic risks^[8] are non-correlated and only affect individual farmers. They include technical risks, such as breakdown of farm machinery, but also risks related to the investor and his family, such as illness or the death of a family member.

• Systemic risks^[9] are covariant and affect all producers in a region or of a certain commodity. They include climatic events such as droughts and floods, major outbreaks of pests and diseases, sudden price declines or drastic changes of macroeconomic parameters (exchange rate, inflation, etc.).

In practice, many risks lie somewhere between pure idiosyncratic and systemic, because they may affect farmers in different ways. First, external shocks differ in their intensity and frequency. Second, location factors and management practices shape the impact of adverse events on individual farm households.

The next section discusses the general risks of financing agricultural term investments before turning to the specific risks affecting the supply of term finance.

1.1.1 Common Risks Faced by Investors and Financiers

Table 1 provides some examples of the types of risk faced by investors. In the case of external finance, these risks also have an impact on the financier in the sense that they affect the repayment capacity of the investor.

Table 1
Types of risk related to agricultural term investments

Production risks

Production risks include all factors that affect the productivity of crop and livestock activities and thus the profitability of related investments. Due to the high dependence of investments in agriculture on biological processes, external events such as drought, flooding, pests and diseases are major sources of production risk. These risks are systemic since they tend to affect a large number of producers in a region. On the individual farmer level, poor husbandry practices are an important source of idiosyncratic production risk. Technical risks, such as the breakdown of machinery, are a subset of production risks and involve the proper functioning of the technology used to enhance the productivity of farming. Technical risks are mostly idiosyncratic^[10].

Technical and to a lesser extent other production risks can be reduced but not fully neutralized by good farm management practices and access to agricultural support services. For example, risk related to investment in orchard plantations can be reduced by a proper selection of sites and planting material, fencing, weed control and application of fertilizer and pesticides. The yield curve and economic life of a mature plantation depend on harvesting techniques, pruning and other agricultural practices. The management skills of the investor and sufficient availability of working capital are important factors in reducing technical risks. However, even if good management practices are applied, the plantation might still be destroyed by fire or new pests, or diseases may break out.

Client risks

Other risks are related to the family and household of the investor. Illness or the death of a family member may lead to labour shortages or increased expenditures for medical expenses, funeral costs, etc. This may affect the allocation of sufficient time and resources to proper operation and maintenance of the investment, affecting its profitability and economic life. Due to the fungibility of money, client risks have an impact on the use of external funds as well as of the income generated by the investment, and these risks increase over longer time horizons.

Market risks

Market risks may be due to factors affecting timely delivery of produce to markets or the quality of the produce (e.g. poor feeder roads and storage/ transport facilities in combination with perishable, bulky produce), as well as to changes in the demand or price. The latter are particularly important to term finance. Agricultural commodity markets are characterized by seasonal and cyclical price fluctuations, often exacerbated by long-term negative price trends. Whereas seasonal or short-term price volatility can be managed, at least in principle, through commodity risk-management instruments such as futures and options, cyclical fluctuation over periods of several years is particularly problematic in the financing of agricultural term investments (see Figure 2). The so-called ‘hog cycle’ is a typical feature of markets for agricultural commodities such as livestock products and perennial crops, where gestation periods create a time lag between investment and the supply of produce. Currently, no proper risk-management instrument is available to investors or financial institutions to protect against cyclical price fluctuations. However, market studies and projections based on historic price data may help assess risk and allow investors and financiers to make anti-cyclical investment and financial decisions.

A long-term declining price trend does not necessarily imply that investments in the respective subsectors cannot be profitable. First, long-term price declines are often superseded by cyclical fluctuations characterized by periods of increasing prices and price peaks, which may last several years, as shown in Figure 2. If investments are carried out during a price slump, the investor may receive higher prices when the crop comes into production. Second, lower prices can be offset by higher productivity or improved management practices, and most term investments are motivated precisely by this purpose.

Long-term price trends are influenced by changing income levels, consumer preferences, the advent of substituting or competing products, trade policy, etc. Changes in these factors are normally gradual and may be assessed through market studies. However, a considerable element of uncertainty is introduced by external factors such as policy changes regarding trade policy, internal price policy, etc., which may severely impact price trends and market prospects. Exchange rate fluctuations have a considerable impact on tradable agricultural products and inputs, and may reverse the projected profitability of an investment.

Figure 2: Cyclical fluctuations and long-term trend in coffee prices (ICO composite indicator price), 1983-2003, annual average

Macroeconomic and policy risks

Unstable macroeconomic conditions, such as high or fluctuating inflation and interest rates, limit the possibility for longer-term financial and investment planning and increase the associated risks. They also increase asset/liability risks for FIs engaged in term finance. The stability and predictability of key macroeconomic parameters, such as the rediscount rate, inflation, and foreign exchange rate, depend to a significant extent on a sound and prudent government macroeconomic policy. Macroeconomic management has generally improved in the developing world over the past two decades, but considerable differences among developing countries remain. However, important sources of uncertainty are beyond the control of individual governments. Fluctuations in international commodity prices affect the macroeconomic stability of those developing countries that depend to a significant degree on the export earnings of a limited number of primary commodities. The recent financial crises in Asia and parts of Latin America have illustrated the contagious effects of such events within or even across entire regions: the crises not only led to increased cost and limited supply of external capital, but - as a consequence of currency devaluations - to an export boom followed by a major price decline in major agricultural commodities.

1.1.2 Risks Specific to Term Financiers

From a financier’s perspective, the risks of financing term investments are exacerbated by problems of asymmetric information and moral hazard, quality of collateral and enforceability of contracts. Systemic risks pose difficulties for asset/liability management (ALM) and may threaten the overall quality of the portfolio.

Asymmetric information and moral hazard risks

Some risks faced by a financial institution are rooted in asymmetric information between lender and borrower. The lender does not have the same information as the borrower regarding the specific factors affecting the feasibility and profitability of the proposed investment or the financial conditions of the farm household. Moreover, the lender does not know whether the borrower will use the funds for the stated purpose or whether he/she intends to repay. Asymmetric information, in combination with contract supervision and enforcement problems, increases the risk of moral hazard risk: the borrower might change behaviour after a loan contract has been signed, at the expense of the lender. The main types of moral hazard risks are:

• Diversion of funds. The borrower might not use the loan funds for the stated purpose. This may affect the repayment capacity if loan repayment depends to a significant extent on the incremental cash flow produced by the investment.

• Poor management practices. The commitment and discipline of a borrower regarding the proper maintenance of equipment and the application of good agricultural practices are important determinants of the success of an investment and the repayment capacity of the borrower.

• Wilful default. There is always the possibility that the borrower does not intend to repay a loan^[11]. Long grace periods are particularly dangerous in this regard because the borrower may ‘forget’ about his/her repayment obligations. Also, loan waivers or forgiveness are particularly harmful for financial institutions, because they imply moral hazard problems, which may undermine the credit culture in rural areas.

The risk of moral hazard increases in proportion to the term and amount of a loan.

Risks of political intervention and poorly designed credit programmes

Rural financial markets are prone to government interventions such as loan waivers and debt forgiveness programmes, which may seriously undermine the repayment discipline of borrowers and the credit culture in rural areas. This might be especially problematic in regions where larger and politically well-connected farmers have lobbied successfully for loan-forgiveness programmes, and where foreclosure on collateral cannot be enforced. Loan waivers often form part of election campaigns of politicians and may discourage the provision of term finance, because the likelihood of their occurrence increases over longer time horizons.

Ill-conceived government or donor programmes using targeted and subsidised credit are further sources of risk for the development of sustainable term finance arrangements. If term loans are used as an instrument for meeting pre-defined physical output or investment targets or as a disguised tool for income transfer to certain target groups, proper incentives and enforcements mechanisms to ensure loan repayment are seldom in place. The co-existence of poorly managed and enforced term loans under specific programmes or projects with RFIs also striving for financial self-sufficiency is problematic, since laxity in loan enforcement tends to confuse borrowers and have a negative impact on the rural credit culture.

Collateral risks

To a certain extent, idiosyncratic risks, including those related to asymmetric information and moral hazard, can be reduced by the use of collateral. However, its use in rural areas of developing countries is subject to risk and transaction costs that might undermine its suitability as a risk-management and coping instrument. Box 1 sets out the main functions of collateral and the determinants of the collateral value of rural assets.

Many farmers can only offer assets with low collateral value (see Box 2, page 13). Moreover, in many developing countries, severe deficiencies in the legal and administrative framework constrain the expansion of secured lending^[12] in rural areas. For example, land titles, where existent, are often outdated, and lenders face difficulty in ascertaining that there is no senior claim on the asset. Registry systems may exist only for certain types of assets and are often located in major cities far from rural areas. Even if a security interest in the asset can be created and perfected, there are risks related to high transaction costs and delays in foreclosing and selling. Long legal procedures are especially harmful in the case of movable assets such as machinery, equipment or livestock that may depreciate over time (see chapter 7).

Apart from legal and administrative constraints, other factors may affect the value of collateral as a risk-management and coping instrument. First, collateral might depreciate, as mentioned, or be stolen or lost.

Second, its sale at its estimated value depends on demand and the size of the market. Collateral might work well to protect lenders against idiosyncratic risks caused by moral hazard or other events. It is, however, a poor protection against major systemic risks affecting a number of borrowers. In the case of systemic shocks, causing the default of a large number of borrowers, a lender would have difficulty selling the asset because the demand and prices for rural assets might collapse.

Techniques for maximizing the use of rural assets as collateral in combination with collateral substitutes are discussed in section 4.2, while 7.1 deals with legal and regulatory problems in the use of collateral and outlines areas for policy reform.

Asset/liability management risks

An RFI engaged in term finance has to manage risks resulting from mismatches between the terms (i.e. the amounts, maturities and costs) of assets (e.g. loans) and of liabilities (sources of funds). Three main sources of asset/liability risk can be distinguished:

• Liquidity risk is caused by maturity mismatches between assets and liabilities: transforming short-term liabilities into longer-term loan assets is a high-risk activity and requires considerable skill.

• Interest-rate risk occurs if term loans with fixed interest rates are funded through liabilities with variable costs, such as deposits and short-term loans. Increasing the cost of funds may seriously affect the profitability of a financial institution.

• Foreign exchange risk is found where a financial institution borrows from outside the domestic currency area and no intermediary is prepared to assume the potential costs of a slide in the value of the local currency. It may also affect customers that borrow in hard currency and produce for the domestic market.

Issues related to asset/liability risk are discussed in section 3.8 and chapter 9.

Table 2
Examples of risk and risk-management/coping options for investors and financial institutions

Portfolio risks

Portfolio risks are caused by the concentration of single or correlated risks in the loan-asset portfolio of a lender. This may be the case if a few large loans account for a significant share of the total portfolio, or if there is a concentration of loans with similar credit-risk profiles (correlated risks). In either case, loan default would have a significant impact on the total portfolio of the institution. Due to their larger sizes and sensitivity to systemic risk, agricultural term loans lead to a concentration of portfolio risk. This may prevent smaller rural financial institutions (RFIs) from providing agricultural term loans. In order to pool correlated price and yield risks, financial institutions have to diversify their portfolio, either by expanding into different regions or by servicing different types of customers.

1.1.3 Capacity of Investors and FIs to Manage and Cope with Risk

Risk-management strategies address risk-related problems ex-ante, while risk-coping strategies deal with the consequences of risk expost. The ability of investors and FIs to manage and cope with risk and their related strategies has an important impact on the effective demand and supply of term finance. Table 2 shows some examples of risk-management and coping strategies used by investors and FIs.

Farmers typically manage risk by using good agricultural practices, diversifying into different farm and non-farm activities, building savings in cash or in kind, providing self-insurance through informal networks, etc. They may also invest in low-risk/low-return activities. Risk-coping strategies include reducing consumption, taking out loans (mostly from informal sources) or sales of assets^[14]. Options for financial institutions in managing risk will be discussed in part B. They include careful selection and supervision of clients and appraisal of the investment, portfolio diversification, risk-based pricing, securing loans with collateral and appropriate loss provisions. Risk-coping strategies include foreclosure on and sale of collateral, or rescheduling/restructuring of loans and taking out loans from other financial institutions to offset liquidity shortages.

These strategies might work well in the case of idiosyncratic risks, as well as of systemic risks of a lower intensity, frequency and outreach. They are, however, insufficient or may even collapse in the case of major external shocks. For example, diversification into other farm and non-farm activities to a certain extent helps investors reduce their vulnerability to commodity-specific risks such as price shifts or pests and diseases. However, due to the close interrelationship of these activities, external shocks affecting farm income also reduce the demand for products and services from non-farm activities^[15].

Even the best financing technology or use of collateral cannot protect against major systemic risks such as drought, flooding, pests or sudden price declines. Systemic risk may force FIs to manage portfolio risk through diversification into different rural areas or into rural and urban areas. There is a trade-off between diversification and specialization in certain activities. The broader the range of clients and regions, the less specific is a lender’s knowledge about clients, economic activities or local conditions. The institution must either become larger or lose specific client knowledge, thus increasing credit risk (Skees, 2003).

Table 3
Cost components of term loans and determinants

1.2 Costs of Providing Term Finance

From the perspective of a financial institution, term lending costs have three components:

• cost of funds;

• transaction costs of loan appraisal, administration and supervision; and

• risk costs, such as loss provisions or write-offs.

In practice, these cost components are often interrelated: managing risk implies costs both ex-ante, to protect against default, and ex-post, after a default has occurred. In order to manage and reduce risk, information has to be collected and analysed, which increases transaction costs and staff time. If transaction costs are reduced by diminishing the time and effort spent on assessing loan applications or supervising borrowers, risk costs might increase. High arrears, in turn, increase the cost of funds, because a lender with high levels of default has to pay more. Secured lending might involve costs for inspection, valuation, registration and possibly foreclosure and sale of collateral. However, collateral may considerably reduce moral hazard risk and help the lender cope with other risks related to agricultural term finance. Table 3 summarizes the main determinants of these cost components, which are then briefly discussed in terms of the differences between shortand long-term loans.

Cost of funds

Cost of funds varies according to the type of funding source. An important distinction can be made between concessionary and commercial funds. Concessionary funds have lower direct costs such as interest rates, but may have hidden costs such as reporting requirements (Giehler, 1999). The costs of commercial funds such as deposits, bonds and equity increase in proportion to the maturity of funds. Term loans require more sophisticated asset/liability management, which adds to the transaction costs. Financial institutions with a strong equity base have to calculate only the opportunity cost of funds.

Transaction costs

Transaction costs comprise appraisal of loan applications, administration of loan accounts and supervision of borrowers. A significant part of appraisal and administration costs are fixed per transaction and do not vary significantly by loan size or maturity. These include costs for loan promotion, application (helping clients complete application forms), disbursement and defaulted-loan collection. According to a recent study of 14 microfinance institutions (MFIs) in Ecuador, El Salvador and Paraguay, these costs constitute over 90 percent of the unit loan costs (Gheen, 1999, cited in Westley, 2003). Spreading these fixed costs over a longer time period results in a considerable reduction of overall costs.

Other transaction costs for managing and coping with risk depend on the maturity and size of the loan: larger sizes and longer maturities require a more comprehensive appraisal of the creditworthiness of the borrower and the proposed investment (feasibility and market studies, etc.). Collateral has to be appraised, registered and - in the case of default - foreclosed^[16]. Larger loans may not be approved at the branch level, but by credit committees at higher levels of the FI, increasing costs. Moreover, larger investment loans usually require supervision, especially if the asset financed has a significant impact on the borrower’s repayment capacity or serves as the main collateral for repayment. The absolute amount of transaction costs for granting term loans is usually well above those for short-term loans^[17].

However, this picture changes considerably if transaction costs are related to the amount and maturity of loans. Due to their larger size and longer maturity, term loans offer considerable economies of scale in the costs of appraisal and administration. For example, if US$ 10 000 is disbursed as a term loan with a maturity of five years, only one appraisal is needed. If the same amount is disbursed as five subsequent short-term loans of US$ 2 000 each, five loan appraisals would be required. The difference would be even more pronounced if the amount is disbursed as 50 microloans of US$ 200 each, which would require 50 loan appraisals. For this reason, high interest rates are needed to cover the cost of microlending operations. Thus term loans might be provided at significantly lower transaction costs than are short-term or microloans.

Risk costs

Apart from risk-related transaction costs, there are direct costs for managing and coping with risk. Loan-loss provisions are geared to protecting the lender against potential default. They are based on the expected default rate and include costs for enforcing repayment of overdue loans, foreclosing and selling collateral. Whereas transaction costs are often charged to the borrower as loan appraisal fees, risk costs tend to be added as risk prime to the interest rate. Both add to the total cost for the borrower.

Term loans generally require higher loss provisions due to the elevated level of uncertainty. Also, as compared to short-term loans, term loan amounts, terms and conditions cannot be easily adjusted to changing circumstances. However, these risks (and the costs of managing them) vary considerably depending on the type of investment, characteristics of the investor, market environment, availability of riskmanagement instruments, and other factors related to the economic, institutional, legal and political environment.

Whether the aggregate risk costs of term loans are below or above the costs of seasonal or microlending may depend on the capability of the lender in establishing cost-effective procedures for accessing and evaluating information, supervising borrowers, etc. An FI starting out in term finance may face considerable set-up costs, as will be discussed in chapter 3. Transaction and risk costs tend to decrease as a lender gains experience in term finance, a suitable financing technology has been developed, and costs can be spread over a larger portfolio. FIs accumulate specific knowledge of their client base and a better understanding of key risks and the potential of specific subsectors and markets.

A successful track record also lowers the cost of an FI’s access to funding sources.

1.3 Determinants of the Feasibility of Term Finance

The feasibility of term finance depends on the profitability of financed investments and the ability of investors and financial institutions to manage risk at a reasonable cost. In some cases, risks are prohibitively high: for example, in the case of uncertainty so great that it leads to risk avoidance rather than management. In such cases, there is neither supply nor demand for term finance. In other cases, risk may be manageable, but at high costs that undermine the profitability of the investment.

A precondition for term finance is a stable macroeconomic environment characterized by low and stable inflation and interest rates and realistic foreign exchange rates. Moreover, a certain level of political stability, a profitable agricultural sector, a rural credit culture and a legal and institutional framework for contract enforcement are indispensable. If these conditions are absent, there is little scope for providing term finance, or its provision may actually impact negatively on the financial health of financial institutions and lead to the decapitalization of farmers.

Some additional factors influence the risks of term finance and thus the cost of providing it in a sustainable manner. They need to be analysed in assessing the feasibility of term finance:

Type of investment. The risk profile of term investments depends on physical and economic characteristics such as size of the investment, length of the gestation and amortization periods, specificity of the asset, its market and collateral value, and its technical sophistication and requirements in terms of maintenance and skills. The risks related to financing of a term investment have to be traded-off against its riskreducing and profitability-enhancing features.

Type of investor. Important determinants of the risk profile of clients include skills and experience, stability of the business, level and diversification of income sources, collateral assets, relationship with market partners and previous experience with loans. Clearly, it is less risky to finance the expansion of an existing business than diversification into new activities or adoption of new technologies.

Market environment. There are significant differences among agricultural commodities in volatility and in trends in demand and prices. Marketing relationships such as contract farming or other forms of vertical integration may reduce risk related to market access, and sometimes also to price fluctuation.

Availability of support services. Extension, farm-business and financial- management advice reduce production, technical and client risks. The same applies to the availability of suitable technology, after-sales support services, spare parts, planting material, fertilizer, agrochemicals, etc. Financing farm machinery is less risky in areas in which a ‘machine culture’ already exists.

Legal environment. The legal and institutional framework for the use of rural assets as collateral and the enforceability of contracts has an important impact on risk as well as on the transaction costs of using collateral as a risk-management tool.

Availability of specific risk-management instruments. Risk-management instruments such as insurance or hedging allow investors to transform systemic risks related to climate factors, pests or commodity prices into ex-ante premium payments. This makes it easier for both investor and financier to determine the risk-adjusted returns of an investment and compare them to investment alternatives.

Characteristics of the term finance provider. The size and experience of the term finance provider impact on its ability to offer term finance and on the related costs. For example, larger FIs are in a better position to manage portfolio risk through diversification and access to a wider range of funding sources.

From this discussion it can be concluded that despite the generally higher risk, there might be scope for term finance, both on cost grounds and with a view towards its risk-reducing and profitability enhancing features. However, the feasibility of term finance depends on a number of factors that are highly situation-specific and may vary considerably according to local conditions. Feasibility has to be assessed on a case-by-case basis. Part B will illustrate how this can be done, based on the experiences of the case-study institutions.

From a dynamic perspective, the provision of term investment finance to promising clients can benefit financial institutions: it enhances profitability and reduces the risk profile of clients, creates a sustainable demand for other financial services such as short-term loans, and provides incentives to short-term borrowers to honour their repayment obligations in order to become eligible for term loans.