Term loans are the most widely used term finance instrument. They allow considerable flexibility in adjusting loan amounts, disbursement and repayment schedules to the cash flow of the investment and the farm household. Depending on the target clientele and the experience of the lender, medium-term loans can be designed either as general purpose loans or as investment loans for specific purposes.
This chapter discusses elements of a term lending technology: selecting borrowers and investments, using collateral and collateral substitutes, appraising repayment capacity, structuring loan disbursement and repayment schedules, pricing term loans, monitoring loans and supervising borrowers, and dealing with default.
A thorough screening and selection of clients is key to reducing the risks of term loans. Most case-study institutions provide term loans or leasing to individual farmers. Farmer groups often play an important role in screening and supervising clients, procuring inputs and marketing outputs (ANED, Rural Bank of Panabo), or as joint liability mechanisms (BAAC). The following are the most important factors determining the risk profile of a potential client:
Experience and skills. The level of general farm management skills as well as specific experience with the investment or activity are important determinants of idiosyncratic borrower risk. Thus many lenders restrict term loans to the renewal or expansion of existing activities in order to ensure that the client has relevant management experience.
The extent to which previous work experience is a prerequisite for a loan depends also on the size of the investment, the quality of collateral and the loan appraisal method. For smaller equipment, such as power tillers or irrigation pumps, requirements regarding experience are less stringent. In the case of larger equipment - and to the extent to which loan repayment is linked to the incremental cash flow - the client must have the technical skills to operate and maintain the equipment and must have relevant work experience.
Multipurpose term loans, as offered for example by CLA, are basically an extension of short-term loans, to be repaid over a longer period. In this case, incremental net cash flow is not taken into account in fixing the repayment schedule. Financial institutions offering such loans based on existing cash flow assess only the stability of the business of the prospective borrower. They do not require specific technical experience as long as the investment does not have a profound impact on the existing cash flow.
Character. Multipurpose terms loans, by definition, eliminate the risk of diversion of funds and reduce the risk of improper management of the investment. Moral hazard risks increase to the extent that loan repayment is linked to the incremental cash flow produced by the investment. A progressive lending approach is one way to gain information about the character of the borrower. The credit history might also be checked with credit bureaus, other lenders or informal sources (other borrowers, farmer-group leaders or co-liable members, traders, village authorities or local institutions).
To a certain extent, a sound borrower track record can substitute for tangible collateral. However, larger amounts and longer terms will require collateral as an additional protection against moral hazard risk. Down payments or equity contributions are another way to ensure that the investor is financially committed.
Cash flow. Farmers with a variety of income sources from farm and non-farm related activities are normally preferred clients for term loans. Diversified income sources allow more frequent instalments for loan repayment, reduce the need for a grace period and provide an alternative source for loan repayment in case of lower than anticipated profitability of the investment activity.
To a certain extent, this may penalize more specialized farmers, who often have better technical and management skills in the activity financed. However, their larger exposure to systemic risk may force lenders to apply stricter collateral requirements. Their eligibility also depends on the market environment and the availability of insurance and other measures to manage systemic risk. For example, a specialized dairy producer with a marketing contract, receiving relatively stable prices, may still be a low risk. Contract farming and other forms of vertical integration, availability of crop insurance, and mechanisms to manage price risks enhance the bankability of specialized farmers.
Market partners. For both existing and new activities, loan applicants should possess identified market outlets. Marketing risks are lower if proven farm enterprises are financed, given that marketing channels already exist. However, if a larger number of term loans are provided for a specific activity, care has to be taken, because the increase in productivity and output can lead to oversupply. For example, ANED experienced increasing problems of default after the rapid expansion of leasing of irrigation pumps for vegetable production, since the increased production resulted in declining prices in the limited local markets.
Vertical integration is also a good way to ensure marketing for incremental produce, especially if the processor has a stake in the financing of farm-level investments, either by providing loans directly or by guaranteeing loan repayment to a bank.
Unlike collateral, substitutes have little or no market value and contribute to enforcing loan contracts without the use of judicial proceedings. They comprise joint liability groups and co-guarantors, pledging of unregistered farm and household assets, liens on produce and other mechanisms. The key feature underlying all types of collateral substitutes is the linking of access to future loans with the repayment performance on existing ones.
The case studies show that there is scope for collateral substitutes in smaller term loans. They can be effective in guaranteeing repayment if the client has a long-standing relationship with the lender and if there are few other sources of finance at comparable terms.
Joint liability groups. The most popular collateral substitute used by MFIs is some form of solidarity-group lending. Either group members are co-liable for the existing loans of fellow group members, and/or the failure of one member to repay a current loan results in all group members being denied access to future loans. Several instances have been observed in which group solidarity breaks down over time, and for term finance this is an important issue. When a certain number of members default, the paying members will weigh the utility of maintaining the group (access to future loans) against the need to repay several loans of peers in addition to their own commitments. This is particularly a problem with the greater amounts of term loans.
Similarly, a group might only be willing or able to guarantee a limited number of term loans, and the total amount guaranteed by the group may leave some members unsatisfied - again threatening group solidarity over time. Generally, the role of joint liability groups in term lending is more to help the RFI screen clients and to provide pressure for repayment, complementing other forms of collateral.
BAAC uses such groups up to a maximum loan amount of 100 000 Thai baht (THB) (approximately US$ 2 000), irrespective of the term. These groups had already been established and maintained over a long period for short-term loans. BAAC is the only provider of loans for most farmers in Thailand and has by far the best conditions. Thus maintaining a good relationship with BAAC is extremely important for most Thai farmers.
Pledging business or personal assets with high use value. Some institutions have adopted techniques of questionable legality in accepting substitute items as collateral that are not readily marketable, but that constitute effective incentives because they are highly valued by the clients. For example, borrowers may be required to deposit landreform titles with the lender or to sign documents authorizing lenders to seize goods such as tools and equipment used in production or TV sets and other consumer durables in the event of loan default. Various institutions use this type of informal pledging of non-registered rural assets up to amounts of US$ 7 500 (CLA and Agrocapital).
Informal foreclosure might depend on the consent of the borrower, since formal foreclosure through the court system is normally costly and time consuming or may even be impossible. In a real sense it is the threat of action, rather than the action itself, that is useful in maintaining credit discipline. The effectiveness of this mechanism depends to a certain extent on the ignorance of the borrowers. A further disadvantage of using non-registered assets is that the borrower might pledge them to more than one lender.
Third-party personal guarantees. Under this arrangement, a third party (co-signer) assumes responsibility for ensuring repayment of the loan principal and interest in the event of default. This can be an effective guarantee if the party has sufficient income and/or assets that can be liquidated to pay any shortfall left by the defaulting borrower. It is expected that third parties will respond without the lender undertaking legal proceedings because they want to maintain their own creditworthiness. For example, BAAC accepts personal guarantors for smaller loans of up to US$ 1 000.
Delegated agents. Another collateral substitute involves tapping the knowledge and social position of local village agents. This approach was already mentioned in connection with the screening of group members by the group leader, as applied by CIDRE. In Uganda, local councils certify the creditworthiness of borrowers for livestock loans from the Ugandan Commercial Bank. Such agents collect repayments and apply social sanctions to defaulting borrowers. This arrangement is effective if the agent has a strong and long-term interest in maintaining his or her own creditworthiness with the lender. Again, access to future loans and the ties between financial institution and agent are important preconditions. In the case of term loans, delegated agents might complement rather than substitute other forms of collateral.
Compulsory deposits. Some lenders require potential borrowers to save before applying for a loan in order to demonstrate their intention to develop a long-term banking relationship. When the amount saved reaches a specified level, the lender will consider granting a loan, sometimes as a multiple of the amount saved. Some credit unions set loan sizes as a function of the amount of share capital the borrower owns (e.g. CECAM, MCRB). In this way, lenders limit the size of potential loan loss, because the borrowers are essentially borrowing some of their accumulated savings or capital. Though obligatory savings might be effective in helping control moral hazard risk, they increase the effective interest rate and are therefore expensive for the borrower.
Interlinked contracts. The use of agricultural produce as collateral appears to be limited to seasonal loans, mostly in the form of cash advances and in-kind supply of inputs (e.g. contract farming arrangements). In cases where term loans are provided within interlinked arrangements, additional collateral is generally required (see section 4.7).
The role of collateral and collateral substitutes in term lending - lessons learned
Collateral substitutes help lender and borrower overcome problems related to the availability and effectiveness of conventional collateral in rural areas. To a certain degree, they permit the substitution of physical capital with reputation or social capital. They are most viable within a strategy of graduation of clients into larger loans with longer maturities, and in a context of limited competition: if access to future loans from the same lender is the main incentive for repayment, then the lender must be able to effectively deny further access in case of default. These features limit the applicability of collateral substitutes for term loans: they cannot be used for first-time borrowers, and they are only effective if the clients need access to short-term loans from the same lender. Finally, lenders in most countries are only permitted to have a certain maximum amount of unsecured loans in their portfolio.
Collateral substitutes may also result in high costs for the borrower. Gradual access to increasing loan size may force more entrepreneurial but credit-constrained clients into taking a number of small loans that they may not need in order to access a term loan. Group liability implies high transaction costs for members, including non-financial ones, and possibly financial costs if some members default. Moreover, lenders tend to offset the higher risks inherent in collateral substitutes by raising the interest rates. Though this might be less problematic in the case of micro or short-term loans, where access is more important than cost, it may lead to adverse selection problems in the case of term loans (see section 4.5).
As loan amounts and terms increase, there will be a need for additional collateral. Even if the financial institution considers the foreclosure of collateral only as a last resort, a credible threat of possible loss of assets is important in order to demonstrate the seriousness of the financial institution and to set the basic standards for good credit discipline among borrowers. For the same reason, the case-study institutions have occasionally taken recourse to legal action, even if the involved transaction costs exceeded the value of the seized assets. The securing of larger term loans with tangible collateral is also necessary from the supervisory perspective of the national monetary authorities, in order to ensure the health of the financial sector.
In view of the limitations inherent in the use of conventional collateral (high costs and delays in foreclosing and selling), most institutions combine traditional collateral with social collateral. For example, farmers may be required to provide registered pledges or mortgages of land or movable assets, combined with third-party guarantees and the endorsement of the loan by a village or group leader. Still, there may be considerable advantages in comparison with mainstream financial institutions, both regarding the type of acceptable collateral and the percentage of the loan amount that has to be covered by collateral. Mainstream banks often do not accept agricultural land and may require 150-200 percent coverage of the loan amount through collateral.
Expanding loan amounts, terms and conditions require that governments take measures to address the structural constraints inhibiting the use of secured transactions in rural areas (see chapter 7).
The main purpose of loan appraisal is to assess the technical, economic and financial feasibility of the proposed investment and the repayment capacity of the borrower. A good appraisal technique is the key to extracting viable proposals from a number of loan applications. It allows RFIs to switch to cash-flow lending, instead of basing their lending decisions primarily on the quality and amount of collateral provided, thus expanding the frontier of term lending in rural areas32.
CLA uses the same lending technology for financing seasonal inputs and term investments. The maturity and frequency of loan repayments basically depend on the clients existing cash flow, while the amount depends on the track record in the financial system, worth of total assets of the farm household and collateral. No appraisal is carried out of the incremental cash flow created by the investment. This reduces the need for loan supervision and thus saves transaction costs. Moreover, particular attention is paid to the reality of small businesses, which are engaged in a number of activities in which financial resources are extremely fungible and farm and household cash flows are closely intertwined.
Existing household cash flow
The difficulties in appraising the cash flow and repayment capacity of a potential borrower lie in the informal character of most farm and non-farm rural enterprises. Financial statements are seldom available and, if they are, may not be a reliable source of information. Due to the fungibility of money, it is important to assess all sources of income and expenditures of a farm household. On the income side, this may include sales proceeds from crop and livestock activities, non-farm income from other businesses, remittances, salaries, pensions, etc. On the expenditure side, working-capital requirements of the productive activities have to be assessed: seed, fertilizer, farm machinery services, hired labour, water fees, veterinary expenses, etc. Household expenditures may include food, medical treatment and school fees.
In view of the long repayment period, the loan officer has to assess the seasonality of incomes and expenditures, the stability of the business and the related cash flow. This requires a good knowledge of the business cycle of farming and non-farm activities, as well as an understanding of the likely future trends in terms of demand, prices and competition. The relative productivity and growth potential of farmers depend on their age, experience, farming and management skills and their current productivity.
The repayment capacity is also affected by the quality of the productive assets: the loan officer has to assess the state and condition of machinery and equipment, age of existing tree plantations, functionality of the irrigation system, or health of livestock. If equipment has deteriorated, expenses for major repairs or replacement are likely. The age of a tree plantation may determine the cash flow it will generate.
On the household side, the ages and health of household and other family members are important determinants, both of the capacity to generate income and of the risk of expenditures due to marriage, illness or death.
Current liabilities with other financial institutions and informal sources also have to be assessed. It is difficult for a loan officer to get a complete picture of household cash flow during the first appraisal visit. This highlights the benefits of a gradual approach and the importance of a long-term relationship in obtaining client information. In the case of first-time borrowers, the repayment capacity has to be based on very conservative assumptions, or strict collateral requirements have to be applied. In the case of repeat borrowers, the RFI has a better picture of the cash flow and repayment capacity of the farm household.
Incremental cash flow
The appraisal of investments, including the projection of incremental cash flow, is more risky than appraisal of existing cash flow and requires the specific skills of loan officers, credit committees and branch managers. Regarding investment costs, it is important to consider not only the initial expenditure but also incremental working capital requirements and the likely costs of operation, maintenance and repair. Assessment of the incremental income generated by the investment is based on assumptions regarding technical parameters, e.g. future prices or the impact of the investment on farm productivity. This requires knowledge of current yields and market studies of price development. Particularly for investments with long gestation and amortization periods, it is important to assess the long-term price trends and volatility of the main agricultural commodities. Seasonal price fluctuations should be taken into account when fixing the repayment schedule. Cyclical fluctuations are a particular concern. However, a specialized lender may be able to counteract these by waiving principal payments during the slump or even providing additional liquidity.
The extent to which incremental income is taken into account in appraising the repayment capacity and establishing the repayment schedule depends on the risk profile of the client and of the investment, the amount of the loan in relation to existing cash flow and the skills and experience of the lender. Loan appraisal methods vary among the case-study institutions. For example, CLA, the Equity Building Society (Kenya) and RBP use a conservative approach to assessing the repayment capacity of the client: they only consider the existing cash flow of the farm household plus the incremental expenses related to the investment, without taking into account the projected incremental income generated by the investment. This reduces credit risk related to failure of the investment or fungibility of money within the farm household. Further advantages are lower costs for loan appraisal and supervision of borrowers.
Most case-study institutions carry out a more comprehensive appraisal of household cash flow, taking into account both existing and projected incremental cash flow. The extent to which the latter should be considered in deciding the loan amount and determining the loan repayment schedule depends on the:
experience of the financial institution in appraising loan applications for investments;
experience of the farmer with regard to the proposed investment;
types of collateral provided; and
risks related to the investment.
It is important to base the estimated incremental cash flow on conservative assumptions.
Generally, the multipurpose loan approach is indicated for financial institutions that are gradually diversifying into agricultural term lending but have not yet developed the necessary skills to appraise more complex investment proposals. It may also be appropriate for small term loans or to finance start-up investments in new technologies or activities with no proven track record. The investment-loan approach can be adopted by more experienced lenders and is particularly important for financing investments that alter farm income significantly, such as irrigation technology or purchase of land.
Successful term lenders have accumulated an internal pool of knowledge and information on technical production parameters, price ranges of main inputs and outputs, other specific risk factors and market trends. They use relatively simple, standardized appraisal methods for small term loans and more comprehensive loan appraisal methods as terms and amounts increase. Here a lender has to trade off additional transaction costs against a lower level of uncertainty regarding the investment. For example, BAAC uses a simple cash-flow analysis for small term loans below BHT 500 000 (around US$ 12 000). For loans between BHT 500 000 and 1 million (US$ 12 000 - 24 000), a more comprehensive cash-flow analysis is carried out, accompanied by a feasibility study. For larger term loans above BHT 1 million (above US$ 24 000), additional indicators are calculated (NPV, IRR and B/C) and a sensitivity analysis is carried out.
The disbursement schedule depends on whether the investment can be purchased ready for use (such as farm machinery and equipment) or whether a gestation period for construction work or biological processes is required. In the case of investments with a gestation period requiring several staggered expenditures, loan disbursements should be phased accordingly. This allows the lender to monitor the progress of the investment.
The borrowers capacity to repay term loans depends on the extent to which the schedule of repayments has been adjusted to the farm household cash flow including the investment. Farm machinery and equipment that can be bought ready for use usually requires repayment terms of from three to five years. The repayment instalments should not exceed a certain percentage of the estimated yearly cash flow. Many case-study institutions apply a limit of 30 percent of the estimated net cash flow for the repayment instalments, taking into account gestation periods and incremental working-capital requirements. The estimated annual income may or may not include incremental cash flow created by the investment.
Structuring loan repayments requires trading off borrower demand for longer terms and less frequent payments against the lenders risk considerations. From the borrowers point of view, longer terms increase affordability, because repayment instalments are smaller in relation to cash flow. However, a lender has to consider parameters such as moral hazard and other credit risks, inflation and interest rates, the quality of collateral and the types and maturities of funding sources. Though the preference of most lenders for shorter terms might be understandable on moral hazard grounds and to reduce uncertainty, it may increase the risk of default if the repayment schedule is poorly adapted to the cash flow.
The frequency of loan repayments is another important issue: Frequent repayments might be preferable from the lenders point of view since they reduce moral hazard risk and ease liquidity management. However, they might only be feasible in the case of investments that create a steady cash flow, or for farmers with additional, counter-cyclical sources of income that can be used for loan repayments. Farm households that depend to a large degree on seasonal income require flexible treatment. Agrocapital, ANED and CLA offer the option of varying the amounts and periods of the payment instalments according to the cash flow throughout the year. Repayment can be made every 2, 3, 4 or 6 months. Different instalments may apply in cases where there are a main and a second harvest, or in periods with increased household expenditures, such as payment of school fees. Generally, the borrower has the option of prepaying instalments, there- by reducing his total financial costs. Finally, the high transaction costs for borrowers must be considered, especially in rural areas in which repayment at the RFIs office involves travelling long distances.
The financing of investments with long amortization or gestation periods poses considerable challenges to the lender. Examples are investments in perennial crops, herd development, purchase of farms or investments requiring major construction work, such as land levelling or irrigation development. In these cases, the repayment capacity increases over time, as the investment matures and reaches its full production potential. If loan maturities are too short in relation to the cash flow generated by the investment, the borrower may face asset/liability mismatches that increase the risk of illiquidity and, in consequence, the likelihood of default. Investments with long gestation periods may require a grace period. In these cases, the lenders usually insist on the payment of interest to ensure a minimum regular contact with the borrower and to reduce moral hazard risk. This also reduces the borrowers total financing costs by avoiding the capitalization of interest rates.
Due to the high uncertainties related to long-term loans, it may be necessary to build flexibility into the loan repayment schedule to respond to unforeseen changes in the key parameters underlying the investment appraisal.
One important issue is the impact of inflation. Loan repayments are normally calculated as fixed annual instalments, while the productivity of the investment may only reach its maximum after several years. If a modest, constant inflation rate of 5 percent over the term of the loan is assumed, and the net cash flow of the farmer increases by 5 percent per year in nominal terms while the nominal amount of the repayment instalments remains constant, then the real costs of loan repayment decrease over time. These mismatches between the real costs of a loan and the repayment capacity might be tackled by starting loan repayment with modest amounts that increase over time according to the nominal inflation rate or the nominal prices of major farm products.
A second issue is the cyclical fluctuation of commodity prices. While short-term price fluctuations might be managed through forward contracts, put options or hedging, no risk-management instruments are currently available to manage cyclical price fluctuations. This is particularly problematic if the main farm income comes from a crop characterized by such fluctuations, such as many perennial crops or livestock products. One possibility would be to tag the repayment schedule of a term loan to the price of the main cash crop. A price band could be established within which the repayment schedule set out at the time of loan appraisal remains valid. If the price declines below the established trigger price, the borrower would have the option of reducing the instalment amounts, together with a prolongation of the repayment period for the outstanding amount. A similar mechanism could be designed for interest-rate fluctuations if the loan carries flexible interest rates. Such a mechanism would, however, increase the liquidity risk of the lending institution and should be backed by the refinance facility of a second-tier institution.
A further possibility would be the establishment of a deposit account funded from loan repayments during the first years. The deposited funds could be used as a protection against default. If no default occurs, the deposited amount plus interest would be refunded to the borrower. This type of guarantee fund would protect the lender from default and provide additional repayment incentives to the borrower. The deposit would be collected through a surcharge on the interest rate (compliance fee). The downside of this approach is that it increases the interest rate and thus the financial burden on the borrower.
The interest-rate level is crucial from the perspective of both the lender and the borrower. Lenders need to cover cost of funds, operational costs, a provision for expected loan losses and a profit if expansion of operations is envisaged. However, the level of interest rates has an important impact on the financial viability of agricultural investments. With increasing loan maturities, the effective demand for term loans becomes more sensitive to interest rates, and due to the compounding of interest rates, high financing costs for the borrower increase exponentially in proportion to loan maturities. Larger investments with long amortization periods often have lower rates of return than small investments with quick turnover such as those of many microfinance clients. High interest rates may even lead to problems of adverse selection, thus increasing the share of high-risk clients in the lenders portfolio.
Adverse selection is the result of asymmetric information between lenders and borrowers about the risks of investment proposals. If the lender is unable to assess the real risk of different loan applications, it may react by offering the same rate to all applicants and adding a risk prime to the interest rate. As a consequence, potential borrowers with less risky but less profitable projects will not apply for loans, leaving the lender with a portfolio of high-risk clients.
As mentioned earlier, there might be some scope on cost grounds to offer term loans at lower interest rates than short-term loans due to the economies of scale in appraising and administering. Thus risk primes and cost of funds are the most important determinants of the level of interest rates for such loans. In practice, several RFIs apply lower interest rates for term than for short-term loans. However, care must be taken to avoid huge interest-rate differentials between these loan types in order to minimize the incentive for loan diversion.
Adding risk primes to the interest rate is just one way of managing risk - and probably not the most suitable one in the case of term loans. A lender should try to manage risk through other mechanisms: careful selection of borrowers and loan appraisal, appropriate collateral requirements for larger and longer term loans, loan supervision and other elements of a good lending technology. The associated higher transaction costs may be more than compensated by the reduction in credit risk. An increased equity participation or down payment is another way of reducing credit risk through a lower gearing ratio. The quality of collateral also has a significant impact on the level of risk primes as part of the interest rates.
Land Bank: risk categories of clients
These are typically emerging farmers, who lack training in production, financial management and marketing. They include beneficiaries of the South African land-reform programme and farmers on communal land. Again, the products cover long-, medium- and short-term loans. There is a ceiling of 50 000 South African rands (R) and applicants will normally not get this amount on a first loan. Up to R 25 000 can be borrowed unsecured, but some form of security must be provided for loans in excess of this.
A risk fund has been created that will cover inadequate conventional collateral levels of Silver and Bronze clients. The fund charges a fee above the base interest rate. The money is pooled and topped up by the bank to cover default by mediumand high-risk clients. To date, only a limited number of loans have been written off and the fund has been able to cover the exposure.
BAAC: past performance of borrowers
In 1999 a risk-based, interest-pricing client rating was introduced, based on past repayment records. Preferred or lowest-risk clients (AAA rating) are charged the minimum lending rate (MLR). Interest rates increase in proportion to risk, and the maximum interest rate to clients with a B2 rating is MLR+6 percent. Interest on both medium- and long-term loans is calculated daily on the principal balance and becomes payable as the loan instalment falls due. A penalty rate of 3 percent per annum is charged when a loan becomes past due.
Classification of Borrowers
Record of Debt Payment
Full and timely repayments for three consecutive years
Full and timely repayments for two consecutive years
Full and timely repayments in the previous year
Past-due with reasonable cause: due date has been extended
There are considerable differences between the case-study institutions regarding the spread (interest rates over cost of funds) that is charged for term loans. BAAC and Land Bank have considerably lower spreads than smaller and less experienced institutions such as ANED, CLA, CECAM or CIDRE. This is mainly due to characteristics of the FIs, such as size, skills and experience, that were outlined in section 3.7.
A financial institution may consider cross-subsidizing term loans through income from other, more profitable activities, at least during the initial period of introducing such products. This might be justifiable in view of possible benefits of term loans for a lender, discussed earlier, such as retaining good clients, providing incentives for short-term borrowers, strengthening the clients business by reducing production or marketing risks, or enhancing the demand for complementary working capital.
In view of the very different risk profiles of different clients and term investments, it is inappropriate to charge a standard interest rate for term loans. For example, Land Bank applies different interest rates according to the risk profile of the client based on criteria such as track record, equity contribution and quality of collateral provided. First-time borrowers or those with poor collateral pay a risk prime, but may have subsequent loans at better conditions. BAAC bases interest rates on the past repayment performance of clients (see Box 12). Moreover, most RFIs offer performance-based, interest-rate rebates, refunding a part of the interest paid after successful repayment.
The use of fixed versus flexible interest rates is another important issue. Fixed interest rates are generally preferred, since they facilitate the appraisal of term loans and establishment of a repayment schedule. However, their feasibility depends on the structure of the funding source of the RFI and the macroeconomic environment: fluctuating inflation and interest rates expose the lender to a high level of interestrate risk if refinance facilities at fixed rates are unavailable. In unstable environments, interest rates should be pegged to the inflation rate, especially in the case of long-term loans.
Flexible interest rates attenuate asset/liability management problems of the lender, but may increase credit risk. The borrower may also be given a choice of fixed or flexible interest rates, with flexible rates priced below the fixed rates, because the borrower would then carry the interest-rate risk. An intermediate solution might be to periodically revise and - if necessary - adjust the interest rate to changes in market rates and cost of funds. Certain boundaries for maximum and minimum interest rates could be agreed ex-ante to reduce uncertainty for the borrower. Moreover, if the interest rate has to be increased, the lender may offer a longer repayment term for the remaining principal so as not to increase the instalment amounts, always assuming that this would not lead to unsustainable liquidity risks for the lender.
The larger the size and the longer the term of the loan, the more important are frequent contacts with and supervision of the borrower to control the risk of loan arrears. Supervision should ensure that the disbursed loan is used for the purpose stated in the loan contract. This is particularly important if repayment is based on projected cash flow generated by the investment. Borrower supervision enables loan officers to determine if any eventual failure of the investment is attributable to external factors and outside the control of the borrower (e.g. due to climatic factors or natural disasters), or to mismanagement and diversion of loan funds. Contact with the borrower should be frequent. A visit just prior to harvest to estimate probable yields is of particular importance.
Needless to say, frequent supervision is costly and time-consuming, especially in sparsely populated rural areas. Different measures have been developed by the case-study financial institutions to reduce supervision costs:
Disbursement in kind reduces the risk of diversion of funds. Even experienced borrowers might be tempted by the sudden availability of a large amount in cash, or might come under heavy pressure from friends and relatives. After the loan applicant has identified a particular asset (e.g. a tractor or pump), the loan would be disbursed directly to the supplier. In the case of tree-crop develop- ment, seedlings and fertilizers can be provided in kind, leaving a cash component only for requirements of seasonal hiring (however, physical assets are also fungible in rural areas).
Efficient planning of travel schedules of loan officers can reduce costs by combining loan appraisal with supervision and other tasks in the same region.
Social collateral, such as joint liability groups and personal guarantors, exerts strong peer pressure for repayment and transfers part of the supervision to the group.
Frequent repayment instalments of at least the interest ensure regular contact between lender and borrower.
Collaboration with equipment suppliers: in the case of farm machinery and irrigation pumps, special arrangements with equipment suppliers can provide training, technical assistance and maintenance and repair services. Financial institutions can be informed promptly should problems affecting repayment arise.
Partial interest-rate rebates for timely repayments and charging of penalty rates in cases of default are common tools for influencing the repayment behaviour of borrowers.
Loan follow-up should be based on accurate and timely monitoring of loan accounts. This requires good records and preferably a banking MIS that produces automatic reports of loan due dates and past-due loans and provides regular, updated information to management. If the measures listed above are in place, borrower supervision through field visits might be limited to problem accounts to save costs (e.g. CLA). Frequent loan monitoring is a prerequisite for portfolio management, taking into account the performance of specific types of loans according to loan purpose, terms or classes of borrowers.
Many rural and microfinance institutions apply a zero-tolerance policy for overdue loans and arrears. This implies stringent loan recovery, even though the reasons for default or late payment may lie outside the responsibility of the borrower. At first sight this policy seems reasonable in the light of the "culture of non-repayment" that is prevalent in many rural areas. Any loan rescheduling may provide the wrong signals to borrowers, further undermining the repayment culture. Thus lenders must show their ability and willingness to enforce loan repayment in case of default. As the case studies from Bolivia and India show, this is particularly important for new institutions that diversify into agricultural finance.
Interlinking credit disbursement in cash or kind with output marketing is a powerful tool to minimize the need for conventional loan collateral and to reduce transaction costs related to loan collection, especially in scarcely populated areas. It has been widely used by non-financial institutions such as traders, marketing boards, cooperatives and contract farming schemes to provide seasonal inputs on credit, to be recovered through deductions from the produce. Some RFIs provide loans to farmers with tripartite arrangements with marketing or processing enterprises to facilitate repayment through deduction at the source.
Interlinked transactions are particularly important in areas in which other forms of collateral are unavailable, such as in most of sub-Saharan Africa. Though the main role of interlinking is the financing of seasonal working-capital needs, it has been used in some cases for financing term investments such as the establishment of perennial crops, e.g. sugar cane growers in South Africa, tea growers in Kenya or oil palm growers in Ghana or Indonesia. There are also a number of mutualist RFIs in Africa that provide various loan products, including term loans, to those farmers linked to certain export-commodity chains. However, only in exceptional cases can it completely substitute for conventional collateral in term lending.
Interlinked transactions, especially those involving longer term loans, require a de facto control of the lender over the output to avoid default caused by outside selling. However, these situations are disappearing, because monopolies related to domestic and export crops have been liberalized in most countries in the wake of structural adjustment programmes. In the case of bulky, perishable crops, the need for immediate processing may place processors in a local monopsonistic position in certain areas. However, competition and freeloading are likely to emerge after some time. Another potential weakness of interlinked transactions is the danger of laxness in loan appraisal procedures if lenders are too confident of repayment through automatic deductions at the source. This may lead to overindebtedness of investors and declining portfolio quality. Moreover, even a monopsony situation does not protect against default through crop failures or diversion of inputs.
Vertical integration - through joint ventures in which investors acquire shares in processing enterprises - may facilitate the use of interlinked transactions to provide loans and non-financial services also for non-perishable crops such as rice (see chapter 6).
However, the high exposure of agriculture to external risks beyond the responsibility of the borrower calls for a more differentiated treatment of loan arrears. Defaults due to drought, flooding and other natural calamities, as well as unexpected price fluctuations, may justify loan rescheduling. A blind application of a zero-tolerance policy might not only be inappropriate, but also costly for the lender, because of the transaction costs and delays involved in executing security interests. Successful lenders deal more flexibly with such transitional defaults if the loan officer is convinced of the borrowers willingness to repay as soon as possible.
It is important for banks to be seen as serious regarding the possibility of foreclosure. However, within the context of a generally strict policy of loan recovery, most case-study institutions consider collateral foreclosure as a last resort. Apart from the legal and institutional difficulties in foreclosing on collateral, there is a preference for establishing a longstanding, positive relationship with the client. There is much reliance on the borrowers interest in maintaining his good reputation, both in the community and with the financial institution. Moral pressure is exerted by publishing the names of defaulting borrowers, or announcing their names on the local radio network.
Among the case-study institutions, BAAC has the most borrowerfriendly policy for treating loan defaults. If the reasons for default fall outside the control of the borrower, payment of the due amount is postponed. Moreover, loans are completely written off only after ten years. During the past decade, this policy has resulted in a nearly complete recovery of BAACs past-due loans up to 1997 because borrowers have had to repay earlier loans in order to apply for new ones. This was also possible because of the effectiveness of joint liability groups in controlling moral hazard risks, the long-established relationship between borrowers and loan officers, and the position of BAAC as the sole formal lender providing larger amounts to farmers on terms geared to their needs.
A lease is a transaction in which an owner of a productive asset (the lessor) allows another party (the lessee) to use the asset for a predefined period of time against payment of rent (lease payment). Both movable assets (farm machinery, draught and dairy cattle) and immovable assets (land, buildings) can be leased.
The key feature of leasing is separation of legal ownership of the asset from its economic use. The leased asset is assumed to generate the main source of income for the lease payment. It serves simultaneously as security for the contract, eliminating or reducing the need for collateral.
Financial or full-payment lease
A financial lease is an alternative medium-term instrument for financing the purchase of assets that are ready for use. The lessor buys an asset chosen by the lessee and hands it over to the latter for use, while retaining the ownership title. The lease period normally amounts to two-thirds of the assets economic life to protect against the risk of accelerated depreciation. During the lease period, the lessee meets all operational and maintenance costs and makes regular lease payments that cover all costs incurred by the lessor, including depreciation, interest on capital invested, insurance, administrative costs and profit margin. At the end of the agreed lease period, the lessee has the option of purchasing the asset at the residual value stated in the lease contract. Alternatively, the lessee can return the asset to the lessor and perhaps engage in a new lease contract for another asset.
Hire-purchase is similar to financial lease, but the lessee assumes increasing ownership of the asset with each payment made. The down payment is regarded as the first instalment towards purchase. At the end of the lease period, ownership of the asset is automatically transferred to the lessee (Mutesasira et al., 2001).
Figure 3: How a financial lease works
Source: Based on Dupleich, 2000
An operational lease is a contract allowing the client to use a piece of equipment for a certain period of time, and it does not involve transferring an assets ownership. Normally, the asset is rented to a lessee for a period much shorter than its useful life (typically one production period). It is thus more a rental, rather than an asset-financing mechanism.
Leaseback or retro-leasing
Another modality is leaseback, a type of pawning. This modality can be used for working- and investment-capital finance. Its key advantage is the potential to circumvent deficiencies in the legal and institutional framework regarding conventional collateral.
A financial lease is a very close substitute for medium-term loans in financing equipment purchase. The main advantage compared to other types of leasing is that the lessee will own the equipment before the end of its economic life. This creates a strong incentive for proper maintenance and adherence to the agreed payment schedule.
In Bolivia, ANED offers this product also, which enables the client to liquefy a specific asset (e.g. land or equipment) by selling it to ANED for an agreed amount. The client can then use this money to make productive investments. The leaseback contract specifies lease rates and the date on which the client has the option to buy back the item, i.e. the term of the arrangement. This leasing method is still experimental, but could be used to finance working capital and larger assets such as farm buildings or tree crops. However, scope for the mechanism has been reduced by the need for a registered title and the lack of sufficient funds to finance large-scale purchase of farmers assets. In Bolivia, leaseback constitutes an alternative to conventional mortgaging, since legal restrictions on the sale of small land plots do not apply, allowing even small farmers to access lease finance for investments. The financial institution benefits from increased security, and from reduced transaction costs should foreclosure become necessary.
An operational lease is less attractive for both lessee and lessor due to difficulties in controlling moral hazard problems regarding proper use and maintenance. Farmers and micro-entrepreneurs generally prefer to own an asset, which provides more flexibility and control over the business and constitutes in-kind savings that can eventually be sold or pledged. An operational lease does not provide such incentives (Mutesasira et al., 2001). Moreover, the lessor might have difficulty assessing the depreciation of the asset realistically during the lease period and thus its residual value. If the depreciation is calculated too conservatively, resulting in high lease payments, there might be limited or no demand for the service, and the incentives for proper maintenance might be further reduced. On the other hand, if lease payments do not cover real depreciation, there is a serious risk of decapitalization (Westley, 2003). Thus the provision of hiring services might be more viable than operational leasing for farm machinery and equipment.
Leaseback might be an attractive possibility for obtaining working or even investment capital. It could serve as a substitute for emergency loans by facilitating access to liquidity and preventing the sale of assets that might be vital to the farm household in case of adverse events. It might also be used to finance expansion of existing operations. It does not require mortgaging, because the financial institution becomes owner of the asset. However, in practice, there are several restrictions on the use of leaseback in rural areas in developing countries. First, the lessor must be in a position to evaluate the technical integrity of the asset, its realistic market value and the likely depreciation during the lease period. Second, since two sales transactions are involved, the possible impact on taxes has to be taken into account.
Due to the limited empirical evidence for leaseback, the rest of this chapter will concentrate on financial leasing.
The main advantage is the stronger legal position of the financial institution for seizure and sale in case of default. As the lessor remains the legal owner of the asset, repossession is easier, which reduces or even eliminates the need for collateral. This advantage can be considerable in countries where the legal and institutional environment poses severe constraints on secured lending (discussed in more detail in chapter 7).
Secured lending requires four steps:
1. creating a security interest in the collateral;
2. perfecting the security interest through registration and enquiry about senior claims;
3. seizing the collateral after obtaining a court order; and
4. selling the collateral under court supervision.
Leasing avoids steps 1, 2 and 4. Step 3 is usually simpler, faster and thus less expensive. However, the advantages regarding seizure depend on the country context. According to Westleys study in eight Latin American countries (2003), seizure is considerably faster in Bolivia and Ecuador (1-2 months), whereas in the other six countries (Chile, Colombia, El Salvador, Honduras, Mexico and Peru), the advantages are less pronounced or even non-existent.
In many developing countries, there are two procedures for seizing and selling collateral. The formal procedure involves the judicial system, first for a court order to seize the asset and then for the court-supervised sale. In the informal procedure, the loan officer, sometimes accompanied by the branch manager, takes the collateral directly from the defaulting borrowers and sells it. This procedure refers to the loan contract, signed by the client, which states the assets that have to be turned over to the lender in case of default. Assets might include household goods and appliances, farm machinery and equipment (Westley, 2003).
Not only do faster seizure and sales procedures reduce transaction costs and the costs of staff time. They are also vital for the use of movable assets, the value of which usually declines much faster than the value of immovable assets such as land or houses. The more easily movable property can be seized and sold in case of default, the more a financial institution will be inclined to accept it as collateral. This, in turn, can be a decisive factor in access to medium-term loans for many farmers that cannot offer conventional immovable collateral. Leasing is a way to circumvent problems related to the foreclosure and sale of movable assets.
Informal seizure might also be easier in the case of leasing, because defaulting lessees might be more willing to hand over equipment that belongs to the lessor than collateral equipment that belongs to themselves. According to Westley (2003), this has been an important reason for the recent interest of some Bolivian MFIs in leasing.
Advantages for the client are lower collateral requirements or even absence of additional collateral requirements and faster appraisal procedures. Obtaining a lease tends to be less cumbersome and faster than obtaining a loan. Moreover, they might benefit from a general increase in the supply of medium-term finance to the extent that leasing is able to overcome the collateral constraints attached to loans. However, many lessors in practice also require additional collateral. This reduces the advantage of leasing over lending.
Depending on the legal and regulatory environment, leasing can be provided by banks, non-bank financial institutions such as leasing companies, and other financial institutions. It can also be used by equipment providers as an alternative to supplier credit.
Commercial banks often create leasing subsidiaries. This allows them to contract specialized staff and thus provide leasing more effectively. Moreover, all risks related to leasing are pooled into this separate entity, which also assumes all losses, insulating them from the main portfolio of the RFI. However, creation of subsidiaries adds considerably to costs, because it requires a separate management, computer system, legal department, lease officers, etc. Creating a subsidiary might be advantageous for lessors with a substantial portfolio, who wish to expand and further specialize their leasing business, or for lessors dealing with larger clients requiring more sophisticated equipment.
As opposed to Europe or North America, in developing countries leasing is not yet widely used as an instrument for financing equipment in the small farm and SME sector, despite its potential advantages. In most of these countries, leasing is only available in the formal sector for medium and large enterprises (Bisa, 2001a). A recent study on medium-term equipment finance for urban small and micro-enterprise in Latin America found that of 25 MFIs, only three offered leasing (Westley, 2003).
This can be attributed partly to legal and regulatory constraints, but also to tax treatment that often discriminates against leasing as compared with lending. Moreover, lessors in rural areas face constraints similar to those faced by lenders in terms of exposure of clients to systemic risk, high cost of supervision and informality of businesses. Many commercial banks and leasing companies are urban based and unfamiliar with servicing informal rural enterprises. Moreover, supervision of scattered rural clients results in high transaction costs and makes leasing unattractive to these clients.
Since the 1990s, however, some microfinance institutions have begun developing leasing products for small and microenterprises. Most of these institutions target urban and non-agricultural clients. Examples include Grameen Leasing (Bangladesh), Orient Leasing (Pakistan), Selfina (United Republic of Tanzania) and Supreme Furnishers (Tanzania and Uganda).
Only two institutions could be identified that provide leasing for small farmers and rural non-farm enterprises: ANED introduced financial leasing of tractors, irrigation pumps, ploughs and other farm equipment in 1997 in different rural areas in Bolivia. CECAM, a mutualist network in Madagascar, introduced leasing in 1993 to finance draft animals and equipment (ploughs, harrows), small mills and presses, small motorized equipment and dairy cows. The following section illustrates the main elements of their financing technology in selecting clients and equipment, and in appraising the payment capacity of the client in order to protect against default. Reference is also made, for some aspects, to an analysis of leasing providers in Tanzania and Uganda, based on Mutesasira et al. (2001).
Lessors targeting small and microenterprises, including ANED and CECAM, mainly finance medium-term machinery and equipment. Many of the elements of the financing technology are geared to addressing the risks of equipment finance, and apply also to medium-term loans. Common issues are flexible payment schedules adjusted to the farm household cash flow or the need for long-term funding sources. This section focuses on the central role of the leased asset as the main security and source of payment. Given the absence of collateral, the skills and experience of clients, down payments, selection of equipment, and monitoring and supervision are even more important for lessors than for providers of term loans.
Selection of clients
Skills and experience. The most important selection criterion is the experience of the client, together with skills for handling the asset, especially in the case of larger leases. ANEDs clients for tractor leases have prior work experience as tractor operators (some have been trained by a dairy development project funded by a bilateral donor). The farmers that lease irrigation pumps have received technical training from NGOs promoting the use of this equipment. Most clients of CECAM have some equipment or animals and use the lease to upgrade their equipment or increase the number of animals.
Down payment. A further criterion is the ability to make a down payment or deposit. In the case of ANED, the down payment amounts to 25 percent of the purchase price of the equipment, to counter the high depreciation of the asset during the first year. CECAM requires 20 percent down payment for new equipment, 25 percent for animals and 40 percent for used assets, to cover the higher risk of technical breakdown. In the case of animals and used vehicles, additional collateral is required amounting to 50 or 150 percent of the purchase value respectively. According to Mutesasira et al. (2001), lessors in Tanzania and Uganda usually require a deposit instead of a down payment, amounting to 25-30 percent of the asset value. This amount has to be deposited in a blocked account and is repaid after the lessee has completed the payment obligations. In many cases, additional collateral and guarantees are also required.
Role of farmer groups. CECAM involves farmer groups in the selection process. They verify the integrity of the applicant and the accuracy of the data provided in the application. They also assess the suitability of the equipment chosen by the applicant and supervise its use. In some cases, joint liability is used. This helps reduce transaction costs and risk. As the network has become more confident in the use of leasing, this requirement has been relaxed. Individual farmers can now obtain leases without requiring group guarantees.
Selection of equipment
Selection of the asset is crucial to success, because it constitutes the main source of payment and the only security for the transaction (if no additional collateral is requested). Due to the reasons discussed in chapter 4, lessors prefer to lease equipment that generates a regular income flow, can be easily sold on the second-hand market, has multiple uses rather than a single one, and has a clear ownership title for ease of repossession and liquidation (Mutesasira et al., 2001).
New versus used equipment. Most lessors prefer new and more expensive equipment, which still has a warranty and is less prone to technical failure. However, this translates into high financial costs for the lessee, in terms of both the down payment and the lease instalments. Farmers and microentrepreneurs often prefer used equipment, which is much cheaper but still useful. However, from the lessors point of view, it is difficult to assess the quality and thus the expected useful life and real value of an older asset. In addition, in rural markets, there are often no titles of ownership for used assets. If the lease cannot be registered, the risk for the lessor increases. Some lessors finance used assets (e.g. in East Africa and Bolivia), but require some type of additional guarantee.
Another important issue is who should select the leased asset. According to Micro-Save Africas study on leasing markets in East Africa (Mutesasira et al., 2001), lessors always leave the selection of the asset to the client. This saves transaction costs and ensures that clients are comfortable with the equipment, which has a positive impact on attitudes towards lease payments and maintenance. If the lessor chooses the asset, the client could blame it if the investment fails. CECAM uses a similar approach, but the credit officer or the joint liability group has to assess the asset before the lease is endorsed. In the case of leased animals, a veterinarian might also be consulted.
There may be circumstances, however, in which the lessee is not aware of the best available choice. This might be due to lack of market information and the unavailability of equipment in rural areas. Another issue concerns the suitability of equipment for smaller producers. According to ANED, most of the farm machinery/equipment readily available in Bolivia is mainly suitable for larger-scale farmers, who constitute the main effective demand. ANED has adopted an intermediate approach by making a preselection of the equipment through contracts with one major importer (which guarantees support services, quality and warranty). The lessee can choose between two different makes of irrigation pumps and between two different models from each supplier. The contract with the importer and bulk purchasing allow ANED to negotiate better conditions, including prices, training and after-sales services.
An efficient and competitive structure of importers, manufacturers, wholesale and retail dealers and repair shops facilitates the choice of equipment for particular types of users and uses, and guarantees the availability of spare parts and technical support. Thus it significantly reduces the risk of technical failure. Developing medium-term finance products such as leasing should be accompanied by a comprehensive strategy for mechanization or irrigation development based on a private-sector-driven supply chain. Donors can play an important role in supply-chain development by facilitating financial and non-financial support services.
While in principle a financial lease could also be structured as a multipurpose lease, ANED and CECAM base the appraisal mainly on the incremental cash flow generated by the equipment, seeing this as the main source for lease payments. Lease appraisal requires considerable skill, particularly for larger and more sophisticated equipment. The loan officer needs technical knowledge of the equipment, as well as a general background in farm economics and related financial flows. The appraisal should take into account the entire farm household income in order to identify a secondary source of payment should the main activity decline. Cash-flow analysis should also take the incremental working-capital requirements into account. A tractor, for example, requires on average 100-150 percent of its purchase value for repairs and spare parts during its economic life.
Structuring lease payments
All institutions engaged in leasing for farmers and microenterprises try to adapt the lease payment schedule as closely as possible to the farm household cash flow. This flexibility includes:
varying amounts during the year in order to reflect the seasonality of cash flow;
scheduling higher payments in early years when repairs costs are low, but depreciation of the equipment is high; and
providing a grace period (a maximum of six months).
The institutions that use tailor-made schedules find that this has a very positive impact on the ability of lessees to make regular lease payments.
Terms and conditions
Lease terms are shorter than the economic life of the leased assets. This provides a cushion for the lessor against accelerated depreciation due to inappropriate handling. It also provides additional incentives to the lessee to make timely payments so that full ownership is hastened. Lease terms are normally from three to five years, depending on the asset. Smaller items such as pumps may require shorter terms, two years in the case of ANED. The lease rate is 16 percent of the asset value per annum, and the lessee is not allowed to return the asset before the end of the contract period. In the case of CECAM, the term is three years and the leasing rate 30 percent.
Monitoring and supervision
As in the case of term lending, a good MIS is important for monitoring the outstanding lease portfolio and identifying problem accounts. Monitoring and follow-up are even more critical in the leasing industry and involve visits to control the state of the equipment and assure its proper handling and maintenance. ANED and the East African leasing companies do this through frequent visits by loan officers. CECAMs strategy for supervision is to use proximity structures such as members of the local credit committees or joint liability groups. The latter also exert pressure for timely payment.
Dealing with default
Immediate action is important to maintain credibility among lessees and to discourage other defaults. If a lease payment is overdue, the loan officer calls or visits the client to identify the cause. If it is not within the control of the lessee, a plan for making the outstanding payment is established. Should the client not meet this plan, repossession is initiated. Neither ANED nor CECAM have had massive problems with default (see Box 17). It has, however, been necessary to repossess items in some cases, when equipment was not maintained properly or had been sold.
Outreach. CECAM has provided 25 000 leases since 1993, for a total value of 20 billion Malagasy francs and 5.8 billion in 2001 (approx. US$ 1 million). Leasing accounted for about 20 percent of the total outstanding portfolio. However, a minority of borrowers, constituting only 4 percent of all members, have been found to be eligible. ANED has a smaller outreach than CECAM, partly due to the type of equipment (tractors), but also to the relative newness of the programme. There are indications that the markets for irrigation pumps and tractors in the areas where ANED operates are already satisfied (see the case study for details).
Sustainability. ANED and CECAM have achieved lease payment rates above 90 percent, which is satisfactory in view of the experiences of many term lenders. In the case of CECAM, the payment rate for leasing is even above the average repayment rate of their lending products. However, as mentioned earlier, both institutions benefited from long-term concessionary loans from donors and, in the case of CECAM, ongoing technical assistance to develop products and train their staff. The relatively high lease payment indicates high transaction costs in appraisal and supervision and possible operational inefficiencies.
The limited use of leasing for asset financing of urban and rural small and microenterprises is the result of various constraints. The main problems encountered in the case studies by the lessors were:
moral hazard risk related to the leased asset;
high transaction costs in dealing with small-scale clients;
lack of long-term funding sources;
problems of repossession, particularly lack of awareness of local authorities of the legal issues;
difficulty in selling repossessed assets; and
an inappropriate tax environment.
For the lessor, the main problem is moral hazard risk, such as inappropriate handling, damage, loss or sale of the asset by the lessee. These risks can be partly handled through careful screening and selection of the lessee, coupled with close supervision. However, this means higher transaction costs, which increase the lease rate and make leasing more costly to the lessee. The use by RFIs of informal mechanisms such as joint liability groups might be one way to reduce these costs, especially in the case of smaller leases.
Introduction of leasing may require higher set-up costs then would be required for term loans, since staff of FIs must familiarize themselves with the legal, regulatory and tax requirements. Moreover, simple materials have to be produced to market leasing products and facilitate their understanding; contacts and contracts with insurance companies have to be established; and staff have to be trained in appraising the value of assets and in their potential to create additional cash flow in farm enterprises.
Need for sensitization
There is a clear need to improve the availability of information and to mainstream the concept of leasing, not only among local farmers and equipment suppliers, but also among local authorities. Lessors have to invest considerable time and resources in explaining the concept of leasing and the rights and obligations of lessors and lessees.
In some cases, repossession has been hampered by ignorance of the relevant law on the part of local authorities, especially the courts and police. In other cases, clients have denied the lessor access to their property. These issues can be overcome through awareness-raising campaigns on the concept and procedures of leasing and through the appropriate design of contracts.
In some countries, the banking regulations stipulate that financial institutions have to create special leasing subsidiaries. For example, Law 2 297 in Bolivia, approved on 20 December 2001, requires that any regulated financial institution must carry out its leasing operations through a subsidiary. Several regulated MFIs, including CLA, have cancelled their plans to offer leasing because of the considerable costs this would have implied. Similar legal provisions apply in Colombia and El Salvador (Westley, 2003). Decisions regarding the pros and cons of leasing subsidiaries should be left to the management and owners of financial institutions and should not be prescribed by banking regulators.
In principle, unregulated FIs such as financial NGOs or some credit unions do not face restrictions on engaging in leasing. However, superintendencies in some countries have the right to regulate all financial activity, including which institutions may lease and in what form. Thus leasing is allowed only for certain types of financial institutions. In Mexico, for example, equipment suppliers are not allowed to provide leasing. No such restrictions apply for medium-term loans.
Such discrimination against leasing seems unjustified, since it cannot be considered more risky than lending. (This observation does not apply to operational leasing, which is exposed to significant damage, second-hand market and residual-value risks.) Thus bank supervisory authorities should adopt a clear definition of financial lease as opposed to operational lease, and should not restrict financial institutions that are allowed to provide medium-term loans from also engaging in leasing.
In some countries, tax laws and regulations discriminate against leasing, effectively increasing the cost. In other cases, tax depreciation benefits cannot be realized by lessees in the rural or microenterprise sector due to the informality of the business or low profits. Most farmers do not pay value added tax or income/profit tax. This deprives them of an important advantage that makes leasing attractive to formal lessors, such as medium and large enterprises (Mutesasira et al., 2001).
A study comparing the tax environment for leasing in eight Latin American countries concluded that the tax systems in most of these countries had a modest anti-leasing bias, at least when the lessors were informal enterprises.
Due to the separation of the ownership of equipment from its possession and use, some disputes may arise. For example, if the equipment breaks down during the warranty period, the supplier may refuse to bear the cost of repair or replacement, claiming that the lessee had abused the machine. These and other types of issues resulting from the separation of ownership and use rights should be addressed in an appropriate legal and regulatory framework. In practice, they might be reduced if the lessor established partnership arrangements with equipment suppliers, as will be discussed below.
Absence of suitable insurance products
The availability of insurance against theft or breakdown of the equipment would considerably reduce supervision costs. However, the insurer would then face moral hazard problems, leading to high premiums. These range from 3 to 8 percent of the value of the asset in Tanzania and Uganda (Mutesasira, 2001). ANED considers the premiums in Bolivia too high in relation to the real moral hazard problems experienced.
A related issue is life insurance coverage linked to a lease, which would also apply to loans. This practice is used by Orient Leasing in Pakistan, where average leases amount to US$ 10 000. This not only reduces risk for the lessor/lender, but prevents an undue burden on the family in the event of the clients death.
Access to long-term funding sources
This is a critical issue for lessors, both for initiating a leasing programme and for scaling it up. The examples of ANED and CECAM underscore the importance of the availability of long-term, cheap resources. These examples and the previous arguments show that considerable resources have to be invested in building local capacity among all actors in order to make leasing and hire-purchase work. This justifies an element of subsidy in the resources made available to those lessors that have demonstrated the capacity to operate effectively, that are in a position to expand their operations, and that are constrained only by liquidity issues.
From the lessees perspective
In the case studies, the following problems were encountered by lessees:
high down-payment requirements and, in some cases, collateral requirements;
rigorous selection criteria regarding skills and previous experience;
reluctance of lessors to lease low-cost technology or used assets; and
higher payments (compared to term loans) due to shorter lease periods.
Though these measures might be necessary from the lessors´ perspective, they limit the outreach of leasing and may prevent smallerscale farmers from seeking and obtaining a lease. This applies especially to down payments of 30 percent with new equipment or the practice in Africa of requiring additional collateral or guarantors. In developed countries, one of the main advantages of leasing is that the down payment is very small (typically less than 5 percent of the value of the asset). Down payments and compulsory deposits reduce the working capital available to farmers and thus limit the advantages of leasing as compared with lending.
The previous discussion illustrated that leasing is not an easy panacea for the lack of medium-term agricultural asset financing. The following section suggests some measures for mainstreaming leasing in order to finance farm assets in developing countries. Some of the proposed measures would also apply to financing equipment through mediumterm loans.
Partnerships with projects and NGOs. These can play an important role in making appropriate technology available locally and in training farmers in selecting the right equipment and managing it properly. Simple technology (e.g. treadle pumps) can serve as a step- ping stone for small-scale and inexperienced farmers. More progressive farmers could be trained to use animal powered or motorized equipment. Projects and NGOs could train farmers in farm management skills, while lessors could provide financial management training. Savings-based financial institutions could offer diverse savings and loan products, helping farmers save the required down payment for a lease.
Partnerships with equipment suppliers/dealers. Lessors could negotiate better conditions, especially price discounts for bulk purchases. They could also seek to arrange warranties, training and after-sales services (repairs, spare parts). Suppliers often have frequent contact with clients through promotional activities. However, care must be taken to avoid a supply-driven approach. An important cushion would be to share the default risks between lessor and supplier. In this case, suppliers would have an incentive to participate in the screening of clients, provide effective training and combine after-sales services with supervision.
Alliances with MFIs. This strategy would seek to combine the strengths of formal leasing companies with those of MFIs. The former possess specific knowledge and appraisal techniques, MIS for portfolio management and better access to funding sources. The latter would contribute local presence and experience and techniques in dealing with small and informal clients and thus offer the potential to broaden markets. MFIs might also collect lease payments on behalf of the leasing company, as they have ongoing contact with their clientele through other financial transactions. Moreover, they could provide additional working capital if needed. The key, again, is to combine these strengths into suitable arrangements that share risk, cost and profits, and to design contracts providing the right mix of incentives, checks and balances.
Innovative savings products. Savings-cum-lease products could help more clients accumulate funds for a down payment. For example, CECAM has developed a product in which an applicant makes monthly deposits over a period of at least one year. This serves as a screening device, while the client becomes used to making frequent payments. After having completed the savings plan, and if the application is approved, the client receives a lease at a down payment of 24 percent instead of the usual 30.
Designing multipurpose lease products. Smaller leases may also be offered as multipurpose leases, analogous to the multipurpose medium-term loans offered by some RFIs. This would render the criterion of experience less important and would require fewer lessor skills in appraising the asset and the generated cash flow. It would also increase the scope for leasing second-hand equipment.
Some measures to improve the legal and regulatory environment are outlined in chapter 7.
Equity is the capital paid into an enterprise by owners or shareholders. Equity finance has three key advantages over both leasing and loan finance, which require fixed payments for principal and interest on a predefined schedule. First, an equity investor has residual claims on the profits of a business only if a profit is made. Also, the sale of shares or divestment can be adjusted more flexibly to volatile conditions in agriculture and to changing profit and liquidity positions. Second, the investor has a certain influence in or control over the management of the enterprise. This reduces moral hazard problems caused by asymmetric information and may strengthen the management of the company. Third, equity enhances the stability of the enterprise and can be leveraged by additional loan finance. Thus equity finance allows better sharing of the risk of investments in unstable environments or in longer-term and larger- scale investments than do long-term loans, which carry fixed and predefined repayment schedules.
Providers of equity include individual investors, stock markets, risk-capital funds, national and international development banks and socially oriented investment funds. Providers of risk capital or international development banks usually invest equity in a company over a time horizon of 5-15 years, followed by a period of gradual divestment. These investors share the risk and profits of the investment and expect to gradually divest the capital over the amortization period, with a profit margin commensurate with the risk and transaction costs. Venture capital means the use of equity finance for capitalizing extremely risky investments such as start-ups, diversification into new markets and financing of investments with longer amortization periods, which would not be able to attract traditional bank finance.
International development finance institutions, such as the International Finance Corporation, the Commonwealth Development Corporation or the Deutsche Entwicklungs Gesellschaft, finance investments in plantation agriculture and agroprocessing. Moreover, the principles of equity finance are inherent in many Islamic financing instruments, such as musharaka (partnership finance), which avoid fixed interest payments.
These are funds created to buy minority shares in SMEs in dynamic sectors with high growth potential. The fund provides equity for investment that helps the enterprise grow or develop/introduce a new technology. The investor has at least one seat on the board of directors. It provides technical and management assistance (business development services, accounting, taxes, etc.). Once the growth objectives are achieved, the fund gradually divests from the enterprise (the exit strategy). Depending on the type of enterprise and the environment, this can be through selling shares on the stock exchange, to the majority shareholders/co-owners or to third parties. The investor expects a sizeable valuation of the shares as the return on its capital and management inputs. Expected returns are frequently above 20 percent to compensate for the high risks involved.
However, two major constraints limit the use of equity finance for SMEs engaged in agricultural production and processing. The high risk of agricultural term investments and a secular decline in the terms of trade of agricultural products make it more difficult to obtain returns comparable to other sectors of the economy. Moreover, equity investments imply high transaction costs, both in appraisal of the investment opportunity - which normally includes sophisticated financial and economic analysis of the company, feasibility studies, business plans and exit strategies - and in monitoring and supervision of its management. Thus few commercially oriented equity finance providers are investing in the agricultural sector.
Despite the limited suitability of equity finance as a direct financing tool for small- and medium-scale farmers, equity investment in processing companies and plantations can have important backward linkages, enhancing the prospects for farm-level investments. The availability of processing and marketing outlets reduces risk for those farm-level term investments related to marketing and input supply. Moreover, they are often accompanied by investments in infrastructure such as roads, transport and storage or communications facilities.
Two institutional arrangements can be used to strengthen the links to small- and medium-sized farms engaged in primary production: contract farming arrangements, such as the nucleus estate smallholder schemes, and joint venture companies, in which farmers can acquire shares in production, marketing and processing facilities.
Advantages and disadvantages of venture capital
For the VCF
For the company
· Possibility of achieving high
· Less risky than bank loans (no
collateral, no fixed financial obligations, dividends depend on
For the VCF
For the company
· High risk, exit not
· The owner loses his management
Within nucleus estate smallholder schemes (NES), term loans might be provided by the processing company or a financial institution for long-term, farm-level investments such as land development, irrigation or planting of perennial crops. Loan repayment is usually collected in kind through the processing company. NES approaches have been used to finance perishable crops, which require close integration of production, processing and marketing, often in relation to export markets in vegetables, palm oil or sugar cane.
One of the main strengths of the NES approach is the planting of large areas under estate conditions, which allows economies of scale in production and marketing. It is particularly suitable for developing tree crops in sparsely populated areas, possibly in conjunction with settlement schemes. Moreover, in-kind collection means cost-effective loan recovery for crops with an immediate link to processing, provided that outside selling can be controlled.
In Indonesia, since 1977, about 400 000 ha of smallholder tree-crop plantation have been established under NES, including rubber (46 percent), oil palm (41 percent) and hybrid coconut, tea and coffee (13 percent). Many of the first-generation NES were funded by donors such as AsDB and the World Bank. It is based on linking of technical assistance, finance and output marketing.
The nucleus, a private company or parastatal agency, develops a large plantation using estate methods and technologies. Smallholders sometimes participate as wage labourers during construction. The establishment costs are financed through long-term loans provided by commercial banks, refinanced by credit lines from the central bank. When the tree crops come into production, part of the plantation is handed over to smallholder farmers (conversion). Normally, each smallholder receives 2 ha of the estate crop area plus 0.5 ha for growing food crops. To save transaction costs, smallholders are organized into blocks; and input supply and credit are often channelled through cooperatives that receive a fee of 2 percent for their services. Only plots fulfilling minimum quality criteria in terms of density and quality of trees are transferred to smallholders. The latter sign a smallholder credit agreement (SCA) that obliges them to sell all their produce to the nucleus. The smallholder loan includes the development costs of the 2 ha plot, plus the interest accrued during the immaturity period. The loan repayment amount is normally 30 percent of the produce delivered to the company.
However, the NES approach is also plagued by several weaknesses: One obvious problem occurs if there are competing buyers that can pay more for the produce (because no loan deductions have to be made). Outside selling to avoid credit repayment has been a particular problem for crops such as rubber and coffee, which normally have several marketing channels. This scenario is by no means uncommon, even for supposedly safe crops such as oil palm. In West Africa, there are small-scale, village-level processors as competing buyers, whereas in Asia, increased density of oil mills and/or better road networks have led to increased competition. Though beneficial to the farmer, this undermines interlinking as a loan repayment mechanism.
A further problem is that nucleus companies and outgrowers are highly unequal partners in terms of access to information, educational background and market power. Moreover, they do not have the same objectives. A monopsonistic situation always conveys the danger of opportunistic behaviour by the mills. If farmers feel cheated, they try to avoid the perceived exploitation through outside selling. Conflicts between smallholders and the nucleus are frequent, both in Indonesia and elsewhere. However, it has to be emphasized that outside selling can be minimized in well-managed NES schemes. Experience shows that efficient management and transparency in the calculation of deductions and the management of smallholder accounts are of utmost importance in achieving high repayment rates and creating a win-win scenario for all participants. This requires considerable input in farmer training and strengthening of farmer organizations, especially those in charge of account management.
A number of small palm-oil mills have sprung up on the periphery of the concession of the Ghana Oil Palm Development Company (GOPDC), in close proximity to GOPDC outgrowers. These mills pay the same price or slightly more than GOPDC and pay immediately in cash. The fact that GOPDC cannot pay in cash when produce is delivered is a major competitive disadvantage that strongly encourages producers to sell to other processors. The current GOPDC payment process takes about three weeks. At this stage in the life cycle of the outgrowers palm trees, the 17 000 ha under cultivation should be producing about 170 000 tonnes (10 tonnes/ha) of palm fruit per year. However, only about 120 000 tonnes are being delivered to the GOPDCs 32 collection stations or to the mill, suggesting a considerable level of extra-contractual marketing.
In response to this, the company has decided that seedlings, which previously were provided on credit, will now be sold for cash. Thus a new outgrower with the average 2.5 hectares would have to invest 6.5 million Ghanaian cedis (US$ 938) to start a new farm. Outgrowers feel that this investment would be such a high barrier to entry that it would exclude nearly all new entrants.
Potential for a win-win scenario
The possibility of establishing joint venture companies (JVCs) between farmers and commercial partners such as banks and agribusiness in the form of joint stock companies has received increasing attention recently. Such joint ventures may have several advantages over conventional approaches such as cooperatives or contract farming arrangements. They may overcome the typical management and capital constraints of cooperatives, while still enabling farmers to reap economies of scale, participate in profits of downstream activities and get reliable access to inputs, output markets and support services. If farmers are shareholders in processing companies, their income doesnt depend only on farming but also on patronage refunds, dividends and increases in the value of shares, which are marketable. Joint ventures between commercial farmers and landless workers have been used as an alternative to conventional land redistribution programmes in South Africa. The limited profit margins in agriculture can be increased through vertical integration.
Agribusiness investors may have different interests in and benefits from such partnerships. Conflicts might be resolved between commercial farmers and their workers (southern Africa) or between big plantation companies and smallholders/workers (Indonesia, the Philippines). The efficiency of contract farming and interlinking arrangements can be improved by avoiding problems related to asymmetric information and lack of transparency, which create mistrust and the incentives for free-rider behaviour such as outside selling or buying. As the Equity Share Schemes in South Africa demonstrate, better incentives and a sense of ownership improve the productivity of workers and lower costs related to supervision.
The potential of JVCs lies in the long-term nature of the partnership, which conditions the behaviour and expectations of both parties into a long-term horizon. The "corporative" approach (the Philippines) shows that incentives are particularly strong if farmers can increase their shares and eventually become the majority shareholders of the enterprise. Such a dynamic approach enabled RBP to divest its capital and provide a range of loan products secured only by interlinked transactions between the corporative, farmers and the bank. RBP was interested in building up a clientele with greater incomes and expectations - leading to more business for the bank.
Joint ventures might be set up as tripartite schemes among an agribusiness company, an equity investor (probably a development finance institution) and a farmer group. For example, the agribusiness investor would pay in the majority of the shares and manage the scheme. The equity investor would take a strong minority position. The farmers would make only a small initial contribution, with the option of gradually increasing their shareholdings, e.g. through deductions from the produce delivered. They would thus gradually buy out the equity investor.
The Philippines. Inspired by the corporative approach developed by RBP, the Land Bank of the Philippines (LBP) initiated the Access Programme in 1999. LBP finances up to 40 percent of investment costs as equity in an agribusiness company, established as a joint venture between a commercial entrepreneur and farmer cooperatives as raw material suppliers. Over a period of five to ten years, the cooperatives gradually buy out LBP through deductions from the proceeds of their product deliveries. Joint ventures between plantation companies and workers are also being used as vehicles within the land-reform process.
Kenya. The Kenya Tea Development Authority (KTDA), a former parastatal agency in charge of the smallholder tea subsector, gradually established 65 tea factories cofinanced by the Commonwealth Development Corporation (CDC), through equity finance, and the World Bank, through loans. During the last decade, smallholders gradually bought out CDC and the Government of Kenya through deductions from tea proceeds. Farmers now fully own the tea factories and KTDA, which still serves as their management agent. The listing of shares on the Nairobi stock markets is now under discussion.
South Africa. Equity Share Schemes (ESS) between landless black farm workers and white commercial farmers have been introduced in South Africa as an alternative to land reform. The approach has been designed for areas where high-value export crops are produced (apples, table grapes and olives), and redistribution of land would be prohibitively costly. Typically, the original owner-operator remains the (co)owner-manager, with a portion of the owners shares allocated to the workers/ shareholders (usually, but not always a minority). ESS normally have land redistribution and investment components. The model removes constraints on black farmers becoming individual commercial farmers - constraints related to high prices for suitable land and the lack of management expertise and bankability. The commercial farmer benefits from increased productivity and better working relations through an enterprise culture and may divest additional shares at a later stage to the workers trust.
A development bank or social investor could have a significant nonmonetary impact on the long-term stability of the JVC by safeguarding the interests of the farmers, especially during establishment of the joint venture. It could also act as an arbiter in case of conflicts. NGOs could play a similar role.
Issues and constraints in the governance and financing of a JVC
The establishment of a JVC of farmers, agribusiness and financial institutions must overcome a number of challenges. Some issues emerging from the case studies in South Africa and the Philippines illustrate how closely governance and financing issues are interlinked:
Profitability. The key condition for the viability of JVCs is high profitability. This is particularly important if the increase in farmer shares is to be financed gradually through deductions from purchase prices of agricultural products, wages or dividends. JVCs, with unequal partners, are more sensitive to low profits than other enterprises. If farmers do not receive competitive prices for their products, there is always the danger of outside selling and disintegration of the JVC. Commercial investors are less sensitive to short-term losses, but would also expect a reasonable return on both their capital and management inputs over the long term.
Asymmetric partnership. The structure of the JVC must address the huge asymmetries of the partners involved and provide the necessary incentives and safeguards. Commercial investors and small farmers differ not only in terms of socio-economic and educational background, but also with regard to risk aversion and their time horizon for investment decisions. Farmers need to receive tangible benefits that improve their living conditions rather soon, in order to develop a sense of ownership and feel committed to the JVC. On the other hand, joint ventures require financial stability, especially during the initial years. The use of discretionary dividends is one way to address these issues: the commercial investor waves its dividends until the capital base of the enterprise has been stabilized.
Distribution of shares among the parties. A marginal participation by farmers should be avoided, since it would not allow them to reap the potential benefits of such a partnership and may reduce the stability of the arrangement. The option of eventually becoming majority shareholders in the enterprise would provide a strong incentive to farmers to increase their production and the delivery of produce to the company. It may, however, weaken the incentive to the commercial partner and thus bring into question the long-term sustainability of the enterprise. A strong minority position for farmers might be the most feasible option, as it combines incentive to the main investor and availability of management expertise with meaningful participation by farmers, resulting in tangible benefits.
Financing initial capital requirements. Due to the high risk of investment in agribusiness, the initial capitalization should be based mainly on equity, subordinate loans or concessionary funds if available. This provides more flexibility to contingency operations, such as the waiving of dividends and divestments in order to ensure continuous payment of salaries and competitive purchase prices from shareholders. The gradual purchase of company shares by farmers should not be financed through loans. Moreover, farmers should also make a significant contribution at the outset of the venture in order to reduce free-rider problems.
Capacity-building. Farmers should become familiar with the basic concepts of company management and the rights and duties of shareholders. The issues of transparency and accountability must be resolved, especially if farmers are represented on the board of directors through a cooperative or trust. Mechanisms and procedures for conflict resolution must be established, and the drafting of related by-laws needs substantial external support. Once JVCs are introduced, sufficient funding must be earmarked for ongoing capacity-building and for support by competent legal and business advisors.
Exit and entry arrangements. Questions must be addressed regarding exit and entry options for existing and new shareholders, along with regulations on the tradability of shares. Can shares only be sold within the company or also to third parties? Do all farmers and workers automatically accumulate shares over time through deductions from their due payments, or can they opt for higher prices/dividends? When can shares be sold and what are the payment modalities? The sale of shares must be regulated to prevent windfall profits, particularly if grants are used for capitalization of farmer shares.
The limited evidence on using equity and loan finance to establish JVCs does not allow strong conclusions about the scope and replicability of this approach. Most equity finance and joint venture programmes supported by donors and governments are fairly recent. However, they show some promise and should be closely monitored.
 Start-up finance might
be acceptable if a loan applicant has gained experience as a worker on other
farms or plantations.|
 Finance frontier refers in this context to the type of clients and rural areas that can be serviced with term finance instruments.
 For example, dairy cows, tea, farm machinery and transport equipment.
 The capital recovery factor is used to transform the loan principal into periodic annuities at the interest rate of the loan. If the real interest rate is positive, inflation does not affect the real value of the loan principal and the spread of the lender is covered in the instalments.
 Equity Building Society and SACCOs provide similar loans to tea, coffee and dairy farmers.
 The South African Sugar Association provides medium-term loans of up to seven years to smallholder farmers on communal land. Sugar cane is bulky and has to be processed within hours after cutting, thus ensuring control by the mills over the output.
 The Kenya Cooperative Bank has financed a number of coffee factories run by marketing cooperatives. The availability of donor funds and the ability to deduct loan repayment at the source have undermined scrutiny in loan appraisal and contributed to oversized projects in an environment of declining international coffee prices.
 Diversion of inputs is more likely if in-kind provision of inputs is the only source of credit and farmers need liquidity for other consumption and productive purposes.
 In some cases such as in Bolivia, the regulatory framework for classification of past-due loans is not adapted to the specific conditions in rural areas. In this case, flexibility implies high costs for the regulated financial institutions due to the specific requirements of loan-loss provisioning.
 Thus ensuring that the asset can be used as collateral.
 For a more in-depth discussion of tax issues related to leasing in Latin America see Westley, 2003.
 Mismanagement of accounts or large deductions to cover high overheads of the nucleus have occurred frequently in Indonesia.