Posted November 1997

Participation in practice / 7 The financial component

ACCUMULATION AND REINVESTMENT of wealth are driving forces behind economic development. Financial institutions - such as banks, credit unions and informal savings societies - have, therefore, an important role to play in participatory projects: they provide a secure place for group members' savings, facilitate financial transactions and supply credit for investment in group activities.

In most developing countries, however, the rural poor have little, if any, access to institutional finance. This is partly because the rural poor lack the physical collateral normally required to qualify for bank loans. Another disincentive for banks is the high per unit cost of delivering financial services to the poor. Reaching and servicing large numbers of scattered and unorganized rural people is time-consuming, and the volume of their individual savings and loan operations is low. Dealing with the poor as individuals is simply not cost-effective for banks, nor is it profitable, given the interest rate ceilings under which most banks operate.

Facilitating savings and access to credit

Although PPP financial approaches vary according to local conditions, all of them share five basic elements:

• Savings first. Groups are encouraged to initiate group-based savings schemes prior to applying for bank loans. Progress in mobilizing group savings provides a measure of members' commitment to the group enterprise and their loan repayment capacity.

• Group savings and credit. Delivery of financial services to participatory groups, rather than individuals, carries cost advantages for both banks and the poor. For example, a joint loan application submitted by a group of 10 farmers reduces the bank's loan administration costs by a factor of 10. Group saving offers similar reductions in deposit account maintenance costs. Transactions costs are also lower for the group members: they need to prepare only one loan application and make a single trip to their local bank branch.

• Credit Guarantee Fund. To encourage an interested institution to lend to participatory groups, each PPP project provides a special Credit Guarantee Fund (CGF) to cover losses resulting from loan defaults. The fund, held in an interest-bearing account at the institution, is governed by a written agreement that sets out conditions under which loans are to be granted from the bank's own capital, as well as procedures to be followed in case of non-repayment of loans.

• Linking savings with credit. Through the CGF agreement, the cooperating bank also requires that groups open a joint savings account and make regular deposits for a specified period before becoming eligible for loans. Some projects limit the maximum amount that a group can borrow to a multiple of the amount in the group's savings account, or require the group to deposit part of its loan as savings.

• Loans based on social collateral. In PPP projects, the cooperating bank is encouraged to relax requirements for physical collateral and use "social collateral" in its place. Members of borrowing groups are held jointly responsible for the repayment of their group loan. Should one member of the group fail to repay his or her portion of the loan, the entire group loan is considered delinquent and all group members are barred from obtaining credit until it has been repaid. (This mechanism is partly responsible for the PPP loan recovery rate of 80-90%, roughly double the rate achieved by most small farmer credit schemes.)

• Group training in financial self-reliance. An essential element of PPP is the training of group members and leaders in the importance of achieving financial self-reliance. Groups are encouraged to exercise discipline in the use of savings and credit in order to maximize the income-generating potential of their activities, to accumulate wealth and to build credit-worthiness. The group promoter plays an important role in this education process and serves as a link between the group and the cooperating bank.

Adapting to local conditions The design and operation of the PPP financial component is tailored to conditions in individual countries. When the PPP project began in Ghana, for example, the country suffered from high inflation and a shortage of foreign exchange. To facilitate project operations, the guarantee fund was transferred into an Input-Import Fund held in convertible currency outside the country, while the Ghanaian Government allocated funds sufficient to cover most local currency costs. The collaborating bank received the inputs, which were then distributed to the participants on credit. The price of inputs in local currency was determined jointly by the government, the project and the bank. In Sierra Leone, where the PPP project provided credit directly, a detailed system was developed to provide and recover loans in kind. In Zambia, credit is administered by a national cooperative organization. Other project-specific arrangements include group marketing of surplus in Ghana and the formation of local credit unions in Lesotho.

There are several selection criteria. First, the institution should have a widespread network of branches in rural areas, and particularly in the project action area. Its management should be willing to introduce and test group approaches to delivering financial services to small farmers and should accept the concept of group-based social collateral. The institution should also agree to the establishment of the Credit Guarantee Fund. Finally, it should also be prepared to provide group-based or individual savings facilities for project participants and to introduce mechanisms to stimulate saving. Once an appropriate banking institution has been selected, the next step is to negotiate the Credit Guarantee Fund agreement. In PPP's experience, negotiation of this agreement may take time and project activities may have to begin before the actual agreement is signed. Nevertheless, the proposed agreement with the selected institution should be made a part of the project document.

To ensure that the bank provides proper supervision and technical support to its new clients, CGF agreements usually call for the setting up of a small farmer finance management committee within the bank to monitor the implementation of the project's financial component. Representatives of the cooperating bank may also be asked to serve on local or national project coordinating committees.

Finally, group promoters play a critical role in building up financial-self reliance among PPP groups. The GP must not only train members in basic financial skills, but assist the bank in recovering loans and building stronger links with the groups. As the groups reach maturity, however, this responsibility should be assumed gradually by inter-group federations. The federations thus complement - and help reduce the costs of - the bank's own supervisory and monitoring support.