agricultural finance: getting the policies rightagricultural finance revisited agricultural finance:...

Agriculture Finance Revisited

Food and Agriculture Organization of the United Nations (FAO)Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ)

No. 2

AgriculturalFinance:Gettingthe Policies Right

cover RP 12-08-1998 20:19 (1,1)

The designations employed and the presentation of material inthis publication do not imply the expression of any opinionwhatsover on the part of the Food and Agriculture Organizationof the United Nations concerning the legal status of any country,territory, city or area of its authorities, or concerning the delimi-tation of its frontiers or bounderies.

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© FAO 1998

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AGRICULTURAL FINANCE REVISITED

AGRICULTURAL FINANCE:GETTING THE POLICIES RIGHT

ELIZABETH COFFEY

June 1998

Food and Agriculture Organization of the United Nations (FAO)

Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ)

NO. 2

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Preface

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Policies are powerful tools. They are basic to governance and adminis-tration. They exist at several levels: national government, local govern-ments, and within firms and institutions. They are so basic that they areoften overlooked in the search for better ways of pursuing objectives.This applies in many spheres of human activity. It applies especially tothe provision of banking services for low-income people in rural areas.

Why is this the case?

There may be several reasons, and many of these are specific to a givencountry, district or institution. But a common thread is that the policieswhich affect agricultural and rural finance belong to several differentpolicy-making zones. Three in particular have an impact, namely: agri-cultural sector policy, financial sector policy and macroeconomic policy.Since many different groups are involved there is the danger that the spe-cial needs for rural banking could be overlooked, or, as is more likely,that policies will be developed which are partially in conflict with oneanother, rather than being mutually supportive.

What are the inputs to policy making?

The essence of successful policy making is that it captures the views ofall the stakeholders in the delivery of the policy, backed up by relevantanalyses of key data. This is not as easy as it might seem, for a furtherrequirement for an efficient policy-making system is that it is able to dothis on a continuing basis. Policy-making is an ongoing responsibility,not a single event.

Because a range of ministries, institutions, firms and individuals shouldbe involved, there are bound to be significant differences in the extent towhich influences can be brought to bear on the policy making process.Creation, and maintenance of a level playing field is a further require-ment for an efficient system.

This publication sets out to clarify the process of policy making for agri-cultural and rural finance, and dwells especially on the mechanismsinvolved. It is addressed to those responsible for formulating, managing

PREFACE

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and tending the rural financial system, namely, policy makers, donorsand managers of rural financial institutions. It lists some of the keyissues, and provides a Diagnostic Methodology which can be used as anaid in the evaluation of the comprehensiveness of a given policy-makingsystem at national level. Case study examples are presented throughoutthe document to highlight the importance of some key issues when for-mulating an agricultural finance policy.

FAO and GTZ see the Diagnostic Methodology as an evolving tool, andwelcome suggestions for its improvement.

This publication is the second in the series produced under the jointFAO/GTZ Initiative: Agricultural Finance Revisited.

Publications in this series comprise of the following:

• Agricultural Finance Revisited: Why?• Agricultural Finance: Getting the Policies Right• Better Practices for Agricultural Finance - Doing it Right• Sources of Funds for Agricultural Finance• Prudential Regulation and Supervision for Agricultural Finance• Improving Farmer Bankability and Financial Management Skills

R.A.J. Roberts A. HannigChief Lead Financial EconomistMarketing and Rural Financial SystemsFinance Service Development & Banking ServiceFAO GTZ

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INTRODUCTION

Introduction

Numerous changes have occurred in rural financial markets during thepast few years1. This includes the collapse of traditional institutionsthat once were the backbone of these markets, overall contraction in thevolume of agricultural credit due to hostile economic environments,repressed financial sectors, and a shift in donor interest to financingrural poor and small enterprises. These changes have been accompaniedby a switch in the dominant development paradigm from one emphasis-ing central planning to one that relies on market forces. Dissatisfactionwith the results of traditional agricultural credit policies and the incon-sistencies between these policies and the use of market forces are forcingpolicy reassessments in many countries.

Although numerous new or reformed financial institutions haveemerged, substantial gaps persist in many rural financial markets2.These gaps relate to scarce provision of formal agricultural credit tosmall farmers, a paucity of medium- and long-term lending, and fewdeposit facilities in rural areas. The absence of these financial serviceshave important implications for agricultural development and for smallfarm households. Major segments of agriculture cannot modernisewithout the support of a strong financial system; an increasingly capital-intensive agriculture requires access to working capital and seasonalloans along with medium- and long-term credit for on-farm investments.Likewise, many poor people in rural areas are disadvantaged by finan-cial markets that perform poorly. They have less opportunity to climbout of poverty by accumulating financial savings and they have noaccess to formal credit because the financial system is not innovative orsufficiently efficient to reduce transaction costs and to provide smallclients with access to affordable and durable financial services. A moreefficient financial system would help accomplish the dual objectives ofboosting production and easing rural poverty.

Recent experience provides useful lessons about rural finance policies,both positive and negative. These lessons are summarised in the first

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1 The term “rural finance” covers agricultural lending, loans made to non-farm ruralfirms, and deposit services in rural areas.

2 These institutions include non-governmental organisations, credit unions, privatebanks, village banks, and reformed agricultural development banks.

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part of the discussion that follows. This includes negative lessonslearned from past errors and more recent positive lessons derived fromexperiences with new policies and approaches. This is followed by asecond section where the process of policy formulation is discussed andan outline is presented of a framework that might be useful in formu-lating and implementing policies that strengthen rural financial markets.Specific country examples are presented in boxes that support the twosegments of the paper.

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Acknowledgments

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The author wishes to extend thanks to the many people who made thispublication possible. The contribution of Dale Adams to Part I of thedocument is particularly acknowledged as are his comments on variousdrafts.

Thanks to Richard Roberts and Anthon Slangen for their continual sup-port and contributions, in particular for their respective inputs to theKey Issues in the paper. Special thanks to Brigitte Klein for her valuablecontribution to the Diagnostic Methodology, her comments on variousdrafts and to her boundless enthusiasm.

The author also thanks colleagues Pekka Hussi, Åke Olofsson andThorsten Giehler in FAO, and Alfred Hannig, Sylvia Wisniwski andMichael Fiebig in GTZ for their inputs, constructive criticism and edi-torial advice in the production of this document.

ACKNOWLEDGMENTS

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Table of Contents

vii

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

PART I: LESSONS LEARNED

1. Performance of Agricultural Credit . . . . . . . . . . . . . . . . . . . . . 1

2. Directed Credit and Financial MarketDevelopment: Difference between Concept and Reality . . . . . . 72.1 Problem Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72.2 Role of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . 82.3 Users of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . 92.4 Sources of Loanable Funds . . . . . . . . . . . . . . . . . . . . . . . 102.5 Role of Subsidies and Taxes . . . . . . . . . . . . . . . . . . . . . . 102.6 Credit Information and Evaluation Systems . . . . . . . . . . 12

3. Transition to the “New” Approach . . . . . . . . . . . . . . . . . . . . 13

PART II: THE POLICY FRAMEWORK

4. Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4.1. Policy Fields Affecting the Formulationof Agricultural and Rural Finance Policy . . . . . . . . . . . . . . . . 224.1.1 Macroeconomic Environment . . . . . . . . . . . . . . . . . . 224.1.2 Agricultural Sector Policy . . . . . . . . . . . . . . . . . . . . . 274.1.3 Financial Sector Policy . . . . . . . . . . . . . . . . . . . . . . . 28

4.2. Essential Elements of Policy Making . . . . . . . . . . . . . . . . . . . 284.2.1 Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294.2.2 Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

TABLE OF CONTENTS

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4.2.3 Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324.2.4 Donor Co-ordination . . . . . . . . . . . . . . . . . . . . . . . . 34

4.3. Policy Making Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344.3.1 Summary of Key Issues to be examined

in Policy Making . . . . . . . . . . . . . . . . . . . . . . . . . . . 364.3.1.1 Main Objectives of Agricultural

and Rural Finance Policy . . . . . . . . . . . . . . 374.3.1.2 Main Policy Makers in Agricultural

and Rural Finance . . . . . . . . . . . . . . . . . . . 384.3.1.3 Policy Areas that affect the Provision

of Agricultural Credit . . . . . . . . . . . . . . . . . 404.3.1.4 Different Opinion Leaders

and Stakeholders and theirParticipation inthe Policy Making Process . . . . . . . . . . . . . 42

4.3.1.5 Role of Information and Researchin Policy Formulation . . . . . . . . . . . . . . . . . 43

4.3.1.6 Policy Monitoring and Evaluation . . . . . . . . 444.3.1.7 Role of the Government in Agricultural

and Rural Finance . . . . . . . . . . . . . . . . . . . 45

Case Study Boxes:

Box 1: Increased Outreach to Thai Farmers: BAAC . . . . . . . . . 3Box 2: Directed Credit Leading to Institutional Collapse:

BAP in Peru . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5Box 3: Social Concern versus Institutional Viability: India . . . 14Box 4: Lessons Learned from the Collapse

of an Agricultural Bank: BAP in Peru . . . . . . . . . . . . . 16Box 5: Mistrust in the Policy Dialogue: Zambia . . . . . . . . . . 24Box 6: The Importance of Leadership: Indonesia . . . . . . . . . . 29Box 7: Stakeholder Participation in Policy Dialogue: India . . 30Box 8: Non-Governmental Organisations (NGOs)

and Agricultural and Rural Finance . . . . . . . . . . . . . . 39Box 9: Rural Finance Policy Dialogue: Uganda . . . . . . . . . . . 41

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Table of Contents

Figures

Figure 1: Policy Fields Affecting The Formulationof Rural and Agricultural Finance Policy . . . . . . . . . 22

Figure 2: Diagrammatic Outline of the DiagnosticMethodology: Guidelines for the Formulationof an Agricultural Finance Policy (Annex 2) . . . . . . . . 26

Figure 3: Rural Finance Policy Making Process . . . . . . . . . . . . . 35

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

Annex 1

The Difference between the Directed Credit Paradigm and theFinancial Market Paradigm. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

Annex 2

Diagnostic Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

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PART I

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Part I: Lessons Learned

1. Performance of Agricultural Credit

Since the early 1950s governments and donors have spent large amountson agricultural credit programmes. The World Bank alone committedover US$16 billion to these efforts from the mid-1950s to the late 1980sand other donors also spent substantial amounts. In several countries,such as Brazil, India, Indonesia, Mexico, and Sri Lanka, supply-led anddirected credit programmes were the dominant tool used to spur agri-cultural development during the three decades prior to the 1990s. Incentrally planned countries directed credit was likewise a prominentinstrument used to implement agricultural production plans. However,directed agricultural credit programmes continue to play a strong role insome developing countries, e.g. the Philippines (see section 3).

The assumption behind these efforts was that many farmers faced liq-uidity constraints that limited their ability to make farm investments andto use additional modern inputs. Relaxing these constraints by provid-ing them with loans, therefore, was thought to be an easy way of stim-ulating farm investment, boosting the use of modern inputs, and aug-menting farm production. It was further assumed that most farmerswere too poor to save, that informal financial markets were dominatedby monopolist money lenders who charged usurious interest rates, andthat commercial bankers were too conservative to lend to most farmers.Based on these assumptions governments and donors developed andfunded numerous directed credit programmes around the world thatfocused on overcoming these problems. Most of these efforts were heav-ily subsidised by charging concessionary interest rates or tolerating loandefaults.

A common arrangement for providing rural financial markets withdonor or government funds was to open concessionary rediscount win-dows in the country’s central bank to disburse funds to selected groups,regions, or activities. Banks and other financial institutions were stim-ulated to grant targeted lending by making concessionary funds avail-able from the rediscount window. The interest rates on these funds weretypically lower than the rates lenders were paying for alternative sources

1

LESSONS LEARNED

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of funds. In the later 1970s, for example, the central bank in Indonesiaadministered nearly 200 directed credit lines, many of which were aimedat agricultural activities, and most of which were subsidised.

In some cases, the availability of rediscount funds was augmented byimposing loan portfolio requirements on commercial banks. Theserequirements were intended to compel banks to either make more loansfor purposes targeted by the government, or to lend on concessionaryterms to other institutions, especially agricultural development banksthat were doing targeted lending. In Thailand, for example, during the1970s and 1980s the government required all banks to lend an increas-ing percent of their total loan portfolio to farmers. If they were unableto comply directly with this requirement, they were allowed to fulfiltheir obligation by lending money at concessionary rates to the Bank forAgriculture and Agricultural Co-operatives (BAAC, see p. 8). In somecountries subsidised loan guarantee schemes were also established tofurther encourage agricultural lending. The assumption behind theseschemes was that by transferring part or all of the loan recovery risk tothe insurance programme, lenders would be induced to do more of thelending preferred by policy makers.

As part of this process, many countries formed or expanded agricultur-al development banks to handle the bulk of the targeted lending.Ministries of agriculture typically played a dominant role in these banks,and in the formulation and implementation of associated policies. Insome cases, especially in Latin America, these banks and ministriesformed supervised credit programmes that tied technical assistance andtraining to subsidised lending, especially during the 1960s. In manycountries political considerations were involved in loan approval andloan recovery decisions. Government-mandated loan forgiveness inBangladesh and Loan Melas (fairs) in India during the 1980s beingexamples of such political interventions in financial sector operations.

Shifts in political priorities and donor preferences have often resulted insubstantial changes in roles assigned to rural financial markets.Sometimes farm production and farm investments were stressed, whileat other times poverty alleviation, pacifying the countryside, or disasterrelief were the primary objectives of directed credit efforts. In severalcountries such as the Philippines and Indonesia, major segments of the


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Box 1

Increased Outreach to Thai Farmers:

Bank for Agriculture and Agricultural Co-operatives, BAAC

Thailand has been characterised by stable macroeconomic and open market policies

for the past decades. In 1997 before the currency and financial sector crisis, the Thai

government estimated an annual economic growth rate of 7-7.5%, while maintain-

ing inflation at 5%. Economic growth and stability are expected to result in a more

equal distribution of income, alleviate poverty and improve the quality of life of the

Thai people. In an attempt to achieve these objectives, clear targets are set by the

Ministries of Finance, Commerce, Communication, Central Bank, Budget Bureau,

Office of National Economic and Social Development and private sector bodies.

In the economic development process, the agricultural sector is expected to play a

major role. Past government policies have emphasised the accessibility of farmers to

agricultural credit at affordable costs. The government created the Bank for

Agriculture and Agricultural Co-operatives (BAAC) in 1966 with the objective of

attending small farmers, agricultural co-operatives and farmers’ associations.

However, despite government concerns, directed credit failed to meet the total farmer

demand. This led to a mandatory requirement for commercial banks to lend a min-

imum fixed percentage of their total lending to the agricultural sector (lending direct-

ly to farmers or lending money to the BAAC at concessionary rates) and this measure

has had a significant impact on increasing the volume of lending to farmers. In 1997,

80% of all Thai farmers are registered as borrowers with BAAC, either individually

or through membership of co-operatives and associations.

The charter of BAAC sets the framework for its credit operations, where lending is

possible only to farmers and until recently, exclusively for agricultural purposes.

Restricting lending to farming activities affects BAACs ability to attend the financial

needs of small-scale farmers who, due to the small size of their holdings, are also

dependent on off-farm employment and non-farm activities for additional income. A

proposal to amend the charter to allow all-purpose rural lending, thereby allowing a

diversified loan portfolio, is under consideration at parliament and is an essential pre-

condition for the profitability and continued viability of BAAC.

BAAC is under pressure to enhance the scope of its lending to cover an increasing

proportion of the poor farming population, while at the same time, it is required to

operate in a viable way. It receives support from the government for specific lending

programmes, while effective management and use of appropriate financial technolo-

gies have enabled BAAC to meet the challenge of viability and equity.



rural financial system were attached to crop production programmes. Inother countries such as Egypt and Brazil large subsidised credit effortswere justified on the basis of compensating farmers for other economicdistortions in the economy, such as food price controls or over-valuedforeign exchange rates.

The support for these traditional directed agricultural credit effortsbegan to wane in the 1980s and by the end of the decade most donorsand some governments sharply reduced their support for agriculturalcredit. In part, this decline in support was due to the unsatisfactory per-formance of these efforts. Critics increasingly argued that relatively fewof the credit subsidies were captured by poor people and that subsidisedand directed credit had a weak effect on farm production and invest-ment. Serious and chronic loan recovery problems, dependency on out-side funding, and overall costs eroded the support for these efforts. Poorperformance and the lessening of donor and government support led tothe collapse of many public agricultural development banks and rural(government directed) co-operatives in the 1980s. In some countriessuch as Peru and Bolivia traditional agricultural banks were closed (seep. 6). In other countries such as The Gambia and ex-USSR all or partof the development banks were sold or privatised. In still other coun-tries these development banks and rural credit co-operatives persist buttheir financing activities have been sharply reduced, such as inGuatemala, Nicaragua, and Uganda.

Several major forces led to the collapse of many of these directed creditefforts and to the general disillusionment with the directed-creditapproach. With the benefit of hindsight, it is clear that many of theseprogrammes operated in hostile economic environments that were notconducive to the development of healthy financial markets. Cheap foodpolicies, subsidised food imports, farm price controls, unfavourableterms of trade for agriculture, and distorted foreign exchange rates allcontributed to this hostile environment. In addition, little investment inrural infrastructure, lack of law and order, and failed land reform effortsfurther dampened economic incentives in some rural areas. Rural finan-cial markets cannot thrive and grow if their clients lack creditworthi-ness, lack the ability to repay loans, and are unable to save because theirincomes are depressed.

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5

Box 2

Directed Credit Leading to Institutional Collapse:

Banco Agrario del Peru (BAP)

The predecessor of the agricultural development bank in Peru (Banco Agrario del

Peru, BAP) was formed to provide loans (directed credit) to cotton, sugar and rice

producers in the coastal region. Shifts in focus occurred throughout subsequent

decades and were pronounced with changes in political power. Throughout the

1970s and early 1980s the number of employees and BAP branches rapidly expand-

ed to provide an increasing number of subsidised loans to remote areas (e.g., from

early 1975 to late 1979, the number of employees increased by 46 percent). The

adverse effects of this expansion on the administration costs was compounded by

hefty inflation that substantially exceeded the nominal interest rates charged on BAP

loans. In the late 1980s the government instructed BAP to disburse loans to disad-

vantaged areas at zero nominal interest rates with the promise to reimburse BAP the

interest rate subsidy, a promise that was not kept.

During this period, BAP did achieve considerable outreach, growing from 4 percent

of all farmers to 25 percent. By the late 1980s, BAP extended loans to farmers who

cultivated approximately half of the total land area. The growth of BAP caused a

crowding out of commercial banks. In the 1950s, BAP provided about one third of

all formal agricultural credit, the remainder being provided by the commercial banks.

However, by the late 1970s, BAP captured more than 90 percent of the formal agri-

cultural loan market and 80 percent thereafter.

In addition, the importance of savings mobilisation as a source of funds declined

rapidly throughout the 1980s when BAP became increasingly dependent on donors

and Central Bank funding. It was cheaper for BAP to utilise external funds than to

mobilise deposits from rural households. In addition, such dependency increased the

vulnerability of BAP to political intrusions and donor fads.

BAP faced both internal and external problems. Among the external forces, which

were beyond the control of BAP, were an unstable macroeconomic environment,

poor financial sector policies (forced interest rate ceilings, limiting the ability to price

financial products according to their costs and risks) and forced political directives

(sometimes loan approval and loan repayment decisions were made outside the

bank). Among the internal problems were lack of deposit mobilisation, dependency

on external funding, non-banking culture and huge administrative and transaction

costs. Close ties with the Ministry of Agriculture resulted in BAP recruiting individ-



Development of rural financial markets was further impeded by repres-sive financial sector policies. Interest rate ceilings were common on bothloans and on deposits. This limited the ability of lenders to charge cost-recovery rates on their loans and limited their ability to mobilisedeposits by paying attractive interest rates. Excessive legal reserverequirements were effectively a tax on deposit-taking and further low-ered the rates of interest that could be paid on deposits. Limits on bankbranching and on the formation of new financial institutions restrainedcompetition and efficiency improvements in the sector. In addition,design flaws in what has been called the traditional directed credit par-adigm contributed to the problems encountered in many rural financialmarkets. Support for the directed credit paradigm was further under-mined by the world-wide shift in development philosophy from one thatstressed central planning to one that stresses free markets. Credit plan-ning, credit directing, and credit subsidies are inconsistent with allowingfree markets to allocate scarce resources.

6

uals with a knowledge of agriculture rather than banking. Success was measured by

the number of loans disbursed, crops planted, investments funded and size of the

organisation. Little or no attention was paid to transaction costs, to administrative

costs, to quality of service, or to financial innovation. In some cases the bank was

required to charge the least for loans that were the most costly to administer. BAP

was constructed and operated in line with the old directed credit paradigm, compat-

ible with subsidies, suppression of market forces and central planning. As in many

other countries with the onset of market liberalisation, BAP collapsed and left a void

in servicing small farmers and rural households.

Source: Dale W. Adams and Juan Jose Marthans., “Benefits and Costs of

Liquidating an Agricultural Bank in Peru” and “The Rise and Fall of an

Agricultural Bank in Peru”, 1997.

Box 2 (Cont.)

Directed Credit Leading to Institutional Collapse:

Banco Agrario del Peru (BAP)



2. Directed Credit and Financial Market Development:Difference between Concept and Reality

The directed agricultural credit programmes proved to be subsidydependent, prone to disasters, and ineffective in helping to achieveimportant goals. Instead of building a sustainable financial infrastruc-ture, many of the directed credit programmes undermined the develop-ment of a viable financial market. Critics of the old paradigm increas-ingly claimed that cheap credit was ineffective in alleviating rural pover-ty, in stimulating agricultural investments and in spurring agriculturalproduction. The flaws of directed credit in the 1990s led to the forma-tion of a new paradigm, labelled the financial market approach. Thisnew paradigm is markedly different from the directed credit approach3.

For purposes of differentiating old policies from new policies it may beuseful to briefly outline six major features and to compare the two par-adigms on the basis of these features.

2.1 PROBLEM DEFINITION

The existence of market imperfections is often used to justify directedcredit. These imperfections may be seen as too few loans being made topoor people or to small farmers in general, exploitation of borrowers bymoneylenders, lack of loan collateral, or monopoly power in rural finan-cial markets. Other more sophisticated statements may include con-cerns about asymmetric information between lenders and potential bor-rowers that may limit the ability of lenders to determine accurately thecreditworthiness of some individuals, thus creating a so-called marketimperfection. In the past, there has been an over-emphasis on credit asthe cure for all small farmer ills. At the same time, there was little or noconsideration given to high transaction costs and to new financial tech-nologies that would reduce these costs. It is generally recognised that

7

3 The new “financial system” approach covers all financial institutions, financial markets

and instruments, the legal and regulatory environment and financial norms and behav-

iour (BMZ, 1994).


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providing banking services to farmers is more costly and difficult thanattending urban clients. With traditional banking practices, dispersedsmall farm households will, as a result, have limited access to financialservices.

This problem definition suggested three general policy avenues to over-come the observed imperfections. The first was to expand the formalfinancial system as rapidly as possible to fill some of the gaps in ruralfinancial markets. Second, this expansion, combined with regulation ofinformal finance might be instrumental in tackling the supposed monop-oly power of local moneylenders, thus forcing them through competi-tion to lower their loan charges. Third, efforts to overcome marketimperfections were directed explicitly at specific areas, activities and dis-advantaged population groups.

In contrast, the new financial market approach focuses on the high costsand risks associated with rural lending and on ways to overcome theseproblems. Since many of the financial transactions in rural areas aresmall—both for loans and for deposits—the transaction costs per unit ofmoney involved are necessarily high compared to larger transactions.Distances between clients and financial intermediaries, transport andcommunication difficulties, and the risky nature of agriculture that isvulnerable to natural disasters boost these costs. Weak land titling andcumbersome and costly court procedures also compound the problemsof providing conventional collateral for loans in rural areas, thereby fur-ther increasing the risks of rural lending. Reducing these costs and risksis the focal point of the new financial market development approach.These issues are dealt with in greater detail in another publication in theAgricultural Finance Revisited series; “Better Practices: Doing it Right”.

2.2 ROLE OF FINANCIAL MARKETS

Those supporting the directed credit approach assign numerous dutiesto financial markets. These include poverty alleviation, stimulating pro-duction and investments, boosting production, moderating the effects ofdisasters, helping to implement central planning, and providing employ-ment opportunities. Directed credit programmes were a major feature


9


of government and donor efforts to solve many development problems.It is paradoxical that proponents of the directed credit approach assignmany tasks to financial markets on the one hand, but on the other handpay little attention to maintaining the financial infrastructure needed tocarry out these assignments. The extensive use of agricultural develop-ment banks during the 1960s through the 1980s to administer largenumbers of targeted credit lines and their subsequent debilitation or liq-uidation being examples of this paradox.

In contrast, the new market approach assigns a more modest role tofinancial markets. Instead of involving financial institutions in distrib-uting subsidies and directing credit, the new approach stresses theimportance of the process of financial intermediation. The primary goalin improving this process is to enhance the efficiency of resource alloca-tion in the economy. This is done by efficiently mobilising deposits fromsavers who, otherwise, have only low-return options for investing theirsurplus funds, and then efficiently allocating loans to creditworthy bor-rowers who have too few funds to capitalise on viable investmentopportunities. Critics of the old paradigm argue that using financialmarkets to direct credit weakens the ability of these markets to effi-ciently intermediate between savers and creditworthy borrowers.However, the transition from the old to the new paradigm continues toencounter strong political resistance in many countries, as outlined insection 3.

2.3 USERS OF FINANCIAL SERVICES

Under the directed credit approach the recipients of targeted loans areoften called beneficiaries. They are seen as benefiting from the efforts ofcredit planners or providers of subsidised loans, for example, for peoplewho merit sympathy and special attention. Such altruistic views may belater engaged to justify slack loan recovery procedures, thus furtherexpanding the magnitude of the credit subsidy. It is a short step fromjustifying an interest-rate subsidy on loans for people because they arepoor, to justifying loan forgiveness because poor borrowers later turnedout to be “too poor” to repay their loans.


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Under the new financial market approach there are no subsidies associ-ated with loans so there are no favours associated with lending.Financial intermediaries must treat their borrowers and depositors asvalued clients if they are to stay in business. This forces intermediariesto be attentive to the quality of services they provide, to the transactioncosts they impose on their clients, and to financial innovations thatreduce these costs.

2.4 SOURCES OF LOANABLE FUNDS

Financial institutions that provide directed credit usually rely on “out-side” funding: government funds, donor resources, or concessionaryloans from other financial institutions. In some cases, institutions thatprovide subsidised loans are not involved in the mobilisation of theirown internal funds, and in other cases they do capture some deposits,but without much enthusiasm because using external funds is less cost-ly. Likewise, subsidised interest rates on loans force deposit-takers tooffer even lower rates of interest on savings, thereby weakening theincentives of savers to deposit surplus funds in banks.

Financial institutions that are heavily involved in channelling subsidisedcredit tend to become left handed-the left-handed portion of financebeing lending and the right-handed portion being deposit mobilisation.The users of financial services in a system strongly influenced by direct-ed credit tend to be borrowers rather than depositors; the system is bor-rower dominated. By contrast, the new financial market approachstresses the importance of mobilising local deposits, and efficiently inter-mediating between savers and borrowers.

2.5 ROLE OF SUBSIDIES AND TAXES

Subsidies play an important role in directed credit and are, perhaps, itsdistinguishing characteristic. There is little logic in attempts to directcredit without subsidies. These subsidies can take the form of conces-


11


sionary interest rates on funds provided to lenders, subsidised interestrates on loans made to beneficiaries, implicit subsidies involved in loansthat are not repaid and written off, government or donor grants to covercosts of institutions involved in directed credit, and subsidies for sup-porting loan guarantee schemes.

The old adage that there is “no free lunch” applies to credit subsidies.For every subsidy there is a tax. Someone must pay for subsidiesthrough explicit or implicit taxes. The incidence of the tax associatedwith directed credit subsidies will vary from case to case, but is likely toinvolve some or all of the following: explicit taxes on the citizens of thecountry that are used to fund government subsidies, explicit taxes onpeople in foreign countries that fund donor aid programmes, implicittaxes on holders of financial assets imposed by inflation caused by mon-etary issuance to finance credit subsidies, and implicit taxes on deposi-tors who receive low rates of interest on their savings as a result of sub-sidised credit programmes.

An important objective of the new financial market approach is to elim-inate subsidies in rural finance, especially those related to low lendingrates, that do not cover all financial intermediation costs, or loandefault. Market forces, instead of subsidies, are relied upon to mobilisefunds from savers and enforce financial intermediaries to improve theirloan allocation and loan recovery. Any subsidies should be temporaryand transparent and not linked to lending activities but rather to insti-tution building. To help reduce transaction costs, for example, trainingfor bank staff in new lending practices or for banking operations andautomation may be subsidised.

The absence of subsidies allows financial institutions to focus on finan-cial intermediation. Since financial institutions are not processing sub-sidies under the new system, they are much less susceptible to rent seek-ing and corruption, common features of the directed credit approach.



12

2.6 CREDIT INFORMATION AND EVALUATION SYSTEMS

Typically, the volume of information associated with directed credit pro-grammes is substantial. Each directed credit line typically has its ownidiosyncratic data requirements, including collecting extensive informa-tion about characteristics of final borrowers and measuring the impactof credit on beneficiaries. Each credit line may require lending organi-sations to submit periodic reports to the providers of funds. It is notuncommon for the ample amounts of direct-credit information to crowdout other information flows that might be more useful to managers ofthe financial institutions. Managers of directed credit programmes maybe able to provide detailed information on data required by fundsproviders, but be unable to generate critical up-to-date managementinformation, such as the status of loan recovery. Concerns about meet-ing lending targets may also deflect policy makers from monitoring theoverall performance of rural financial markets.

To justify the subsidies associated with directed credit programmes, it isalso common for credit planners to require that credit impact studies bedone on these programmes. These studies usually require collection ofcostly primary data that is not ordinarily assembled by lenders. Thecosts of managing the dense volume of information generated by direct-ed credit activities typically augments loan transaction costs for bothlender and borrower.

In contrast to the dense information systems in the directed creditapproach, the financial market approach generates less but more usefuldata. The absence of numerous directed credit lines eliminates the needto process data for each sub-programme. Since the new approach stress-es making loans based on creditworthiness, rather than on the basis ofneed, there is likewise much less data processed on the characteristics ofborrowers and the impact of these programmes.

The focal point of data gathering and processing under the newapproach is to provide information that is essential to manage financialintermediaries efficiently and prudently. The performance of financialinstitutions is measured by indicators such as deposit mobilisation,transaction costs, loan recovery, number of clients, and financial and


13


operational sustainability. In sharp contrast to the costly data that arecollected to measure the credit impact at the borrower level under theold approach, performance under the new approach is largely measuredusing information normally collected by well-managed financial institu-tions.

Annex 1 summarises the difference between the old and new paradigms.

3. Transition to the “New” Approach

World-wide, the switch from directed credit to financial market devel-opment is only partial. In countries such as Chile, El Salvador,Indonesia, Peru, and Uganda only a few remnants of the old directedcredit approach remain. In many other countries the conversion to thenew approach has been less complete. Typically, partial conversionsinvolve interest rate deregulation and a reduction of subsidies and fewerfacilities in central banks providing concessionary funds to lenders. TheInternational Monetary Fund and the World Bank have played key rolesin prodding this conversion as part of the economic reforms under struc-tural adjustment programmes, that aim at creating economies that areless planned and more market driven.

Understandably, these conversions usually encounter strong resistance.Directed credit programmes were put in place for powerful reasons (seeBox 3). Various interest groups pushed for their formation and thesegroups often argue for their continuance. These interest groups includedonors who have found it easy to move relatively large amounts ofmoney through directed credit programmes, politicians who are able toquickly respond to crises by announcing a directed credit initiative, man-agers and employees of development banks who benefit from handlingdirected credit programmes, and the beneficiaries who are able to cap-ture the subsidies involved in these programmes. Since the benefits (sub-sidies) from these programmes are usually concentrated and the costs(taxes) diffused, it is much easier to mobilise defenders of the benefitsthan to organise those who bear the costs of these programmes.


14


Many policy makers and politicians continue to support directed credit.They believe that subsidised credit is an effective tool for alleviatingpoverty, stimulating technological change, promoting desirable invest-ments and boosting production. It often takes time for policy makerswho have been steeped in the visible hand of central planning to over-come the directed-credit habit and develop confidence in the workingsof the invisible hand of the market. The mixed signals that policy mak-

Box 3

Social Concern versus Institutional Viability:

India

The National Bank for Agricultural and Rural Development (NABARD) was creat-

ed as an apex level financial institution in 1982 to provide guidance and focus on

rural finance. It has also been given a mandate to co-ordinate, supervise and build

the capacity of rural financial institutions. It sets down policies on lending rates,

institutional development and regulation and supervision of rural financial interme-

diaries. It also provides finance to primary lending institutions for on-lending to the

rural population and supplies a substantial part of the credit demand in rural areas

through refinancing.

An economic reform package was launched in 1991 and to date the response of the

different sectors to a market oriented private sector economy has been positive.

Agriculture, however, has been subject to limited reform in the ongoing liberalisation

process. The main government objectives of agricultural policy continue to be of a

social and political nature. It is now recognised that subsidised directed credit pro-

grammes to the rural and farming sectors and to selected beneficiary groups within

the rural population have not achieved their objectives. The social objective of

poverty alleviation through subsidised credit has not been achieved and the creation

of a strong rural financial system has been undermined. Policy in the past, while it

concentrated on subsidised credit, also supported an expanded outreach, but finan-

cial deepening and widening and viability and sustainability of financial institutions

was not part of this policy framework. New policies in the financial sector are imple-

mented by institutions, therefore changes at policy level in the financial sector deter-

mine the shape and nature of rural financial institutions. As the government owns

85% of rural financial institutions, government interventions continue, particularly

in the areas of promotion of different types of financial institutions and disbursement

of credit to priority sectors.


15


ers may receive from donors further complicates the move away fromdirected credit. It is still common for some donors to tie their assistanceto credit lines that aim to support specific target groups such as women,small farmers, and microentrepreneurs4.

Events in the Philippines over the past two decades illustrate the prob-lems associated with attempts to shift from the old to the new paradigm.In the early 1980s the financial system in the Philippines was severelystressed and the government initiated substantial financial sectorreforms. This included deregulation of interest rates, allowing morecompetition in banking, and closing most of the discount lines in theCentral Bank that had provided large amounts of subsidised and direct-ed credit. On the surface, at least, the Philippines appeared to havelargely adopted the new financial market approach. Recent analysis,however, showed that directed credit is still common in the country.Research has documented about 90 directed credit programmes in thePhilippines, most of which involved substantial implicit or explicit sub-sidies. Many of these programmes resulted from political mandates tosatisfy the demands of special interest groups and a number of thedirected credit programmes were supported by donors. Although thenotion of charging market interest rates has been widely accepted, thereare often substantial differences between interest rates charged on tar-geted loans and the rates that are required to cover all financial trans-action costs and credit risks.

Experience suggests that rapid conversion to the new financial marketparadigm only occurs when policy makers are faced with a collapse intheir financial sector and/or when political leaders are not subject tostrong democratic forces. Even in these cases, there are periodic calls fora return to subsidised directed credit. The more typical cases are incountries where economic crises are less intense and where leadership ismore subject to democratic forces. In these cases it is common for pol-icy makers to straddle the new and old views. This typically involvescharging less subsidised interest rates on loans, but not stimulating

4 Most donors have not adjusted their rural or microfinance strategy so that it reinforces

deposit mobilisation, a vital component of the new financial market development

approach.



16

deposit mobilisation and reduction of transaction costs, which are othervital elements in the new approach.

The issue of whether to restructure or abolish state-owned agriculturaldevelopment banks in the shift from directed credit to financial marketdevelopment needs to addressed in many countries (see Box 4). In orderto survive, such banks must first emphasise their role as financial inter-mediaries rather than attempting to promote the adoption of particular

Box 4

Lessons Learned From the Collapse of an Agricultural Bank:

Case: Banco Agrario del Peru (BAP)

When attempting to transfer lessons learned from one country to another, one needs

to be cautious. Nevertheless, lessons learned from the collapse of the Banco Agrario

del Peru (BAP) provides some useful pointers for governments that have to address

bank liquidation. In many cases in the past, closing a specialised agricultural devel-

opment bank has proven to be an easier option rather than assessing the reasons why

the bank performed poorly and trying to resolve this.

Forcing development banks to manage large numbers of directed credit lines dimin-

ishes transparency and masks useful information. In addition, banks that provide

highly subsidised directed credit discourage other financial institutions from expand-

ing rural operations and, when they are liquidated, they leave a large void in rural

areas.

Governments must recognise their role in the creation and maintenance of a finan-

cial infrastructure that supports rural development. At least they should direct pru-

dential regulation and supervision, especially for those institutions handling deposits,

demanding information that clarifies the financial performance of banks, thereby

ensuring transparency. Governments may also provide seed capital for start-ups or

temporary subsidies to strengthen existing financial institutions. Correct policies

include allowing lenders to charge market interest rates that fully cover their costs

plus allowing a reasonable profit margin.

Changing public and private sector roles and economic environment requires both

incentives and time. The incentives include changes in the role assigned to new and

existing organisations. The changes involved in successfully developing new finan-


17


cial institutions may be similar to the changes needed to successfully reform existing

development banks. If policy makers cannot effect these changes through reforming

development banks, they may be unable later to effect similar changes in promoting

successful new financial institutions. Indeed, policy makers may be later forced to

establish new institutions using remnants from the old development bank.

Conditions necessary to successfully reform a traditional agricultural development

bank or to create efficient and durable alternative rural financial institutions are

essentially the same. They both require favourable macroeconomic and financial

sector policies that reinforce rather than destroy financial institutions, free them

from political interference and instil financial discipline.

Source: Dale W. Adams and Juan Jose Marthans., “Benefits and Costs of

Liquidating an Agricultural Bank in Peru” and “The Rise and Fall of an

Agricultural Bank in Peru”, 1997.

Box 4 (Cont.)

Lessons Learned From the Collapse of an Agricultural Bank:

Case: Banco Agrario del Peru (BAP)

crops or the adoption of specific technologies. The most difficult con-straint facing these banks if they are to operate in a liberalised, compet-itive market is to overcome the deficiencies arising from state ownership.

If policy makers wish to accelerate the pace of the conversion from theold directed credit to the new approach of rural financial intermedia-tion, experience shows that there are systematic ways of doing this. Themanner in which policies can be harnessed in this task is explored below.


PART II


Part II: The Policy Framework

4. Policy Framework

A policy can be best described as a framework or strategy,giving a broad outline of the direction and overall strategyfor the development of a particular sector. It is formulatedby central government, from within a particular ministryto regulate the performance of individual sectors (OECD,1988).

Policies often focus on creating a strategy which will arrest the declineof a specific sector or redress the imbalances which have occurred as aresult of market forces. It is usually possible to identify a number of dif-ferent functional sectors which normally correspond with the division ofthe government into ministries or departments. However, the formula-tion or re-definition of an effective policy for rural finance does not referto a single sector, but rather to three main policy spheres which areclosely interconnected and include the prevailing macroeconomic para-meters, the agricultural sector and the financial sector (see Figure1).

Moreover, during rural finance policy analysis and formulation, inter-national and regional trade should be considered in view of the currentincreasing globalisation of the world economy.

All three policy areas have their own impact on the effective provisionof financial services. Generation of an effective agricultural and ruralfinance policy depends on the definition of a clear overall rural financepolicy framework and strategy. Tensions and contradictions do occurbetween each of these policy areas, which need to be debated andaddressed through effective and continuous policy dialogue. Often,however, an effective policy dialogue platform does not (yet) exist, as isthe case in Zambia (see Box 5), with a lack of confidence between thepublic and private sectors.

21

THE POLICY FRAMEWORK


22


Figure 1: Policy Fields affecting the formulation of Agricultural and RuralFinance Policy

4.1 POLICY FIELDS AFFECTING THE FORMULATION OF AGRICULTURAL

AND RURAL FINANCE POLICY

The existence of a favourable and stable macroeconomic environment isimperative for the development of a country’s economy.

4.1.1 Macroeconomic Environment

The macroeconomic policy conditions and legal framework that exist ina developing country can either enhance or impede the development ofagriculture and the financial sector. Governments and donor agenciespresently acknowledge the necessity of an enabling environment for pri-vate sector development, but all too often in the past they have sup-ported direct government interventions and supply-led credit pro-grammes to achieve short-term social equity objectives, which in mostcases have performed poorly through inefficient management and polit-ical interference.


23

The sequencing of structural adjustment measures in a liberalised mar-ket environment has strong implications for the development of both theagricultural and financial sector. In the standard model of structuraladjustment, demand management stabilisation measures should precedeconventional structural production adjustment measures. More specifi-cally they argue that domestic financial markets must be liberalisedbefore product markets are reformed, otherwise limited access to effec-tive financial services will hamper the performance of scheduled privati-sation programmes. Inefficiencies in the financial sector, if not address-ed and corrected in time, will arrest, in this case, the development of thenon-financial sectors.




24

The Agricultural Sector Investment Programme (ASIP) was launched in Zambia

1992, and constitutes the basis for the agricultural policy. Its main weaknesses are:

the absence of a comprehensive policy and planning framework; delays in imple-

mentation of the restructuring of the Ministry of Agriculture; lack of donor interest

in supporting an appropriate rural finance strategy, lack of effective government sup-

port to private sector development and lack of confidence between the public and pri-

vate sector.

The Ministry of Agriculture as key player in the field of agricultural finance sup-

ported directed agricultural credit programmes until 1997. The national Agricultural

Credit Management Programme (ACMP), was characterised by high credit adminis-

tration costs, lack of accountability and dismal loan recovery rates. Seasonal fer-

tiliser credit to farmers, based on fertiliser donations, seriously distorted private sec-

tor fertiliser marketing operations. A strong contradiction existed between the gov-

ernment interventions in fertiliser marketing and fertiliser credit for maize produc-

tion, alongside the rapid overall privatisation of the economy.

In these circumstances, it is hardly surprising that the private sector, in particular, is

not convinced that the government commitment to privatisation and reform is real

and permanent. In view of the strong mutual mistrust between the public and the

private sector, there is a definite need for establishing an effective policy dialogue

platform, where all stakeholders, ranging from government to farmer organisations,

private sector and donor agencies can discuss main issues and thus influence sound

decisions concerning the development of an effective agricultural finance policy.

Box 5

Mistrust in the Policy Dialogue: Zambia



25

Appropriate government policy support measures that facilitate the roleof the private sector, and in particular, provide favourable investmentopportunities for small-scale farmers, should recognise the interdepen-dence of the financial and non-financial sectors.

While measures to create a favourable policy environment for agricul-tural and rural finance are necessary, they may not be sufficient in them-selves. Development of rural financial markets requires a supportivelegal and regulatory framework, and direct interventions may be need-ed to accelerate the building of robust rural financial markets.Formulating appropriate prudential banking laws, financial contractlaws and procedures for the effective enforcement of these contracts areimportant areas for policy interventions in developing countries andcountries in transition, in view of the recent changes in the macroeco-nomic environment as a result of liberalisation and globalisation.Financial institutions cannot depend solely on agricultural lending,which faces high risks; indeed the trend is to restructure agriculturalbanks into universal rural banks. The banking legislation should speci-fy the contractual form for agricultural loans and strengthen theirenforcement mechanisms. Under the joint FAO/GTZ programmeAgricultural Finance Revisited, a separate publication entitled“Prudential Regulation and Supervision for Agricultural Finance” willbe produced in the planned series of documents.



26

Figure 2: Diagrammatic Outline of the Diagnostic Methodology: Guidelinesfor the Formulation of an Agricultural Finance Policy (Annex 2).


27


4.1.2 Agricultural Sector Policy

Governments must sincerely work for the removal of pric-ing and supply distortions in agricultural products so thatactivities supported by credit may be sufficiently remuner-ative for small farmers’ (Chowdhury and Garcia 1993, p.43).

The crucial issue in agricultural sector policy is the profitability of farm-ing. As long as this remains low, then lending for agricultural produc-tion will be risky. It is important that the agricultural sector becomes asprofitable as other sectors if it is to attract funds for viable investments.While no simple solution exists, the formulation of effective policies foragricultural sector development is imperative. Appropriate macroeco-nomic policies and the provision of essential rural infrastructure andsupport services such as roads, markets, agricultural research and exten-sion are crucial to making farming more profitable in developing coun-tries and countries in transition. Favourable agricultural policies createan environment in which private financial institutions are willing to ser-vice farmers.

Governments should avoid undue taxation of agriculture. Instead, pol-icy makers should liberalise agricultural trade and product prices, thusmaking on-farm investments more profitable and attractive, as well asbenefitting the national economy. While accessible credit and depositfacilities may help poor rural people to smooth their production andconsumption needs, there may be limited opportunities for farmers andmicroentrepreneurs to use these facilities productively, unless accompa-nied by a broader set of non-financial support services and investmentsin rural infrastructure. There are different interests at stake in anattempt to address this issue (see Figure 2), which are further investigat-ed in the Diagnostic Methodology (Annex 2).



28

4.1.3 Financial Sector Policy

In all cases, government should be guided by the principlethat any intervention should only be directed to improvingthe workings of financial markets (Stiglitz, 1994).

Rural financial reforms should be a vital part of financial sector reform.The challenge is to promote a variety of viable financial institutions thatare client oriented, that mobilise deposits efficiently, and that provideaccess to loans to a broad spectrum of farmers, agribusiness entrepre-neurs and other rural clients. Policies should facilitate the experimenta-tion and adoption of new financial technologies and development ofattractive financial products.

The new financial market approach does not ignore the important roleof government in reducing risks and increasing confidence, by improv-ing information and providing incentives to improve the performance offinancial intermediaries. In particular, the government has specific pow-ers regarding taxation, subsidization, regulation and enforcement thatcan influence the direction of desired developments.

Successful financial intermediation, in particular, is dependent upontransparency and accountability. Financial institutions should haveupdated and accurate information systems in place, that are readilyavailable not only to management and bank supervisors but also to pol-icy makers, to assist them in policy revision for improved delivery ofagricultural and rural financial services (see Section 4.2.3).

4.2 ESSENTIAL ELEMENTS OF POLICY MAKING

Although policy making is more an art than a science, at least five com-mon elements are involved in the formulation of rural finance policies:exerting leadership, forging coalitions, providing essential information,promoting donor co-ordination and establishing a framework thatallows the interaction of these four elements.


29


4.2.1 Leadership

One of the results of dismantling traditional directed agricultural creditprogrammes and institutions is that it creates a leadership vacuum inrural finance. The Minister of Agriculture and the head of the agricul-tural development bank were typically responsible for tending the agri-cultural credit system. In many countries that leadership has been dis-

It should be recognised that the expansion of rural banking and the success of Bank

Rakyat Indonesia (BRI) and Badan Kredit Kecamatan (BKK) with rural village bank

units in Indonesia can be attributed to location specific factors. These include: strong

and continuous government support without government interference in bank man-

agement; social sensitivity and cohesion and in particular a conducive macroeco-

nomic environment.

Supportive decentralisation and market-based savings and lending strategies togeth-

er with technical and financial support have filtered down from the Ministry of

Finance through the local government structure to villages. Most of the government

support has been at policy level and has not resulted in bureaucratic interference in

day-to-day operations of banks. The growth and continued evolution of the rural

banking system in Indonesia is the direct result of the presence of a determined leader,

the Minister of Finance, committed to the promotion and strengthening of rural

financial intermediation.

Of significant importance is that external donor assistance was offered to the

Ministry of Finance and the Bank of Indonesia while technical assistance was pro-

vided within an already existing strategy context. This situation contrasts with many

rural banking programmes in other countries where the order is reversed. In this case

the government has little or no involvement in the policy design and implementation

process.

Source: Patten, H.P., and J.K. Rosengard, The Development of Rural Banking in

Indonesia. A copublication of the International Centre for Economic

Growth and the Harvard Institute for International Development, 1991.

Box 6

The Importance of Leadership:

Indonesia



30

For many years now, a reasonably effective policy dialogue platform for agricultur-

al finance has existed in India. The participants in this platform include:

• Members of Parliament, especially those representing rural areas;

• Central Bank;

• Ministries of Agriculture, Finance;

• Commercial and Co-operative Banks;

• National Bank for Agriculture and Rural Development (NABARD);

• Others: e.g. Farmers’ Unions

Ideas for policy amendments generally come from Members of Parliament. Their

role is that of spokesmen for their constituents, rather than as legislators, per se.

Government ministries and the banking sector attempt to accommodate required

changes within existing regulations wherever possible. Any new legislation, of

course, requires a much longer period of time than if changes can be accommodated

under the existing laws.

The policy dialogue platform exists at two levels. Firstly, formal meetings are held

at frequent intervals. Secondly, informal contacts take place between various part-

ners in the policy dialogue process on a more or less continuous basis. Despite the

comprehensive nature of policy dialogue, there have been a number of problems,

such as the fact that some institutions come under State legislation and/or co-opera-

tive legislation, which may lag behind national (All-India) banking legislation in

terms of suitability following structural adjustment reforms. In addition small farm-

ers experience difficulty in having a voice in the policy making process, where par-

ticipation is based on crop commodity associations, such as sugarcane, cotton,

tobacco, cashew nuts and plantation crops.

The intensive lobbying by various interest groups means there is potential to distort

credit policies. Information is essential in the policy making process and feedback

from the various interest groups should be organised in a systematic way, with

increased emphasis placed on the effective participation of grassroots farmer organ-

isations in the policy making process. Additionally, there is a need for a legal frame-

work and supervisory body for NGOs operating in India.

Box 7

Stakeholder Participation in Policy Dialogue:

India



31

solved as agricultural development banks have collapsed, governmentsand donors are reducing their agricultural credit funding, and ministriesof agriculture, under structural adjustment programmes are increasing-ly isolated from decisions that affect rural finance. Rural finance policydecisions are typically unattended in ministries of finance as they areengaged in addressing overall problems in the economy and the finan-cial sector, and are not familiar with agricultural and rural development.

Policy makers often implicitly assume (or hope) that the private sectorwill automatically rebuild or develop a rural financial system oncemacroeconomic and financial sector reform measures have been imple-mented. Experience in many other countries, however, strongly suggeststhat the high transaction costs and risks involved in rural finance requirespecial government attention. This attention, in turn, requires strongleadership.

At least two leadership forms have emerged in low-income countriesengaged in structural adjustment. The first form is where a single indi-vidual, such as a dynamic minister of finance or a new head of areformed government-owned agricultural development bank takescharge. This was the approach used in El Salvador, Indonesia, (see Box6) Malaysia and Thailand. In the last-named country one large and rel-atively efficient public agricultural bank (BAAC) continues to play adominant role in agricultural finance.

The other model is to appoint an inter-ministerial and inter-agency con-sultative policy committee on agricultural and rural development thattakes charge of formulating rural finance policies (see Box 7, India)5.

The committee is comprised of all the stakeholders that are involved inrural finance. This model also exists in the Philippines and in Uganda(see Box 9), where a variety of organisations are involved in ruralfinance policy formulation.

5 An inter-ministerial inter-agency committee appears to work best if it is chaired by a

high level official from the financial sector, rather than someone representing agricul-

ture.


32


4.2.2 Coalitions

Under the directed credit approach, various coalitions of interest groupswere formed. They included farmer groups whose members were ableto capture sizeable amounts of subsidised credit, labour unions in gov-ernment-owned banks whose employees depended on directed creditprogrammes, politicians who built their reputations by dispensing sub-sidised credit, and donors who were able to fill lending quotas throughdirected credit programmes. The configuration of these coalitions is dis-rupted when attempts are made to switch support to the new financialmarket approach. Farmer organisations protest that their members areunable to pay higher interest rates, government-owned bank employeesgo on strike when their organisations are down sized or threatened withliquidation, politicians continue to pass laws that encourage subsidisedand directed lending and some donors may fund programmes that areinconsistent with the new approach.

Sustaining policies that support financial market development necessi-tates defending new policies against these old coalitions, and likewisedeveloping new coalitions that support the new views. New coalitionsmight be fostered among some of the following groups: opinion makerswho are concerned about creating a more efficient and durable ruralfinancial infrastructure, savers who would benefit from more attractivedeposit services in rural areas and higher interest rates, non-farm ruralentrepreneurs who wish to have access to formal finance, and farmerswho, previously, were unable to access subsidised credit.

Policy workshops or seminars may be useful tools to build support forthe new view of financial market development and also to co-ordinatedonor and NGO efforts (see Section 4.3.1.5: The Role of Informationand Research in Policy Formulation).

4.2.3 Information

Information is an essential element in policy formulation and relevantdata pertaining to agricultural finance must be collected. The diagnos-tic methodology which has been developed by the FAO/GTZ team (seeAnnex 2) may assist governments and donors in the task of data collec-tion and analysis.


33


Once a policy has been formulated, monitoring of key indicators is ofgreat importance. Bank data constitute a key element in the assessmentof the effectiveness of current policies. In particular, data that relate tothe volume, composition and performance of agricultural and rural loanportfolios, as well as savings deposits, provide valuable assistance in pol-icy review. Presently, bank data are believed to be insufficiently used inpolicy generation and revision, while in many cases existing data whichare unreliable and not up-to-date need to be improved. The use ofaggregate data (to ensure confidentiality), is recommended. Clear stan-dards need to be set for the collection of consistent bank data, andwhere necessary, management information systems (MIS)6 need to beput in place, implemented and maintained.

Applied research that addresses concerns raised by key policy makers,study tours to successful examples of agricultural and rural finance inother countries and careful diagnosis of traditional directed credit pro-grammes that failed in the country, are extremely useful in building sup-port for the new approach.

6 The use of computerisation, e.g. the FAO MicroBanking System, designed for automa-

tion of bank records, such as loan and savings accounts of small and medium size finan-

cial intermediaries, caters for accurate and reliable record keeping. Benefits from such

a system are enjoyed not only by bank management and supervisors but also by cus-

tomers.


34


4.2.4 Donor Co-ordination

As discussed in Part I agricultural credit has attracted substantial donorattention in the past. More recently, donors have backed away fromagricultural credit projects and have placed greater emphasis on lendingprogrammes for poverty alleviation, women and microfinance.Although many of these new programmes are concentrated in urbanareas, it is not uncommon to find them also in rural areas of developingcountries and countries in transition.

Some of these donor-funded programmes adhere to most of the tenets ofthe new financial market approach: cost-recovery interest rates arecharged on loans, loans are made on the basis of creditworthiness andrepayment capacity of borrowers, bank managers focus on reducingtransaction costs, and sustainability has become a major concern. Otherdonor-funded programmes, however, still largely operate under the oldparadigm: loans are heavily subsidised and are made on the basis ofassumed needs, transaction costs are ignored, loan recovery is givenscarce attention, and financial viability is not a major concern.Understandably, where programmes that do not provide subsidies oper-ate in areas where other subsidised credit programmes operate, conflictsarise. Heavily subsidised credit programmes unfairly compete withlending programmes that are market based, and loan discipline is under-mined by intermediary organisations that accept low loan-recovery ratesand defaults.

A principal part of the task of leadership for the development of ruralfinancial markets is co-ordinating the efforts of donors so that thesetypes of conflicts are avoided

4.3 POLICY MAKING PROCESS

Exercising strong leadership, building coalitions, assembling appropri-ate information, and co-ordinating donor efforts are effective if they arefocused on clearly specified goals. To be consistent with the newapproach to rural financial intermediation, these goals should include:reducing transactions costs, accelerating rural deposit mobilisation,


35

increasing the number of people who have access to rural financial ser-vices, building viable and durable rural financial intermediaries, andreducing risks that affect their performance.

The process that is used to achieve these goals will vary from country tocountry. The determining factor is the extent to which an economy hasbeen liberalised. If the process is successful, it will accomplish twomajor tasks: the first is to build a broad base of support among stake-holders in formulating new policies for developing rural financial mar-kets. The second is to address the concerns of those who oppose thenew approach and continue to promote directed credit activities.

There are different stakeholders at national, sectoral, institutional andfarmer levels (see Figure 3). Policy makers should ensure that all thesestakeholders are consulted. The success of a concerted rural finance pol-icy depends on the interactions of all stakeholders, who will inevitablyhave different goals and interests.

Figure 3: Rural Finance Policy Making Process




36

The dominant government player in the agricultural and rural financepolicy making process varies from country to country (see Section 4.2.1)and can be the Ministry of Agriculture (associated in the past with thedirected credit paradigm), the Ministry of Finance or the Central Bank(that will support the new financial market paradigm) and in excep-tional cases an inter-ministerial committee. The need for a co-ordinat-ing committee is outlined in Section 4.3.1.

The essence of policy making is politics. Politics has been defined as theart of the possible, the art of compromise and the art of who gets what;policy formulation is a key determinant. It is therefore important tohave a clear understanding of the policy making process and of the mainstakeholders who attempt to influence the direction and contents ofrural finance policies. The stakeholders that should be engaged in poli-cy making for agricultural and rural finance include: government min-istries (particularly Agriculture and Finance/Central Bank, but also tradeand commerce may also have an important role to play), financial insti-tutions, farmer organisations and co-operatives, NGOs and private sec-tor representatives.

Conflicts and differences of opinion will arise among the different inter-est groups which should be debated and resolved through dynamic pol-icy dialogue and leadership.

4.3.1 Summary of Key Issues to be examined in Policy Making

When devising a policy for agricultural and rural finance, there are par-ticular key issues that must be considered, but each country is a specificcase and must be dealt with accordingly. However, the issues outlinedbelow are broad questions applicable to any country that attempts toformulate or update its agricultural and rural finance policy.

• what are the main objectives of agricultural and rural finance policy?• who are the main policy decision makers in agricultural finance?• what are the policy areas that affect the provision of agricultural

credit?• who are the different opinion leaders and stakeholders and how do

they participate in the policy making process?• what is the role of information and research in policy formulation?


37


• how best are policy monitoring and evaluation effected?• what is the role of the government in agricultural and rural finance?

In Annex 2, a diagnostic methodology7 is presented to assist policy mak-ers in examining and analysing their specific country situations and inanswering questions such as the key issues addressed above. Thoseengaged in the policy making process may include governments, donoragencies, financial experts/consultants and project designers.

4.3.1.1 Main Objectives of Agricultural and Rural Finance Policy

Traditionally, finance for agricultural and rural development has been apart of the agricultural sector policy falling under the umbrella of theMinistry of Agriculture. It has often been used as a tool for achievingother government development objectives, such as social, political andequity objectives. Even when a specific policy on agricultural credit didexist, the main focus in most cases was on increasing the access of smallfarmers to institutional credit, often at subsidised rates of interest andwithout requiring collateral.

Conventional wisdom is that the overall objective of agricultural andrural finance policy is to secure the availability of appropriate andaffordable financial services to rural households. This involves a shift inemphasis from the supply of predetermined financial products to theprovision of demand-led financial services. For this, it is essential thatbank management and staff understand and respond to the needs oftheir clientele and focus on a demand-driven approach that cultivatesdurable bank/client relations and provides effective rural financial inter-mediation services. This topic is covered in greater detail in anotherpublication in the Agricultural Finance Revisited series; “Better Practices:Doing it Right”.

7 The policy checklist which has been developed by the FAO/GTZ team (see Annex 2) has

been used as a conceptual framework guide while conducting case studies in various

countries throughout Africa, Asia and Latin America. Examples from these case stud-

ies (see boxes) are presented in this chapter to highlight the importance of the key issues

outlined when formulating an agricultural and rural finance policy.


38

4.3.1.2 Main Policy Makers in Agricultural and Rural Finance

Using the directed agricultural credit approach, the Ministry ofAgriculture was mainly if not solely responsible for agricultural financepolicy formulation, while the public agricultural banks that executedthis policy were regulated by special legislation, different from the bank-ing law, and controlled and overseen by government officials under thedirection of the Minister of Agriculture.

As previously stated, the financial market approach focuses on thedevelopment of viable and durable financial intermediation based on theprovision of demand-led financial services, including savings anddeposit facilities and lending for both on-farm and off-farm or non-farmrural enterprises. It recognises, however, that the provision of ruralfinancial services may not always be the most urgent and cost-effectiveway of improving the incomes and alleviating the poverty of the ruralpopulation and should be complemented by other important govern-ment support measures.

The potential tensions and contradictions between overall financial sec-tor and agricultural sector policies, should be noted in this connection.In order to formulate, co-ordinate, direct and review the agriculturaland rural financial sector policies, it is considered essential to establisha national level body, such as an Agricultural or Rural Finance PolicyCommittee. An inter-ministerial and inter-agency committee shouldpreferably work under the guidance of the Ministry of Finance, withrepresentatives of the various ministries and institutions like the CentralBank that are directly involved in agricultural and rural developmentand the financial sector together with the various stakeholders of theprivate sector such as financial institutions, agribusiness and representa-tives of farmer organisations. (see Indian example, Box No. 7).

There is an urgent need to establish such a committee, particularly inlarger countries, where all stakeholders (government, donor community,NGOs, financial institutions, farmer organisations and other privatesector actors) should participate in effective policy dialogue and policyformulation.




39

With the change in focus from directed credit to financial market development, the

type and role of financial institutions has changed. To overcome the high transaction

costs and risks associated with rural finance, increasing efforts are made to involve

various types of decentralised financial intermediaries and grassroots level organisa-

tions.

The rapid increase of NGOs in developing countries has occurred alongside market

liberalisation and privatisation and the emphasis by donor agencies on grassroots

development and poverty alleviation. NGOs are now a preferred channel due to

their proximity to the rural population.

Most NGOs have not been established for the purpose of providing financial services

in general and even less so for financing agricultural production. Therefore, the pro-

vision of financial services by NGOs is not always satisfactory and is further com-

plicated by the fact that NGOs display a great diversity of form and generally lack

legal personality.

NGO staff generally have a good knowledge and understanding of poor communi-

ties, but often lack the necessary professional experience to operate financial services.

Accounts of NGOs are often not presented or audited. In their activities, welfare and

business goals often get muddled, impacting negatively on performance and loan

recovery. Financial authorities in many countries prohibit NGOs and other unregu-

lated financial intermediaries to accept savings deposits.

Projects run by NGOs tend to be expensive, highly subsidised and of limited dura-

tion. However, NGOs may have an important role to play in promoting grassroots

level financial intermediaries, training managers and group members to establish

proper accounting and management procedures and pave the way for building links

between grassroots financial intermediaries and formal financial institutions.

In general, NGOs should be considered a transitional mechanism in financial inter-

mediation and due consideration needs to be given to their regulation and supervi-

sion in the case of intended continued financial intermediation.

Note: The term NGO does not refer to/include registered co-operatives.

Box 8

NGOs and Agricultural and Rural Finance



40

There is often a dichotomy between the setting of agricultural and ruralfinance policies and their implementation and monitoring. Therefore,the constitution of a National Level Policy Advisory Committee should,in large countries, coincide with the formation of decentralised commit-tees at regional and local level to facilitate a two-way flow of informa-tion, from national to grassroots level and vice versa, thus facilitatingparticipation in policy making and providing feedback on the impact ofpolicy delivery.

4.3.1.3 Policy Areas that affect the Provision of Agricultural Credit

Agricultural credit policy should take into account the objectives of thethree inter-linked policy areas, i.e. macroeconomic, agricultural sectorand financial sector policy, as far as they relate to and influence agricul-tural finance (see Sections 4.1.1, 4.1.2 and 4.1.3). It should capture thedynamic interactions between these three areas. In particular, it isimportant to assess the different pace and sequencing of reforms in eachsector, and to identify the strengths and weaknesses of current policies,the presence or absence of complementary policy measures and the exis-tence of major policy inconsistencies that have a direct impact on theprovision of cost-effective and durable agricultural credit services.

Some specific policy areas which should be addressed and which aredealt with in greater detail in the Diagnostic Methodology (Annex 2)include:• the role of formal financial institutions in agricultural finance;• state ownership of agricultural financial institutions;• the role of second tier financial institutions in agricultural refinance;• the role and supervision of NGOs (see Box 8) and the various types

of grassroots level rural financial intermediaries and their linkagewith the formal banking sector;

• the role of central bank in monetary policy, prudential regulation andsupervision of non-banking financial institutions.


41


In the early 1980s international donor agencies, initially FAO, were active in sup-

porting the establishment of an Agricultural Credit Unit, later the Agricultural

Secretariat in the Development Finance Department in the Bank of Uganda. The

principal objective was to facilitate an improved flow of loanable funds to priority

sectors of the economy, in particular agriculture and agro-related industries.

In the late 1980s the government of Uganda, by establishing district and village level

councils, attempted to decentralise political powers and increase the support for eco-

nomic reform and peace. As a result of this, grassroots organisations engaged in

intensive dialogue with the government. In addition, Village Resistance Councils

were established to provide a political platform for the small-scale farmer to voice

their interests. However, rather than exerting influence on policy decisions, these

councils have been used as a channel to move the population in favour of government

reforms.

A National Forum was established in 1992 which brought government officials and

private sector stakeholders around the table, creating a platform to discuss policy

issues impinging on restructuring the financial sector. However, this platform

focused on medium to large scale companies, neglecting smallholders.

In the absence of a clear policy in favour of microfinance institutions servicing the

needs of smallholders and microentrepreneurs, an Association of Microfinance

Institutions, with the membership comprised of NGOs and the co-operatives, was

established in 1997. The department of supervision within the Central Bank has

established close links with this Association in order to promote an innovative regu-

latory framework that supports microfinance institutions.

In 1997, the government of Uganda, in agreement with the World Bank, decided to

establish an Agricultural Policy Committee (APC) under the umbrella of the Ministry

of Finance and the Ministry of Planning and Economic Development (MPED) with

the responsibility to rationalise policy making in pricing, marketing structure and

resource allocation within the agricultural sector. This development resulted in the

Agricultural Secretariat being moved from the Bank of Uganda to an Office for Rural

Finance (ORF) in the Ministry of Finance and Ministry of Planning and Economic

Development.

Box 9Rural Finance Policy Dialogue:

Uganda



424.3.1.4 Different Opinion Leaders and Stakeholders and their Participation

in the Policy Making Process

Policy making is a dynamic and continuous process. Sustaining andimplementing policy reforms under structural adjustment programmes isa question of building a consensus and setting the right priorities andstrategies. Governments not only need to institute right reforms in theright order, but they also have to make them stick. This sometimesmeans compensating losers and providing the right type of incentives topromote certain behaviour. For this reason it is important to strength-en the participation of all stakeholders (financial institutions, farmers,other private sector actors such as traders and agribusiness as well asdonor agencies and NGOs) in the process of agricultural and ruralfinance policy formulation. The following are some areas of concern:• institutional and organisational set-up for policy making;• relation of stakeholders with national level policy makers;• effective participation of all stakeholders in policy making;• organisation of mechanisms that promote transparency and open-

ness in the policy making process;• opportunities for effective small farmer participation in policy for-

mulation.

ORF has been established to formulate rural finance policies, to monitor and evalu-

ate credit programmes, to co-ordinate and maintain a dialogue with donors and com-

mercial lenders as well as to mobilise financial resources. Agreement exists on the

fact that the role of Central Bank is one of establishing an appropriate monetary pol-

icy and, a regulatory and supervisory framework for rural financial intermediaries,

but that it should not set policy objectives for the development of the agricultural and

rural sectors. However, strong political pressure continues to exert influence on APC

and ORF, resulting in little participation from the private sector.

Source: FAO Report, 1997: N.S. Shetty, End-of-Assignment Report;

UTF/UGA/029/UGA and UTF/UGA/032/UGA and GTZ Financial

System Development Division.

Box 9 (Cont.)Rural Finance Policy Dialogue:

Uganda


43


These areas have emerged as important aspects to be investigated in theDiagnostic Methodology (Annex 2), where agricultural sector andfinancial sector policies are examined in relation to agricultural financepolicy formulation.

An important measure of the effectiveness of policy dialogue is thedegree of mutual trust between the public and private sectors. This isdemonstrated by the government providing for equal terms of partici-pation between all pressure and interest groups and institutionalising apolicy dialogue platform with all stakeholders at different levels (see Box9). All stakeholders should be involved in the policy formulation andrevision processes, while the government is ultimately responsible forthe policy decision making.

4.3.1.5 Role of Information and Research in Policy Formulation

Building support for the financial market approach often requires addi-tional information. Many of the costs involved in the directed creditapproach and benefits of the new approach are not readily apparent. Awell-meaning politician, for example, may not recognise the extent towhich subsidies attached to directed credit are captured by unintendedbeneficiaries, how weak an effect these subsidies have on productionand investment decisions, and how detrimental directed credit pro-grammes are for effective financial intermediation. Likewise, well-meaning donors may overlook the effects their directed credit pro-grammes have on the transaction costs of rural financial services or onthe incentives to mobilise rural savings and deposits. Similarly, policymakers may be unwilling to stress savings mobilisation until they areconvinced that the propensities to save in rural areas are significant.

In several countries, small research groups have been formed to assistthose who are formulating policies associated with the introduction ofthe new financial market approach. Research is necessary for under-pinning new policies and designing financial technologies that reducetransaction costs and results should be available to all those who wishto benefit from them. In the Philippines research staff reported to aninter-agency committee and later to the Minister of Finance. InIndonesia much of this type of research was carried out by a small tech-



nical advisory group associated with the Ministry of Finance. In bothcases, researchers gathered information on issues raised by supporters ofthe old directed credit approach as well as by advocates of the newfinancial market view.

4.3.1.6 Policy Monitoring and Evaluation

Policy monitoring and evaluation both at financial institution andfarmer levels are essential for assessing the effects of policy. In particu-lar, policy delivery should be evaluated in terms of effectiveness, effi-ciency, equity and enforceability against stated policy objectives, andprovide feedback to policy decision makers. Some specific areas wherethe effects of agricultural finance policies need to be monitored at insti-tutional and farm level are:

(i) Institutional Level• improved commitment towards sustainability, target group orienta-

tion and outreach of agricultural financial services;• increased independence from governmental/political interference;• increased availability of loanable resources from savings/deposit

mobilisation;• improved access to refinance facilities, if available;• improved access to training facilities and improved management and

staff capabilities of rural financial intermediaries;• increased availability and use of appropriate internal management

information systems in rural financial institutions;• improved mechanism for the flow of feedback information to nation-

al level policy makers;• lower transaction costs;• better performance of loan portfolio.

(ii) Farmer-Borrower Level• improved access to appropriate and durable financial services at an

affordable cost;• increased availability of opportune and demand-led financial ser-

vices;• improved access to essential training facilities;

44



• improved feedback flow of information to national level policy mak-ers.

These two levels are examined in greater detail in the DiagnosticMethodology (Annex 2).

In monitoring and evaluating the effects of policy implementation onfinancial institutions, the issue of risk management should not be over-looked. Risk management is an essential element in building a soundloan assets portfolio and needs to be incorporated into the agriculturaland rural finance policy, along with capacity within the lending institu-tion to collect and analyse information on agricultural risks which con-front small farmers and influence their loan repayment capacity.

4.3.1.7 Role of the Government in Agricultural and Rural Finance

Government interventions in agricultural and rural finance shouldalways be guided by the fundamental objective of complementing orfacilitating the workings of the market. All interventions should aim toreduce direct government involvement over time, while increasing pri-vate sector provision of financial services and competition among finan-cial intermediaries.

Governments should focus on enhancing information and providingincentives necessary to promote efficient private sector operators thuspaving the way for sound financial intermediation. Inadequate infor-mation is a major cause of increased risk.

In policy formulation there is a need for a clear definition of what areconsidered to be indirect and direct government interventions in ruralfinance. According to Yaron et al (1997) “indirect” refers to the policyenvironment (macroeconomic and sectoral policies, legal and regulatoryframework) and “direct” refers to interventions which normally involvethe direct application of public funds for targeted credit and financingof technical assistance to rural finance intermediaries. While a consen-sus is developing among policy makers regarding accepted “indirect”interventions, the appropriate role of governments in “direct” interven-tions is still much debated.

45



The current approach of rural financial market development assigns adifferent role to the government with limited direct interventions in ruralfinancial markets. It proposes, however, a pro-active support role of thegovernment in the following fields:• creating a favourable macroeconomic environment (prudent mone-

tary and fiscal policies, trade liberalisation, encouraging domesticsavings);

• developing a suitable legal framework for market transactions (clearcontract and property rights, a proper regulatory and supervisoryframework for rural financial institutions, contract enforcementmechanism) and

• institution and capacity building of rural financial intermediaries.

The importance of the macroeconomic environment and related policiesare outlined in sections 4.1.1-4.1.3 and are examined in the DiagnosticMethodology (Annex 2). The legal framework and supervisory frame-work for financial institutions will be dealt with in another publicationin the Agricultural Finance Revisited series; Prudential Regulation andSupervision for Agricultural Finance.

Government interventions in rural finance can be of a different nature,but they should be based on the principle of removing the causes of mar-ket failure in a cost-effective way. Ultimately, they should facilitate theeffective working of market forces. This may include grants or subsidiesfor information generation and institution and capacity building, pro-viding seed capital for capital enhancement of new rural financial inter-mediaries, providing rural financial intermediaries with access to refi-nancing facilities, in particular, to be used for term lending. Subsidiesand grants, however, should always be transparent and temporary andprovide incentives to strengthen the role of private sector operators inrural financial markets.

46


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Adams, Dale W. et al. (eds.). 1984. Undermining Rural Developmentwith Cheap Credit. Westview Press, Boulder CO.

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ANNEX 1



THE DIFFERENCE BETWEEN THE DIRECTED CREDIT PARADIGMAND THE FINANCIAL MARKET PARADIGM

1. Primary Problem Market Imperfections High transactioncosts

2. Role of Financial • help the poor FinancialMarkets • stimulate production intermediation

• offset distortions• implement plans

3. Users Beneficiaries Valued clients(borrowers) (borrowers

and depositors)

4. Sources of funds Governments Mainly depositsand donors

5. Subsidies and Many Fewtaxes (persistent) (Transitory)

6. Information Dense, Less dense,systems and mainly for planners. mainly forevaluations Focus on credit impact managers.

Focus onperformance offinancialintermediaryand system

54

FINANCIAL

MARKET

PARADIGM

DIRECTED

CREDIT

PARADIGM

ELEMENTS


ANNEX 2


57

Annex 2: Diagnostic MethodologyModules for Analysing Agricultural Finance Policy

Modules for Analysing Agricultural Finance Policy

This is essentially a checklist of questions designed to serve as guidelinesto governments in formulating and updating agricultural finance policy,in an effort to ensure that important aspects are not overlooked8. It isnot essential that each point be examined in detail and in certain casessome points may not be relevant to the country in question.

Although the focus is on agricultural finance policy, it cannot be regard-ed as a single sector analysis since three inter-related policy areas areinvolved, i.e. the macroeconomic environment, the agricultural sectorand the financial sector. Institutions and procedures for setting policyobjectives and instruments at different levels, and for monitoring policyperformance, are key elements to be examined. A thorough analysis ofthe overall agricultural and financial sectors is not required, but only inso far as agricultural finance policies are affected. While the emphasisin each given country is on the current situation, a concise review shouldbe undertaken of the recent changes in policies, the motives and forcesbehind these changes and their impact on the financing of on-farm pro-duction and the marketing of primary produce. It is of particular impor-tance to identify the tensions and contradictions between the differentpolicy fields and to describe the stated objectives and strategies of agri-cultural sector and financial sector development. The analysis isdesigned as follows:

DIAGNOSTIC METHODOLOGY

8 It should not be viewed as a questionnaire but a conceptual framework guide during the

policy formulation process.



58

• General Background Information

• Examination of Agricultural Finance Policy using threemodules:

Module 1: Macroeconomic policy with relevance to agricultur-al finance

Module 2: Agricultural sector policy related to agriculturalfinance

Module 3: Financial sector policy related to agriculturalfinance

General Background Information

The analysis needs to be undertaken in the context of general back-ground information, including demographic, social and cultural issues;rural infrastructure; agricultural production; the socio-economic situa-tion at farmer level. This component will provide a sound basis forexamination of the remaining three modules.

Module 1Macroeconomic Policy with relevance to Agricultural Finance

This module outlines general macroeconomic policy and macroeconom-ic policy as it relates to both the agricultural and financial sector.

Modules 2 & 3Agricultural Sector Policy and Financial Sector Policy as they

relate to Agricultural Finance

Agricultural and financial sector policy are examined separately but in asimilar manner as follows:(a) relationship to macro level,(b) sector level,(c) institutional level,(d) farmer level.



59

This is to allow for vertical analysis within each sector and horizontalanalysis between the agricultural and financial sectors in order to gain acomprehensive picture of complementary policy measures, as well aspossible policy inconsistencies.

The policy analysis at institutional and farmer levels are intended as areference point for feedback purposes, i.e. they are examined to high-light:(i) the degree of participation in policy decision making;(ii) the effect and realisation of policy at each level.

Examination of the three policy levels will serve to pinpoint thestrengths and weaknesses in the policy formulation and delivery of agri-cultural financial services, to provide lessons and to identify gaps andcontradictions in policy formulation and in the delivery of agriculturalfinancial services.



Demographics, Social and Cultural Issues

• Agricultural/rural/urban population;• Social and human development indicators;• Income distribution;• Role of formal and informal economy;• Ethnic issues;• Religion (Islamic banking).

Rural Infrastructure

• Roads, transport;• Electricity and power;• Telecommunications, water supply;• Irrigation;• Marketing infrastructures.

Agricultural Production

• Agricultural production structure and traditional practices (maincrops/livestock enterprises);

• Natural resources (suitability of specific food and cash crops, outputvariability, seasonality, current threats to sustainability);

• Regional peculiarities;• Agricultural input and output markets (general structure and perfor-

mance, local accessibility, transaction costs and profit margins).

Socio-economic Situation on Farmer Level

• Farmer categories (small, emergent, large);• Family structure (size, age, gender of head of household);• Level of farming technology (productivity, profitability and sustain-

ability and obstacles to further expansion of these technologies);• On/off farm income diversification;• Motivation to improve living standards through increased agricultural

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GENERAL BACKGROUND INFORMATION


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productivity versus investment in general education for off farmemployment or investments in trading and other service activities.

Political Climate

• Political stability;• Recent reforms;• Ethnic, religious conflicts.

MODULE 1: MACROECONOMIC POLICY WITH RELEVANCETO AGRICULTURAL FINANCE

General Macroeconomic Policy

• Macroeconomic situation and reforms GDP/capita, sectoral andregional distribution of GDP, economic growth, inflation & exchangerates;

• Overview of stabilisation and structural adjustment policy liberalisa-tion, decentralisation, privatisation, role of government, fiscal policy:progress, sequencing and status of reforms;

• Role of foreign aid and debt principal donors and influence at macrolevel;

• Social equity policies rural vs urban development, basic needs, povertyalleviation, employment.

Macroeconomic Policy relating to the Financial Sector

• Status, sequencing and progress of structural adjustment in the finan-cial sector:- market orientation;- privatisation of governmental financial institutions;- promotion of private sector;- intervention, subsidies.



• Monetary policy:- monetisation of the economy;- interest rate policy and recent developments;- inflation rate policy and recent developments;

• Influence of Donors.

Macroeconomic Policy relating to the Agricultural Sector

• Status, sequencing and progress of structural adjustment in the agri-cultural sector:- agricultural market liberalisation;- privatisation of government institutions;- promotion of the private sector;- import/export policy (external trade policy).

• Agricultural subsector development plans;• Food security policy;• Influence of donors.

MODULE 2: AGRICULTURAL SECTOR POLICY RELATED TOAGRICULTURAL FINANCE

1. Relation to Macro Level (Link to Module 1)

Identification of Policy Decision Makers, Actors in the Fieldof Agricultural Finance Policy

• Relevant actors formulating policy (financial and non-financial sup-port) in the agricultural sector - Ministry of Agriculture, Ministry ofCommerce, Ministry of Trade.

Identify Policy Objectives

• Food security (plus 10% by the year 2005?);• Commitment to privatisation;• Do agricultural policy objectives comply with overall economic and

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sectoral development policies? (conflicts with financial sector policy;rural versus urban development).

Identify Policy Measures and Instruments

• Further analysis of Module 1 in regard to structural adjustment:- pricing policy and price stability measures (removal of price controls,

government minimum price setting);- trade policies (domestic (food crops); import/export (cash crops), tar-

iffs;- controls on marketing;- provision of agricultural inputs and equipment;- changes in the role of government and degree of intervention;- government Land Tenure Policy;- decentralisation of public agricultural support services;- taxation of agricultural inputs (fertiliser, seeds, chemicals, farm

machinery, spare parts).

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Overview of the Agricultural Sector

• Current situation and recent reforms in the agricultural sector (liqui-dation of parastatals and emergence of new private sector players;involvement in lending activities (quantitative data); extent of marketliberalisation, e.g. move from single channel marketing system to com-petitive market environment.

Identification of the Role and Participation of the Main InterestGroups/Pressure Groups/Stakeholders in the Formulation andExecution of Agricultural Policy related to Agricultural Finance

Common concerns of the Main Interest Groups include:

• Risk management/Risk mitigating measures (public/private sector);• Freedom from political interference;• Provision of financial and non-financial support services;• Link between financial and non-financial support services.

• Ministries of Agriculture, Trade and Commerce:- role in the policy making process for agricultural finance (if any);- organisational structure and flow of decisions;- current agricultural sector policy framework (existence of an agricul-

tural sector development or investment plan?);- policy towards state-run agricultural institutions (input supplies);- capability to provide effective support services (e.g. relevant expertise

and sufficient resources), staff expertise in agricultural finance;- existence of effective marketing information systems for agriculture;- relief measures in the event of a natural disaster;- arrangements for (a) a crop insurance scheme and (b) land

tenure/land registry.

2. Agricultural Sector Analysis



• Extension service:- public/private;- performance and role (if any?) with regard to agricultural credit.

• Parastatals:- steps towards privatisation;- organisational structure and governance.

• Farmer and Women’s Associations and Farmer Pressure Groups:- representative of which farmer groups/categories?

• Agricultural Co-operatives and Chamber of Commerce:- organisational set-up and governance structure;- interest in developing into formalised financial institutions?

• Agribusinesses, Outgrower Schemes, Input (public and private)Suppliers:- ownership structure.

Regulatory Framework

• Existing legislation and its impact on the agricultural sector - laws,regulations, factors impinging on farmer profitability (e.g. extent thatagricultural sector is being taxed);

• To what extent are public and private services bound by regulations,to provide financial and non-financial services to the agricultural sec-tor?;

• Government land tenure policy (land reform package); certification ofownership rights; land mortgage required by banks for collateral.

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3. Institutional Level (reference/control group)

Role and Participation in Policy Decision Making

• See 2 above and select principal actors for further analysis;• What extent does a policy network exist in the field? (Platform for

policy dialogue);• Actors perception of their role in policy formulation vs their actual

involvement.

Effect and Performance of Policy at Institutional Level

• Performance of government institutions to provide necessary expertiseand resources (financial and non-financial);

• Degree of policy dialogue and information flows (collection and use ofinformation);

• Government incentives to ensure timely and reliable financial and non-financial support services to farmers;

• Environment to enable e.g. agricultural co-operatives to become for-mal financial institutions;

• Access to refinance facilities;• Access to training facilities (management and staff);• Identified gaps in the policy framework.

4. Relationship with Farm Level (as a reference group)

Role and Participation of Farmers in Policy Decision Making

• Degree of farmer representation in policy dialogue: Role and partici-pation in policy decision making at farmer level (small farmers,women, self-help groups, emergent and commercial farmers, villageopinion leaders);

• Two-way information flows.

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Annex 2: Diagnostic Methodology

Effect and Performance of Policy Instruments and Measureson Farmers

• Profitability of agricultural production;• Farmers access to yield and price increasing technologies;• Farm management capabilities (repayment capacity) / Risk manage-

ment;• Availability and access to financial and non-financial support services

(are financial services provided appropriate?);• Level of education / Existence of farm management training pro-

grammes.

MODULE 3: FINANCIAL SECTOR POLICY RELATED TOAGRICULTURAL FINANCE

1. Relation to Macro Level (link to Module 1)

Identification of Policy Decision Makers, Actors in the Fieldof Agricultural Finance Policy

Ministry of Finance, Central Bank, Ministry of Agriculture etc.

Identify Policy Objective

• Promotion of private sector;• Commitment to market, target group;• Links, conflicts to agricultural sector policy;• etc.

Identify Policy Measures and Instruments

• See structural adjustment in Module 1;• Changes in legislative framework;• New institutions (e.g. Apex Institutions);• Changes in the organisational structure of decision making proce-

dures;• etc.

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2. Financial Sector Analysis

Identification of the Role and Participation of Main Stakeholders,Interest and Pressure Groups in the Formulation and Execution ofAgricultural Finance Policy

• Common Concerns of the Main Actors:- degree of political interference;- risk management;- coverage of the agricultural sector.

• Government Institutions (Ministry of Finance, etc.): - policy towards the promotion of the efficient performance of finan-

cial institutions in the field of agricultural finance;- organisational structure of policy decision making;- policy towards state-owned agricultural finance institutions;- policy towards NGOs and Co-operatives, respectively, their formali-

sation or linking to the formal financial market, access to refinanc-ing facilities, training and assistance;

- staff expertise in agricultural finance.

• Role of Central Bank:- role of central banks (tasks, reforms);- degree of political independence, interference;- information basis on the agricultural financial sector for policy deci-

sions;- staff expertise in agricultural finance;- organisational structure of policy decision making.

• Banking Supervision Authority:- relation to central bank;- objectives, measures regarding financial institutions in the area of

agricultural finance;- supervision coverage;- performance criteria for financial institutions in rural areas;- enforcement mechanisms to ensure that regulations are adhered to;- staff expertise in agricultural finance.

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• Apex Institutions9:

- Apex Institutions: deposit and loan insurance, creditguarantee facilities, risk information offices, traininginstitutions etc. (see also module 2);

- measures and services with regard to financial institutions in the areaof agricultural finance (e.g. refinancing, training);

- organisational set-up, ownership and governance structure;- performance criteria for financial institutions in rural areas.

• Other Interest and Pressure Groups:- influence of non-financial private or public institutions in agricultur-

al policy decisions, e.g. commercial producers of certain products aspolitical pressure group;

- (see also module 2).

• Role of International Donors:- involvement in agricultural finance policy;- programmes in the field of agricultural finance: vision , measures,

procedures;- networking on donor level in the field of agricultural finance, con-

flicting positions - etc.

Regulatory Framework for Financial Transactions

• Legislative Framework relevant for Agricultural Finance: (e.g. private law, banking law, capital market legislation, co-operativelaw);

• Selective Issues with relevance for Agricultural Finance:- law of property, land tenure, creditor protection;

(informal and implied contracts);- controls or limits on lending;- reserve and capital requirements;

9 APEX: A financial institution that provides banking services to other financial institu-

tions. Used often when donor agencies channel money into developing countries

through financial institutions.

Annex 2: Diagnostic Methodology



- licensing standards;- capital requirements;- deposit insurance;- usury legislation;- etc.

• Recent Changes in the Regulatory Framework:- reasons for reforms;- actors of the financial sector addressed, (dis)advantaged by the regu-

latory framework and its reforms.

3. Institutional Level (as a reference group)


Representative types of financial institutions which offer agriculturalfinancial services: commercial bank, state owned bank, (formalised) NGO(financial/non-financial), (non)financial co-operative, other semi- or infor-mal financial institutions (e.g. ROSCA), agricultural input supply andmarketing enterprise, etc.:- form of involvement in policy decision taking;- existing dialogue platforms;- need for further involvement in policy decisions;- influence from donors on financial institutions;- actors’ perception of their role in policy making, their main interest.

Effect and Performance of Policy at Institutional Level

- Commitment and incentives towards sustainability, target group orienta-tion and outreach in agricultural finance, formalisation;

- independence from political/governmental interference;- access to refinancing facilities;- access to training facilities at management and staff level;- identified gaps in policy framework from institutional point of view;- information delivery exchange system;- performance of policy dialogue platform.

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4. Relationship with Farm Level (as a reference group)


Representatives at farmer level: small (landless) farmers, women, self-help-groups, commercial farmer, leading persons of village:- form and extent of participation in policy decision taking;- existing dialogue platforms;- need for further involvement in policy decisions.

Effect and Performance of Policy Instruments and Measures onFarmers

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

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agricultural finance: getting the policies rightagricultural finance revisited agricultural finance:...

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