Recent Innovations in Rural Finance
I n this context it is also useful to discuss recent innovations in rural finance. The main ones among these are discussed in the sequel.
Finance through forward sales and contract farming seem to be simple and compatible with many of the institutional structures of the developing agrarian countries. They normally involve an agreement between a seller and a buyer. They are widespread in many parts of the world, especially between larger-scale intermediaries, such as processors who need raw materials, and groups of farmers. Many times the processors provide credit in the form of either cash or advance provision of inputs for production. Such contracts are a way to reduce price risks to farmers, but they seem to be more prevalent in products that need processing or are perishable. There are many different types of contracts (Bijman 2008).
Contract farming and forward sales are well suited to the social- network-based institutional setting of African as well as Asian farmers. They are based on trust and hence enforcement may sometimes be difficult. They are also much less appropriate for sales of staples, as the quantities to be delivered are not easy to guarantee, given the changing seasonal food security objectives of farmers. (For useful recent surveys of contract farming see Wang et al. 2014; Prowse 2012).
As liquidity and credit constraints are present in many developing countries, a system that offers considerable promise is the Warehouse Receipt System (WRS). The idea of such a system is that a producer of a storable commodity can deposit in a particular location an amount of the commodity of stated quality against a receipt. The commodity could be cleaned, dried, graded, and stored, all for a fee. The depositor could sell the commodity at any time in the future, and with smaller transaction cost, as the sale could be done with paper or electronically. The main advantage of such a system in credit-constrained rural settings is that the warehouse receipt could serve as collateral for loans obtained by a bank. This could alleviate one of the major constraints of small farmers, namely the need for cash at harvest time, and allow them to market the product at a later time when prices are presumably higher.
A limitation of this system is that a warehouse may require a minimum lot size to issue a receipt, and this may in effect be an entry barrier for smallholders. However, while a WRS may not cater to smallholders, it may well cater to larger operators who may act on behalf of smallholders. These could be cooperatives, larger traders, and others. (For a useful survey of the WRS see Hollinger et al. 2009.)
Another closely related institutional arrangement is an inventory-based credit system. The idea of such a system is that groups of farmers place their product in a warehouse, and a lending institution, such as a Microfinance Institution (MFI) or a bank, uses the inventory as collateral to extend individual loans to farmers. The management of the inventory is the collective responsibility of the group, and this places demands on the system in terms of trust. The difference from the WRS is the less formal nature of the system, and the focus on groups. This system has been tried in Ghana and Zambia among others (Coulter and Onumah 2002).
Another related mechanism would be to indemnify loans for price risk, in the sense that the price risk could be made part of a loan package. In some African settings price risk may be a major reason for possible non-repayment of a crop or other agricultural product loan, thus rendering lending from banks very risky. In such cases a minimum price contract resembling a put option, namely an agreement to pay the farmer a minimum price for his/her product, could be made part of the loan, so that if the price fell below a certain level, the farmer would not have to pay back the loan. The implicit cost of the option could be included in the overall loan, so that the farmer may not have to pay any money up front, but would have to pay back a larger amount later, at the time of repayment.
Another approach to rural finance is cereal banks. The idea here is much like the warehouse receipt system and the inventory-based credit system discussed above, except that it applies mostly to staple crops, such as cereals. Given that cash and export crops are easier to finance than cereals, the cereal bank idea is promising for the largest component of unmet demand for smallholder finance, discussed above.