THE VALUE CHAIN FRAMEWORK, RURAL FINANCE, AND LESSONS FOR TA PROVIDERS AND DONORS Bob Fries – ACDI/VOCA 3/15/07

Key Messages 1.   The Value Chain Framework is useful for expanding financial services, not just for enterprise development. 2.   A value chain perspective helps donors and TA providers to focus on financial services that offer significant economic opportunity.   3.   Financial institutions can learn from and engage more with value chain actors in order to develop new products and reach new markets.

First some useful definitions Value Chain = the set of actors (private, public, and including service providers) and activities needed to bring a product from production to the final consumer. Value Chain Analysis an assessment of the actors, and factors influencing the performance of an industry, and relationships among participants to identify the driving constraints to increased efficiency, productivity and competitiveness of an industry and how these constraints can be overcome. Value Chain Finance = financial services and products flowing to or through value chain participants to address and alleviate driving constraints to growth. Main Points / Highlights: In order to discuss value chains, it is important to first establish a common vocabulary. It is also important to recognize the potential value of value chain finance in enhancing the competitiveness of those who receive it. Value-chain finance may or may not include support from formal financial institutions. Instructions: Discuss the definitions & key points on the slide. ► Move to next slide.

VALUE CHAIN FRAMEWORK AND FINANCE Global Retailers Financial Services Overdrafts/ lines of credit Investments, loans or savings to fund upgrading Working capital to purchase inputs or products Seasonal production loans National Retailers Exporters Processors/Traders It was an interest in these themes of financial services and the value chain that prompted Banu and I to do some research into the dynamics and lessons we could learn from financial services provided by businesses. The result was the AMAP paper, “ Value Chains and their Significance for Addressing the Rural Finance Challenge.” The Value Chain framework recongnizes the importance of … Financial services – critical to facilitate both product flow and upgrading Range of services demanded up the chain Not all of these delivered exclusively by financial institutions… see red. Producers Input Suppliers

Product and Financial Flows within the Value Chain Financial Institution Suppliers  Value Chain Suppliers  Product flow Finance flow Exporters/ Wholesalers  Commercial Banks Non-Bank Financial Institutions Grass-Roots MFIs, NGOs, Coops Processors  Local Traders & Processors  Producer Groups  Main Points/Highlights Many rural enterprises are demanders AND suppliers of financial services! (e.g. Farmer Ranjan). We see that financial gaps are filled by value chain actors – note that finance does flow both ways, as there may be an advance of product by farmers pending payment later. Value Chain actors, if lending, are doing so for different reasons than Financial Institutions. Unlike financial institutions, Value Chain actors may not be worried about making a positive return on the loan, but rather on increasing their purchases and sales, and thereby increasing overall profitability. This is both an opportunity (they are more willing to lend) and risk (they may not be assessing risk or profitability of lending in systematic way, making replication difficult). Instructions: Proceed through the animation, first highlighting the product flow up the value chain and then the financial flows within it. Note that many rural enterprises are demanders and suppliers of financial services. Emphasize that value chain actors have different incentives for and expectations from offering finance within the chain. ► Move to next slide. Farmers  Many rural enterprises are demanders AND suppliers of financial services!! Input Suppliers 

VALUE CHAIN FINANCE - THREE EXAMPLES Contract Farming/ Outgrower Schemes Loans linked to purchase agreements High value Trader Credit Loan between buyer and seller Grains and high value Warehouse Receipts Loans backed by receipts issued by safe, secure warehouse We picked these 3 products for a couple of reasons. Existing literature with available research describing how they worked, and constraints they faced. They also have a significant role for non-financial institutions. We researched leasing as well, but kept encountering services provided by finance companies. Trader credit, or loans between buyers and sellers of inputs or products. Products can be both basic grains or high-value crops. Contract Farming and Outgrower schemes tend to operate around higher value crops. In both of these arrangements, loans are tied to purchase agreements. In outgrower schemes, buyers offer other services, like extension or TA. In warehouse receipts systems, loans are backed by receipts issued by warehouses that offer safe and secure storage facilities for non-perishable commodities.

VALUE CHAIN FINANCE - OUTGROWER SCHEMES Benefits More secure product and market Higher yields and quality Bulk input purchases & product sales Contracts for collateral, loan and sales terms, and product specs Global Retailers National Retailers Exporters Wholesalers Learning Business relations screen, train and monitor customers Processors/Traders Let’s take a closer look at one of these products – outgrower schemes. You can see a modified value chain here. The red lines mark the path of a product, from input to final markets. Green lines added to show flow of loans. These can move in both directions, with exporters or processors advancing cash to producers, or input suppliers advancing inputs to them. We even note producers providing loans to processors and traders. Can any one think of an instance in which this occurs? Let’ think of high value horticulture for this case. The second VC financial service we looked at was outgrower schemes. In outgrower schemes, contracts exist between lender and borrower. The contracts spell out a mix of services and responsibilities: loans, input packages, production specifications, technical services or monitoring, and market agreements. Does anyone see a difference between the lending flows for outgrower schemes, and the ones you saw with trader credit? [Direct links between the larger players and producers. Input suppliers move inputs through larger players] This difference points to a significant benefit of outgrower schemes: More secure product for buyers like exporters and processors; more secure access to higher value markets for producers. With warehouse receipts, the focus is on the lower end of the value chain. Producers and traders store products in secure warehouses. The warehouses issue receipts, which can be used to as collateral for loans from banks. Benefits and learning. Benefits to producers are significant, even without the loan. – More money, lower cost, more efficient marketing system. Allows producers to use existing product as collateral, rather than riskier future product Lower risk and greater legal formality attracts the banks Lessons for Financial Sector Loan terms and structure reflect economic activity Financial Sector can increase trader credit through loans to larger VC actors Producers Input Suppliers

Frequent, creating high default risk VALUE CHAIN FINANCE LIMITS & POWER RELATIONSHIPS LIMITS Trader Credit Contract Farming Warehouse Receipts Monopoly/ Unfair Pricing Checked by market info and trader competition Checked by need for reliable product Without warehouse standards and inspection  Side-Selling Frequent, creating high default risk Less options due to closer monitoring No. Product already deposited Enabling Environment Trust Enforceable contracts Significant legislative/ regulatory changes These products have some limitations as well. Because they tend to be built on personal and business relationships, outreach potential is limited. This is less an issue in the warehouse receipts system, but costs of these systems can create some barriers for direct participation by small farmers. How lenders charge for loans is often not transparent. This can lead to unfair pricing if they are the only lender in town, and market information is not readily available. Borrowers can also take advantage of lenders, selling crops to competing buyers instead of the traders they borrowed from. Warehouse receipts require a number of laws and regulations. Let me mention three quick cases involving these challenges. Ghana cotton – Monopsony undermined not only the trader credit system Small group of cotton seed buyers. Fixed price of seed extremely low, in an attempt to maximize their profits and maintain relationships with producers through continued indebtedness. Both attempts failed. The producers started using the advances to buy inputs for more profitable products, which they produced instead of cotton. This left the seed buyers without security on their loans (which the producers did not repay) and product. Competition and market information can serve as checks to distortions caused by monopsonies. Competiton. In Zimbabwe, CARE designed a program to increase the number of traders in more remote communities. Training plus a temporary credit guarantee to reduce barriers to entry. Gained working relationships with distributors. Over seven years, 580 traders received this assistance. 350 were absorbed into the private input distribution network. Market information. Kenya. How transparent is the pricing? Kenya Tea Development Agency sells fertilizer on credit, and recovers its loan through the price it pays for the tea it buys from producers. Finance charges are incorporated into both fertilizer and tea prices. Price of fertilizer = procurement price + transport cost + interest on large commercial loan by KTDA Price of tea = published auction price – principal and interest charges – profit 400,000 producers receive credit through this structure. Exploitative pricing – Cotton in Ghana Market information – Tea in Kenya Trader competition – Traders in Zimbabwe

VALUE CHAIN ACTORS & FINANCIAL INSTITUTIONS COMPLEMENTARY ROLES Rural Finance Through…. Value Chain Actors Financial Institutions Vertical transactions Make money on VC products Presence and depth of outreach Terms, conditions and risk/cost management fit economic activity Working capital to smaller players Embedded financial services – lower marginal costs, production and marketing benefits Horizontal transactions Financial products Outreach Potential Sound financial practices and technology Working capital to larger players, investment capital Efficiency of unbundled services It is not a question of which set of actors is the key to expanding rural finance. Both have crucial advantages, limits, and roles and perspectives that can complement each other. Start with how you spot their relevance when looking at a value chain. (vertical /horizontal) This reflects where they make their money, where they are today, and what their potential is. (Depth of outreach/ breadth of outreach potential, as well as depth if they align with VC players (Grain warehouse highlights such an example) This difference in where they make their money also highlight their strengths in financial transactions – the fit with the economic transaction (because it is an extension of it, and there to make sure it happens) vs the sound practices and technology that comes with specializing in financial services. The financial products they are more ready to offer – Working capital to smaller players vs. inv cap, working capital to larger players, and savings. And their competitive advantages – embedded vs. Efficient unbundled

IN CONCLUSION: To expand rural finance and enterprise growth ….. Think outside between the boxes Investment Loans Upgrading Financial Market Assessment Value Chain Analysis Financial Intermediation Embedded Services Financial Institutions Buyers and Processors Competitiveness Cost recovery & risk management Banks and Producers Banks and Processors Financial Sustainability Economic Growth Macro-Level The Enabling Environment e.g., Policy Legislation, Regulation, Supervision e.g., Credit bureaus, Auditors, Tech service providers Meso-Level Financial Infrastructure Micro-Level Retail Providers e.g., Banks, MFIs, Insurers Clients Relevance: Financial services not ends in themselves. They allow people and enterprises to save, invest, and operate business. For small enterprises to generate wealth, they need to produce and market their products effectively, preferably in a value chain with growth potential. Financial services are only one component of a larger bundle of services they need to grow. And these services are being demanded, and supplied, by actors in the value chain. Therefore, it is useful to focus on a broader unit of analysis than the financial sector—namely, the value chain. This approach incorporates existing products and relationships. Through Mapping and value chain analysis, those interested in expanding FS, but intimidated by perceived risks, can use VC analysis to identify opportunities and prioritize interventions. These interventions can occur at three levels. Enabling environment changes that expand access to market information, eliminate price distortions, and expand the use and security of collateral are useful. At the institutional level, Actors like brokers, agents and farmer organizations who link small producers, downstream players and financial institutions are key to expanding rural access to both markets and FS. And potential products should tap, learn from, and expand the delivery of financial services through the value chain. Complementarity. Both the value chain and the financial market orientations are necessary to expand sustainable rural financial services… Neither is sufficient value chain lenders do not have the systems and efficiencies of formal financial institutions. Larger players need to tap financial institutions for working capital, and face a trade off between using scarce capital to invest in upgrades or expand purchases. Some borrowers may not really want or need the added services that get bundled with the credit…. But these lenders are providing small farmers with access to finance and to markets for their products. x

Thank You Value Chains and Rural Finance Paper URL: http://www Leave this up on the screen while questions are being asked.