THE VALUE CHAIN FRAMEWORK AND RURAL FINANCE SEEP Annual Meeting This presentation adapted from a Value Chain breakfast series presentation under AMAP. Bob Fries ACDI/VOCA October 2005

KEY MESSAGES 1.   The Value Chain Framework is useful for expanding financial services and for developing enterprises. 2.   Value Chain Finance is not new. It helps to fuel many enterprises. Can you believe it’s happened without us?   3.   Financial institutions can learn from and engage more with value chain actors in order to develop new products and reach new markets.

WHAT IS A VALUE CHAIN? Global Retailers National Retailers Sector-specific providers Exporters Wholesalers Cross-cutting providers Processors/Traders Quick overview of a value chain. Producers Financial (cross cutting) Input Suppliers

In assessing financial markets… 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 In assessing financial markets… The greatest distinction between value chain and financial sector approach occurs at the core levels: Clients Retail Providers

Non-Bank Financial Inst. WE OFTEN THINK ABOUT FINANCING VALUE CHAINS VIA FINANCIAL INSTITUTIONS BANKS Global Retailers BANKS National Retailers Exporters Wholesalers BANKS CREDIT UNIONS Non-Bank Financial Inst. Processors/Traders BANKS CREDIT UNIONS NBFIs MicroFinance NGOs Producers Input Suppliers

In Assessing Markets with VCA Demand: Focuses on most relevant financial services demanded because they help targeted enterprises to take advantage of opportunities for growth Supply: Identifies range of service providers, building on their records, perspectives and relationships Put simply – a value chain lens focuses more narrowly on types of financial services than a financial sector lens, but more broadly on financial service providers – fertilizer suppliers, traders, warehouses, processors, as well as financial institutions.

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 Wholesalers Processors/Traders . It was an interest in these themes of financial services and the value chain that prompted 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 recognizes 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

Financial Service Providers BARRIERS TO ENTERING THE RURAL MARKET Costs and Risks Dispersed market Cost of infrastructure, communication and information Seasonality Shared production and price risks Historic Subsidies Limited collateral x Financial Service Providers Financial services – critical to facilitate both product flow and upgrading Financial institutions are reticent about lending to agriculture and rural customers, due to the costs and risks that many have written about This has led to actors in rural and ag value chains providing financial services to each other, through vertical linkages. The paper takes a look at three of these financial services. Producers

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 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 - TRADER CREDIT Benefits Inputs and product sales Higher yields Bulk input purchases Tap future production for collateral Global Retailers National Retailers Exporters Wholesalers Learning Business information used to screen customers Processors/Traders 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. Trader credit, and the relationships that facilitate these transactions, provide both product related benefits [More sales, higher yields through the use of better inputs], and rural finance-related benefits. ------------------------------------------ Red lines show the product transactions between players… green lines the financial transactions. Commodity like rice. Shepherd’s FAO study of rural finance in Asia found that 80% of rice millers provided credit to producers. Producers may also have inputs sold on credit. Rice producers themselves provide financing to processors and traders. 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

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 . 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. Differences between the lending flows for outgrower schemes and the ones you saw with trader credit include 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. For those of you more familiar with the VC framework, VCA looks at relationships between players, and not just their role in transactions. These relationships are described in terms of Benefits, learning, and relative power between the actors. 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

Producers VALUE CHAIN FINANCE - WAREHOUSE RECEIPTS Benefits Learning Processors/Traders Receipt Warehouse Bank Producers Benefits Extended sales season, higher prices, lower losses Bulk sales, sight-unseen transactions Collateral based on secure product, legal receipts Learning Grading standards Receipts provide screening and security to banks Producers

Frequent, creating high default risk VALUE CHAIN FINANCE LIMITS & POWER RELATIONSHIPS Power / Learning / Benefit 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. Competition. 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

Rural Finance Through…. VALUE CHAIN ACTORS & FINANCIAL INSTITUTIONS THEIR RELEVANCE AND 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. 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 Investment Loans Upgrading Financial Market Assessment Value Chain Analysis Financial Market Assessment Value Chain Analysis Financial Intermediation Embedded Services Financial Intermediation Embedded Services Financial Institutions Buyers and Processors Financial Institutions Competitiveness Cost recovery & risk management Buyers and Processors Banks and Producers Banks 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 Financial Sustainability Economic Growth x

VALUE CHAIN FINANCE THANK YOU