Agrifood value chain finance can expand opportunities for smallholders

Agrifood value chains (AVCs) in low- and middle-income countries (LMICs) have been expanding due to a range of factors, including income growth, urbanization, more market-oriented policies, globalization, and technological changes. Integrating smallholder farmers into those growing value chains, particularly for higher-value commodities, is an important path towards reducing poverty and generating employment opportunities, particularly for women and rural youth.

But participating in high-value agricultural markets presents major obstacles for smallholders. Many lack the financial resources to make the needed investments to join those value chains and to effectively manage the risks in trying new types of products or production methods.

For smallholders to fully realize the benefits of expanding AVCs, raise their living standards, and build resilience to climate impacts and other shocks, they need to overcome those constraints. Creating more and better opportunities to enter high-value agricultural markets requires creative approaches to AVC finance (AVCF)—a key element in financing food systems transformation. In this post, we outline the challenges smallholders face and the potential benefits of AVCF.

Financial constraints

Smallholders have trouble overcoming risk and liquidity constraints for several reasons:

• Transaction costs for making small loans to smallholders are high compared to the costs of working with larger producers.
• The spatially dispersed nature of agriculture means high monitoring costs for lenders and insurers.
• Agriculture involves a greater range of risks than other forms of lending. Risks include severe weather, droughts, and diseases and pests, many difficult to monitor or prevent and representing potential catastrophic losses.
• Where loans are available, the collateral requirements can be difficult for smallholders to satisfy, particularly when property rights over land are not clear.
• Financial institutions may lack knowledge about agriculture and its specific needs, particularly related to seasonality. For example, farmers may not be able to pay back loans until after harvest, and distinct financial needs arise at specific times of the year. These factors can lead to badly designed loans, or financial instruments and services for agriculture may simply not be available.
• Government agricultural or finance policies can exacerbate these constraints, e.g., banking regulations tailored to urban activities based on steady incomes or enforcement of lower than market-clearing interest rates. This can lead to greater overall demand for loans than banks are willing to supply and thus credit rationing, leaving smallholders at a disadvantage.

How AVCF works

AVCF can help to overcome these constraints and expand smallholders’ credit options. A typical agricultural value chain finance scheme requires at least three parties: Smallholders or primary producers, an anchor firm that purchases from those producers, and a financial institution. The financial institution uses the relationship between the primary producers and the anchor firm to lower the risk of the loans it makes, which can either go to the anchor firm and then flow to the farmers, or go directly to farmers, who have a guaranteed market for their crops.

Under this arrangement, farmers can then afford inputs to produce more or higher-quality products, and the anchor firm can obtain more and/or more consistent quality products. There are numerous ways this basic model can be adapted; for example, a four-way adaptation can include input dealers, or relationships within AVCs can be harnessed to promote the use of climate-smart technologies. The spread of digital financial technologies also has the potential to reduce transaction costs through mobile payments and to trace agricultural products through value chains. However, smallholders may prefer not to use phones to manage money and may strongly prefer face-to-face interactions to borrow money.

Some examples of agricultural value chain finance

When conditions are right, the AVCF approach has been quite effective in linking smallholders to high-value markets.

For instance, in Madagascar a vegetable exporter collaborated with smallholders and a financial provider to use AVCF to provide inputs and extension to the farmers, who could then meet European quality standards. And there are several examples of successful AVCF in dairy value chains, in Central and Eastern Europe, Punjab, India, Armenia, and Uganda. In these cases, the anchor dairy, dairies, or milk collection centers offer access to credit for dairy-specific investments by farmers, or facilitated bank guarantees, as well as providing technical assistance. In turn, dairy farmers have expanded production of better-quality milk, benefiting the dairy processors.

Best conditions for AVCF

To be successful, AVCF schemes require certain key elements and careful design and management. Our research identifies six distinct factors that can play a role in making AVC finance preferable to farmers, buyers, and financial institutions:

1. The smallholder adopting a new product, technology, or set of practices must see a clear increase in value at the farmgate and/or downstream on the value chain, which can benefit both primary producers and other actors.
2. Incentives should encourage better risk management through contractual relationships. Note that contracts with smallholders add a risk for buyers, so this condition is necessary but not sufficient.
3. Buyers should gain from the risk-reward relationship. If buyers have capital to self-finance contracts with smallholders, they might not need outside financing. If that is the case, the incentive they have to participate in arrangements with third-party financial institutions is to mitigate their risk. To take part in an AVCF scheme, then, they must either be credit-constrained or see a clear opportunity to reduce their risk level.
4. It is helpful if buyers have market power. If farmers can sell their product to buyers outside the AVCF scheme, the guarantee that substitutes for collateral weakens. Thus, the ideal is an apex buyer offering incentives to increase production, improve quality and safety, or meet sustainability standards. With multiple purchasers, short-term incentives for smallholders to renege on contracts exist.
5. Understanding local institutional conditions such as land rights and business aggregation is vital. For instance, incomplete land rights make farm consolidation and vertical integration less likely, but also undermine the use of land as collateral. A legal framework that allows warehouse receipts to be used as collateral can be quite useful in this context. Well-managed farmer cooperatives can also reduce transaction costs related to aggregation—but if poorly governed, they can exacerbate aggregation problems.
6. Specific financial regulations and/or local institutions can hinder AVCF viability. Fixed interest rates, for example, hinder returns to banks, making it more challenging to take on additional risk from agricultural loans, while agricultural banks may specialize in standard forms of farm credit and reject AVCF approaches.

Policies to support AVCF for smallholders

Despite promising market conditions, in many LMICs smallholder access to credit remains constrained. Within appropriate AVCs, governments can create the conditions for AVCF development using the following policy advice:

1. Credit market regulations. New entrants to credit markets, such as those promoting digital payment products, may be more amenable to using AVCF than agricultural banks. Ensuring that regulations allow for innovative entrants, or the use of innovative products, can foster the use of AVCF.
2. Interest rate policy. Ceilings on interest rates can lead to credit rationing and hinder the development of AVCF schemes. Farmers, cooperatives, and product buyers can all benefit from a lack of distortions in capital markets.
3. Promote the use of alternative forms of collateral. Financial regulations can inhibit the use of forms of collateral such as warehouse receipts that can help to foster AVCF.
4. Promote a stable macroeconomic and general policy environment. Firms and financial actors already face risks to AVCF related to weather, price fluctuations, and other shocks; when policy is uncertain and/or the macroeconomy is unstable, their options shrink further.
5. Build capacity in both the agricultural and financial sectors. Farmers need technology and extension support, while loan officers and regulators need to know enough about agriculture, including production timing and risks, to make the right financial decisions. By working with known firms, AVCF can provide loan officers with a window into agricultural lending—provided that policy support exists to expand farmer access to the appropriate technologies.

Agricultural value chain finance is a key element for financing food system transformation towards healthier, more sustainable outcomes. AVCF offers a flexible template for fostering partnerships between smallholders, local businesses, and financial institutions to tap into expanding markets for high-value products. To make AVCF more effective, international development organizations can support value chain actors, financial institutions, and smallholders through advocacy with policymakers and highlighting further AVCF successes.

Alan de Brauw is a Senior Research Fellow with IFPRI’s Markets, Trade, and Institutions Unit; Johan Swinnen is IFPRI Director General. Opinions are the authors’.