Unlocking Growth and Equity in Agriculture: The Power of Value Chain Finance

Introduction

Agriculture is crucial for sustainable development and the alleviation of poverty. However, finance for agriculture is still widely used, expensive, and unevenly distributed, which significantly restricts the ability of smallholders to compete (World Bank, 2008: 1–2, 13). Sudden and significant changes in food prices have revealed the vulnerability of agricultural production in meeting global demand, emphasising the necessity for increasing investment in agriculture at all levels. How can the appropriate investment be made, especially in a complex environment where financial uncertainty reduces available resources and increases fear and scrutiny of risk? Since regular financial organisations and methods have easily financed agriculture, a solution to these problems goes beyond conventional tactics.

With 'Agricultural value chain finance' (AVCF), it is possible to reach smallholder farmers while lowering the cost and risk of financing. Value chain finance pushes financial institutions to develop solutions that best meet the demands of the businesses in the chain while also understanding the competitiveness and risks associated with the industry as a whole. Naturally, AVCF is not the only source of this more thorough approach to agricultural financing; some of the top financial institutions in the industry also use this focus in their loan assessment procedures, but this is less frequently the case. Value chains receive a significant amount of their funding from individuals rather than financial institutions. Value chain finance can also contribute to the chains being more inclusive by providing smallholders with the resources they need to participate in higher-value markets (World Bank, 2008).

Value chain finance is a word that is constantly changing and has a variety of implications. Money flows to and among the various nodes in a value chain are referred to as "value chain finance." In other words, it refers to any financial products, support services, and services that enter and pass through a value chain. The objective is to address the needs and constraints of those who are a part of the chain. The requirement may be to access finance, ensure sales, obtain products, reduce risk, and improve chain efficiency. It is crucial to analyse and completely comprehend the value chain in all its facets since value chain financing is comprehensive (Miller, C. & Jones, L. 2010).

The Context

The understanding of value chain finance is critical for several reasons. The efficiency of people who provide and need agricultural financing can be increased by analysing value chain finance better. Identifying the financial requirements for the value chain's strengthening; customising financial products to the needs of the chain's participants; lowering financial transaction costs through direct discount repayments; providing financial services. And utilising value chain connections and knowledge to mitigate risks for the chain and its partners. These measures can enhance the effectiveness and calibre of financing agricultural value chains. As agriculture and agribusiness modernise via more integration and interdependent relationships - Value chain finance will become increasingly important. The value chain strategy has a great deal of promise for removing obstacles in the way of value chain players' economic opportunities, inputs, technologies, information, capital, and services.

To take an Agriculture value chain approach, we may take a stepwise process starting with developing an in-depth understanding of the value chain, its actors, and the transaction dynamics between them. The second step would be to identify the current value chain in terms of lead actors, business models and strategies to maintain sustainability for a long time. The third step is to identify the transaction process in terms of value added at various stages. The fourth step is determining the financial requirements' actual and critical points. Finally, the AVCF model must design the best fit option for financing the value chain. Understanding a value chain must comprise understanding the enabling environment, vertical and horizontal relationships, supporting markets or services (financial, non-financial and input supply) and the end market characteristics such as market potential, chain risk and consumer demands and future trends.

An enabling environment implies a favourable value chain environment at regional, domestic, and international levels. Further, it also factors in the opportunities for support and the regulatory constraints. The policymakers should positively address regulatory limitations through enacting and enabling favourable policies at Macro (central), Meso (for private sector intermediaries and micro level (local/ grassroots level institutions). Further, the government should also clarify, develop, and deploy policies and measures related to standards and certifications of food safety and the product's intrinsic value (e.g., quality, variety, size, shape). Finally, the government must address the most difficult challenge of AVCF - Contract reinforcement. Especially at the initial stages before the trust gets more cemented by a long-term interdependent relationship.

AVCF facilitates producers' access to markets, inputs, technology, information, finances and supporting services, resulting in the benefits of diversification and value-addition. One problem area in AVCF deals with the integration of smallholders for whom the scale may act as a barrier to integration in the value chain. Studies on successful models have found that for greater inclusion of smallholders, there is a need for greater intermediation and facilitation for collective action by government, NGO, or other institutional parties with similar agendas. Hence, the AVCF model must be comprehensive to succeed. A noteworthy example is the Basix triad model with its three pillars of LFS (Livelihood Financial Services), IDS (Institutional Development Services) and ABDS (Agribusiness Development Services).

AVCF business models could be of four types - Producer driven, Buyer driven, Facilitator driven and Integrated. Furthermore, AVCF, over the years, has also developed various instruments to help the different actors and stages of the value chain. AVCF instruments may be categorised into Product Financing, Receivable Financing, Physical Asset Collateralisation, Financial enhancement, and Risk Mitigation Products. Numerous studies and research have shown that the value chain approach is buttressed by procurement at open market prices, mutual trust between the parties, choosing the appropriate production region, availability of suitable infrastructure and support of government and institutions. Also, product market orientation; group lending; alliances between financial institutions, value chain actors and lead firms; and mobilisation of surplus funds from chain participants for cash flow smoothening of various actors further strengthen the AVCF approach.

On the policy side, the state must focus on investing in public infrastructure and keeping the policy environment stable. Also, the government should work towards enabling contract formalisation, enforcement, and dispute resolution. Furthermore, encouraging MFIs with agriculture orientation, reducing lending risks and creating risk management funds or government guarantees to create an enabling environment for AVCF.

The Discussion

Like microfinance, AVCF is another approach toward greater financial inclusion. Microfinance is primarily a low-ticket, short-term financial solution for meeting the financial needs of the low-risk, fast-return non-farm sector. AVCF, on the other hand, is directed towards meeting the agricultural financing needs and may not share the limitations of microfinance in terms of ticket size, tenure, riskiness and return cycle. AVCF converts a transaction's credit risk (of wilful default) to the performance risk of the value chain (market, price, and production risks in the value chain).

A range of AVCF instruments is operational in different value chains. One of the AVCF instruments, called 'Receivable Financing', helps curb distressed selling and provides the required capital to sow new crops by converting the same commodity into collateral. AVCF must evaluate the strength of the model, the commodity's competitiveness, and the overall environment for its sustainability in the long term. An excellent example of AVCF in the Indian context is Amul (GCMMF), a three-tier, producer-driven federation of milk cooperatives. In the Amul model, the producer's membership in the village milk cooperative is taken as collateral. Also, the cooperative is used as a distributor for the loans - Reducing both the risk and the distribution cost. Producer-driven AVCF realises higher product prices through leveraging economies of scale.

Another example of an AVCF instrument is 'Contract Farming' between a producer and a firm interested in directly procuring the commodity. A producer's intent to honour the contract is driven by the perceived cost of default in present and future. These costs may also include future benefits from the contracting firm's support and services, e.g., extension services. Many times, the default behaviour of the contracting producer is a function of both type of farmer and the type of commodity. Hence, the designing of the contract becomes very crucial for the success of contract farming. Companies typically screen the farmers before contracting out and weed out side-sellers as they gain more experience over time.

Mechanism of Value Chain Financing:

The agro-food industry has undergone changes that have impacted new production and marketing models that focus on consumer demand rather than producer-defined agricultural goods. This phenomenon has led to a globalised and fragmented market with little seasonality and high product diversity, requirements for food safety and traceability, and higher quality standards in conjunction with the enforcement of crucial environmental regulations. A greater understanding of each value chain's overall transactions and the agricultural sector it operates is necessary to handle this evolution. The best chains are integrated chains, as making financial decisions requires knowledge of this information.

Despite changes in agriculture and agribusiness, the standard offering of financial products and services for agricultural and rural production has been lacking and not particularly innovative. Financial intermediaries still lack much depth in rural areas, and producers, especially smallholders, are still underserved. The conventional wisdom holds that lending in the agricultural sector is costly and hazardous. However, significant players in the banking industry, including Banorte and Rabobank, two sizable financial institutions in Mexico and the Netherlands, respectively, express the opinion that agricultural credit can be profitable if producers are fully integrated into a strong value chain (Shwedel, 2007; Martnez, 2006).

The operational costs for completing a loan transaction or securing capital are less significant than agriculture's systemic or linked risk. This danger is brought on by price volatility and erratic weather patterns that might concurrently affect multiple places. Collateral is utilised in conventional lending to reduce risks for the lender. However, the standard mortgage kind of collateral banks frequently ask for is either unavailable or impractical in rural locations. Therefore, collateral is a significant barrier to accessing funding for agriculture from all sources, including banks, credit unions, and other financial institutions. According to Mrema (2007), changing one's mindset to one of "we" rather than "me" and putting more emphasis on coordinating the use of resources and interventions is the first step in implementing a value chain approach to agriculture.

Inventory Credit or Warehouse Financing:

Warehouse receipts are a crucial tool for value chain financing, and significant focus is placed on demonstrating how to use them effectively. It is a subset of the more general phrase of inventory finance, where the guarantee is provided by the stock of a good or asset. The credit extended in certain situations is relationship-based and does not require any papers. However, warehouse receipts, a type of collateralisation financing, are more frequently used in inventory credit. A warehouse receipt system gives the value chain participant who "owns" the inventory, often a commodity, access to both secure storage and credit. Place the item in storage and use it as security for a loan from a lending organisation. The receipt demonstrates that the goods are physically in the warehouse and secure and safe since they are kept in a licenced warehouse. In contrast to traditional lending, where the underlying collateral is just a secondary source of repayment that must be mobilised when something goes wrong, this receipt acts as the guarantee or collateral foundation for financing. Hence, it serves as the primary means of repayment in collateralised commodities loans.

A controlled warehouse often issues receipts for goods held there; the owner purchases the receipt as collateral, and a financial institution accepts the receipt as collateral and offers loans against it. The warehouse financing model provides several advantages to various stakeholders. Both suppliers and buyers have more financing at the farmer level, and agribusiness companies have easier access to funding based on the strength of clients and purchases/sales. Further, the instruments are negotiable to fit the specific nature of the value chain.

Furthermore, the model can reduce transaction costs of trade finance, such as allowing more use of open trade accounts which are less costly than secured ones. The warehouse financing model can improve account receivable collection efficiency and risk. Hence, the model is widely used by medium and large businesses involved in the trade. The mechanism provides a substantial business line opportunity for the bank and clients of financial institutions. Reduces collateral requirements needed for loans while delivering security and prices.

Internal and external value chain financing approach:

Value chain finance is a phrase that is constantly changing and has a variety of meanings and connotations in the quick-paced development setting. Value chain finance refers to the movements of money to and among the various nodes in a value chain. In other words, it refers to any or all financial services, products, and support services flowing to and through a value chain to address the needs and constraints of those involved in that chain, whether it be a need to access finance, secure sales, procure products, reduce risk, and improve chain efficiency. It is crucial to analyse and completely comprehend the value chain in all its facets since value chain financing is comprehensive. Miller and Jones use the term to describe both internal and external financial mechanisms that are evolving in tandem with the agricultural value chains they support:

1. Internal value chain finance?refers to financial transactions within the value chain, such as when an input supplier extends credit to a farmer or a lead company lends money to a market middleman.
2. Value chain interactions and procedures enable?external value chain financing. As an illustration, a bank may grant a loan to farmers based on a contract with a reliable customer or a warehouse receipt from a reputable storage facility.

Conventional agricultural financing from financial institutions like banks and credit unions is not covered in this discussion of value chain finance unless there is a direct link to the value chain, as mentioned above. Any such definition would inevitably have some ambiguities, and we acknowledge that financing techniques are frequently continuums across which one must establish an artificial line for analytical and discussion purposes.

Input supplier credit in Myanmar, where agro-input retailers offer smallholder farmers deferred payment sales, illustrates internal value chain financing (Myint, 2007). A typical instance of external value chain finance is demonstrated in Kenya, where small fruit and vegetable producers may obtain bank financing for agrochemicals owing to their export contracts. The exporter pays the farmers via the bank, subtracting the upcoming loan instalments before giving the farmer group the net revenues (Marangu, 2007). We must view the Value chain finance in agriculture in the larger context, which includes the business environment of each country, and the value chains themselves, as these impact both the value chains and the financial systems.

Payment by Buyer through the bank

It is not easy to increase finance and investment sustainably. Agriculture financing is still seen as having high operating costs, significant risks, and low returns on investment. The agricultural loan programmes in underdeveloped nations frequently have unsatisfactory results with low rates of return despite (or perhaps partly because of) large subsidies, despite good intentions to direct credit to agriculture. A large part of the reason why agricultural development banks have been reluctant to innovate is because of governmental directives. Due to unpredictable and systemic risks, increased expenses, and bankers' inherent fear of the unknown, commercial banks have traditionally shied away from this industry. Most traditional financial institutions find it typically prohibitive to lend to farmers, especially smaller ones, in hard-to-reach rural areas with less educated and low-income populations. Some of these low-income households are reached by microfinance organisations but doing so comes at a high cost and with short-term loan products that are typically unable to cover the whole spectrum of agricultural demands.

The systemic or linked risk in agriculture is much more significant than the transaction expenses for completing a loan or securing capital. This risk is caused by fluctuating prices and erratic weather patterns that might temporarily affect entire regions, making payments unpredictable. Agriculture is quickly transitioning from fragmented production and marketing networks to integrated market chains. Multinational agri-enterprises dominate the market with ever-increasing vertical and horizontal linkages or integration, driven by benefits from economies of scale and the globalisation of the food chain. As a result, the chain's connections, structure, and general health are more crucial than ever. Farmers, traders, and other food system participants that are not connected and independent will probably break off into separate chains and fail to compete in the future. As a result, agricultural transformation in a market that is becoming more globalised brings with it not only new problems but also new chances to use that integration to boost competitiveness and access to finance.

Financial institutions can act with lower risk to extend their services and further support the expansion and upgrading of agricultural activities as agricultural value chains become more sophisticated with responsive production to guaranteed markets. The view is less discussed in other forms of finance, whether internal financing within the chain, like classic trader credit or financing originating externally, like conventional banking finance, which involves a large amount of risk. Uncertainty, or the inability to completely comprehend the dangers and, as a result, properly assess and mitigate against those risks, is mostly to blame for the added risk. Additionally, uncertainty increases the impression of risk, which lowers traditional financing for the industry.

According to (2007), Chain-based financing necessitates the banker's view and comprehends the organisation. It necessitates adapting to new market circumstances, more precise pricing, a better knowledge of risk, and, consequently, a greater willingness to take the risk. In his role as a value chain finance specialist for Rabobank Mexico, he discovered that a comprehensive understanding of the chain could lower risk and pave the way for financing based on systemic knowledge. In the case of Mexican flower growers, Rabobank provides the working cash, equipment, and technological requirements. In line with this, Rabobank also provides funding to the distributor of equipment that gives farmers access to the necessary technology. The bank provides financing to the farmers since it is familiar with them and is aware of their marketing strategy. The farmers ship goods for auction to Holland, and Rabobank provides financing for the auction to many of its buyers. In this approach, the bank has secured the funding of the entire supply chain and has a thorough understanding of the chain, including the production factors, equipment suppliers, and customers. To directly debit the farmers' accounts for loan payments, the bank needs to know that the farmers receive their money as it is placed in a Rabobank account.

Contract Farming:

In value chains, contracts and contract farming are crucial for securing products, markets, pricing, and assisting in debt repayment. Although agreements between farmers and buyers simplify receivable finance, contract farming is not a value chain financing tool. For agricultural companies, financial institutions, and governments, creating effective and inclusive value chains and enhancing their interaction with financial markets in smallholder-dominated agrarian economies is a significant problem. Conversely, the issue is not insurmountable if these players use creative and focused techniques. These targeted actions give farmers better access to markets, inputs, technologies, information, financing, and services and give them the chance to gain from diversification and value addition. Previous research has demonstrated that contract farming output prices are typically 4-8% higher than open market pricing (Birthal et al., 2005). According to Chen (2008) and Miyata et al. (2009), contract pricing is more expensive than open market prices.

The buyers' propensity to remove small-scale producers from the value chain due to the higher transaction costs of produce aggregation and service delivery to many of them is a crucial complaint of buyer-driven value chains. As a result, value chain finance gives smallholders two more alternatives than traditional borrowing. They frequently access money from other chain participants, such as contract farming agreements where the contracting Buyer provides the funding in kind or cash. They can also utilise their connections with influential partners in their chains to acquire bank money that may not have been possible (via legal contracts or established informal arrangements). Both options can improve their growth and access to funding.

One key lesson is that we must address the issues of the scale limits in the distribution of inputs, financial and non-financial services, and the aggregation of scattered production. Collective action is crucial for lowering transaction costs and enhancing farmers' bargaining strength when negotiating with large corporations. A second and equally critical lesson is that federating farmers into cooperatives, self-help groups, or producer associations may not happen on its own; it necessitates some level of intermediary or facilitation by governments or non-profit organisations. To lower the transaction costs of doing business with small farmers and improve farmers' compliance with their food safety requirements, lead corporations may also encourage collective action.

Low compliance rates may be a problem for buyer-driven value chains, such as contract farming, and are likely caused by weak governance and enforcement systems (Narayanan, 2012; Fang and Wang, 2013). Contracts are frequently informal or oral, restricting their usage as a means of finance for agribusiness and agriculture. It is necessary to create institutional procedures, legal or not, to make it easier to formalise contracts and settle disputes. The trust that exists between buyers and sellers is crucial for the development of value chains. Fixed costs can result in extra-contractual sales. Following open market pricing while providing a premium as an incentive for sellers is a crucial innovation to address this issue (Birthal et al., 2005; Chen, 2008; Miyata et al., 2009; Singh and Singla, 2011). When it comes to inputs, the leading companies that make bulk purchases frequently give farmers a portion of their profit margin. These advances aid in preserving ties between buyers and sellers. The effectiveness of a value chain is influenced by the choice of a suitable manufacturing area, the accessibility of public infrastructure (such as roads, power, and communication), and the government's backing. Public-private partnerships are crucial to establishing and supporting effective and inclusive value chains, as demonstrated by the Chinese citrus value chain.

References and Recommended Readings:

1. Birthal, P.S., Joshi, P.K. and Gulati, A. (2005), "Vertical coordination in high-value food commodities: implications for smallholders", MTID Discussion Paper No. 85, International Food Policy Research Institute, Washington, DC.
2. Chen, K. (2008), “Linking markets to smallholder dairy farmers in China. Quality as a new driver”, in Barbosa, S.B.P., Batista, A.M.V. and Monardesh, H. (Eds), Congresso Brasileiro de Qualidade do Leite, CCS Grafica e Editora, Recife.
3. Fang, X. and Wang, H.H. (2013), "The three-party game of contract farming: low contract compliance rates in grain transactions in China", China: An International Journal, Vol. 11 No. 3, pp. 1-13.
4. Martinez, E. (2006) ‘Banorte Banca agropecuaria’, presentation at the Latin America Conference.
5. Miller, C., & Jones, L. (2010). Agricultural value chain finance: tools and lessons. Practical Action Publishing.
6. Miyata, S., Minot, N. and Hu, D. (2009), "Impact of contract farming on income: linking small farmers, packers, and supermarkets in China", World Development, Vol. 37 No. 11, pp. 1781-1790.
7. Mrema, H. (2007) 'Mainstreaming smallholder farmers into the world economy, using farmer ownership model', presentation at the AFRICA Agribanks Forum.
8. Myint, K. (2007) 'Value chain finance', presentation at Asia International Conference.?
9. Narayanan, S. (2012), "Notional contracts: the moral economy of contract framing arrangements in India", WP-2012-020, Indira Gandhi Institute of Development Research, Mumbai.
10. Shwedel, K. (2007) 'Value chain financing: a strategy for an orderly, competitive, integrated market', available from: www.rural nance.org/id/54079
11. Singh, S. and Singla, N. (2011), Fresh Food Retail Chains in India: Organization and Impacts, Allied Publishers, New Delhi. Marangu, K. (2007) 'Kenya BDS program, experience in value chain facilitation, presentation at the AFRICA Agribanks Forum.
12. World Bank (2008) World Development Report 2008: Agriculture for Development, The World Bank, Washington D.C.