CHALLENGES AND OPPORTUNITIES
A Study by PROFIT and ZNFU
December 2009
Mike Taylor
Joe Dougherty
Rob Munro
TABLE OF CONTENTS
| Executive Summary | 1 |
| 1. Report Background and Objectives | 4 |
| 2. Stakeholders’ Concerns and Impressions | 7 |
| 3. Key Features of the Agricultural Finance Market | 10 |
| 4. Recommendations and Next Steps | 23 |
executive summary
This draft report was compiled by the USAID PROFIT Project at the behest of the Zambia National Farmers Union (ZNFU). ZNFU asked PROFIT to assess the market (supply and demand) for agriculture finance in Zambia for two reasons: 1) to address the concerns of many of its members, who are finding it increasingly difficult to obtain affordable and appropriate business finance, and 2) to inform the work of the newly-convened Agriculture Finance Committee under the Ministry of Finance and National Planning. ZNFU is an active participant on the Committee. The main goal of this Report is to identify the key factors which inhibit agricultural finance and recommend concrete steps towards addressing them.
Zambia’s market for agricultural finance is fundamentally dysfunctional. From the farmers’ perspective, credit is scarce and expensive and heavily skewed towards the larger, corporate sector. Loan terms are often too short to accommodate the long term nature of agriculture, and the processing of loan applications by banks often takes too long. These problems cause an already-risky sector to become even riskier. From the bankers’ perspective, agricultural lending is both risky and expensive. They are reluctant to lend without very high collateral coverage and a high risk premium. When they do lend, they often lose money. Non-performing loans in the agricultural sector now exceed 37%, against 13% across all other sectors of the economy. This high level of distress represents a serious loss for banks – one which will make them even more reluctant to lend in future. Thus, the agricultural finance market is caught in a self-perpetuating cycle of risk and loss, which benefits no one.
In addition to the normal risks associated with agricultural production – weather, macroeconomic instability, and price volatility – three factors account for the fundamental problems facing Zambia’s agricultural finance market:
1. A highly-risky lending environment caused largely by unpredictable Government intervention as well as weaknesses in the legal framework;
2. Limited understanding of agricultural markets and limited expertise in agricultural finance among most banks and other financial institutions;
3. Poor risk management practices and limited financial analysis and management capabilities within the agricultural sector.
To address these underlying constraints, the Report recommends that farmers (represented by ZNFU), along with lenders (represented by the Bankers Association of Zambia) and Government work together to reduce some of the structural risks inherent in the Zambian agricultural sector, strengthen understanding and expertise in agriculture among bankers, and improve financial management practices among farmers.
Specific recommendations include the following:
1. Strengthen the enabling environment for Zambian agriculture
Some risks inherent in agriculture, such as weather and global commodity price fluctuations, are to a large extent uncontrollable. Farmers themselves can reduce some of these risks
through crop diversification and investment in irrigation but a more systemic approach to reducing risks in agriculture would involve the fostering of a more conducive enabling environment for profitable and competitive agricultural growth. There are four main steps that can be taken that can mitigate some of the risks inherent in Zambian agriculture:
· Reduce Government intervention in agricultural markets and make it more predictable.
· Identify strategies for reducing the costs of agricultural production
· Strengthen the legal and regulatory framework for agricultural finance.
· Move towards a more transparent and secure agricultural marketing environment.
2. Strengthen understanding and expertise in agricultural finance
With so many agricultural loans in distress, Zambia’s banks are facing a major challenge and the challenge to the sector is to prevent the cycle of risk and loss that has occurred with disturbing regularity over the past decade. But the current crisis also presents an opportunity to improve lending skills by capturing lessons learnt through loan workouts. The Report recommends that banks take three steps to improve their agricultural portfolios:
· Train lenders in the fundamentals of agricultural economics in Zambia
· Create specialised agricultural units with in-house agricultural risk assessment skills
· Engage the agricultural sector to improve understanding, increase information flow, and assess risks
3. Develop and test new financial products and lending approaches to spread, manage and mitigate risks
Agricultural finance can be profitable – even in a country like Zambia – as banks in other countries have demonstrated. But the agricultural sector demands a specialised, innovative approach. Loan terms must be matched to the agricultural cash cycle, for example, and mechanisms must be built in to guard against the risk of unforeseen changes in prices. Examples of such developments could include:
· The use of non-traditional forms of security
· Agricultural equipment leasing
· Developing the agricultural insurance market
· Developing hedging mechanisms
· Explore the use of international lines of credit and risk mitigation
4. Improve financial management in the agricultural Sector
While banks improve their understanding of agriculture, farmers can make themselves more attractive to banks as clients through developing and demonstrating financial proficiency. ZNFU and its development partners might wish to enhance the ability of the Union to conduct financial skills training for its members, including sessions on how to approach banks and prepare and manage a successful loan application.
In order to implement these recommendations, the Report strongly encourages ZNFU to engage proactively with the Bankers Association of Zambia (BAZ) to identify common interests, provide a forum for information sharing and feedback, and lobby jointly for changes to Government policy that will benefit both the agricultural sector and the financial sector.
If these recommendations are carried out, and if lenders and borrowers can work together with Government and other stakeholders to solve common problems, then we are confident that the vicious cycle of risk and loss that afflicts Zambia’s agricultural finance market can be reversed. Together, ZNFU, BAZ and the Government can launch a ‘virtuous circle’ of growth and profit, based on mutual understanding and trust. PROFIT stands ready to assist.
a. felt four years later.
Weaknesses in the legal framework, especially the poor enforcement of contracts coupled with the high cost of litigation. A number of farmers complained that buyers sometimes do not honour the price they had originally agreed to pay for a commodity, if the index price of the commodity changes
a. significantly before delivery. With a long and expensive judicial process facing a potential complainant, sellers often have little option but to accept price reductions. To a lending institution, the uncertainty that this creates in terms of projected income is a powerful dissuasive element.
b. Volatility of input and output prices. In line with agriculture in other countries and especially in the last two years, Zambian agriculture has experienced significant swings in input and output commodity prices. Over the last eighteen months, wheat prices have declined by more than 50% (see chart above). Between June 2007 and June 2009, for example, the global price of di-ammonium phosphate (DAP), an important fertilizer input, increase by 300% and then decreased by 320%. Farmers in all countries are subject to these price swings and the underlying risks (like weather, shifts in global supply and demand, and natural disasters) that cause them. However, in many countries, farmers have access to a range of risk mitigation products – forward and future contracts and options as well as various insurance policies – that shield them, at least partially, from the worst effects of price volatility. In Zambia, these products are generally either non-existent or only offered at a high price.
c. Margin sensitivity in commercial farming. Related to the above point, farming margins can swing dramatically between years as a result of input and output pricing. The graph left shows that at 2009-10 cost and price estimations, margins are extremely tight and only a small decrease in price can push a commercial farm into negative profitability.
d. Unpredictable Government intervention in agricultural markets. Historically, the main causes of price spikes and slumps in Zambia which are not directly related to supply and demand fundamentals are related to government agricultural policy. Interventions that cause market instability and reduce market transparency are:
i. Ad hoc export or import bans
ii. Introduction or removal of import or export duties
iii. The volume, geography and pricing of government procurement
iv. Government off-loading public stored crop onto the market
v. Rumours surrounding any of the above
Below is a graph that demonstrates the effect government policies can have on price volatility. It measures the conditional coefficient of variance in maize prices over the last fifteen years – i.e. the unpredictable component of price variation once predictable variation due to seasonality, production and world price influences have been removed. For comparison, the Kenyan example is taken, which shows much lower levels of price variance as a result of non-market factors, which in turn corresponds to much lower levels of state intervention in the maize market:
Anecdotal evidence points to ‘non-market’ related maize price ‘spikes’ in excess of $60/ton (between 20% and 25% of average price) as a result of market paralysis following import restrictions and similar ‘slumps’ as a result of export bans.
Governments in many countries intervene in agricultural markets to some degree – often for valid reasons – but they strive to make their intervention predictable, so that farmers and other market players can plan effectively, and to reduce the degree to which their intervention distorts price signals. Unpredictable behaviour by the state, however, adds another dimension to price determination other than supply and demand, which again creates uncertainty when seen through the lens of agricultural financing.
a. Lack of access to affordable and appropriate finance. The high cost of credit, along with the lack of long-term lending, creates a vicious cycle: When interest rates are high, the probability that farmers will fail to repay their loans is increased, since their debt burden is higher relative to their incomes. High rates of non-repayment, in turn, encourage banks to raise the risk premium and charge higher rates. Similarly, when a farmer must repay a loan for purchase of capital equipment over one or two years instead of five, there is a greater chance that the farmer will not earn sufficient revenue to repay the loan on time. Delinquencies rise, which reinforces the banks’ tendency to offer only short-term loans.
The cost and margin chart on page 19 also illustrates the impact of high interest rates on the financial viability of farming in four important sub-sectors. For all four crops, finance costs represent a significant drain on gross margins. In wheat and soya, average finance costs are actually greater than gross margins. Farmers of those crops currently pay their banks more than they earn themselves. While output prices can change rapidly, interest rates (i.e. finance costs) remain fixed, as do the costs of most inputs (e.g. labour, seed and overhead). When prices drop, farms can very quickly become insolvent. High interest rates combine with volatile commodity prices (spurred in part by unpredictable Government interventions) to make Zambian agriculture very risky indeed.
In this manner, the riskiness of agriculture becomes a self-fulfilling prophecy. Some banks, seeing the high level of risk in the sector, seek to avoid or contain the risk by increasing interest rates, reducing the loan term, and moving to foreclosure in the event of repayment problems. But these actions actually increase the risk to both farmers and bankers. Ideally, banks would work together with farmers to identify, mitigate and manage risks by offering a wide range of tailored and flexible financial products including credit, insurance, price risk mitigation products and others. Some of the reasons why this is not the case in Zambia are described below.
3.7 Lack of Expertise and Poor Communication
In addition to citing the high level of risk in agricultural lending, bankers also complain that some farmers do not take adequate measures to manage risks on their own and that farmers often do not provide them with sound, accurate financial data. PROFIT’s own experience working with farmers at all levels tends to corroborate this impression. Even among relatively large-scale farmers, financial analysis skills are sometimes not very sophisticated. As one would expect, smaller farmers tend to have less financial management capacity than larger-scale farmers. However, it is not clear whether it is a lack of financial acumen that causes the gap between bankers’ expectations and farmers’ ability (or willingness) to deliver the data they require. Other factors, such as a lack of trust or a reluctance to share personal information, could also be at play. At the same time, banks’ uneasiness with agricultural lending could be prompting them to ask for data that is not particularly relevant or useful. PROFIT has not had the opportunity to look at specific loan applications or credit files in order to address this question more specifically.
What is clear, however, is that the lack of expertise does not lie entirely with farmers. All of the bankers whom PROFIT interviewed said that they would like to increase their understanding of the agricultural sector and their ability to lend to farmers safely and profitably. Several leading banks have taken steps in this direction. One bank, for example, has brought in experts from outside Zambia to work with its local agricultural lending team. Another bank has sent its staff abroad to learn about agricultural lending from colleagues in other countries. All banks believe that there is still room for improvement.
3.8 Conclusion
Zambia’s market for agricultural finance is fundamentally dysfunctional. From the farmers’ perspective, credit is scarce and expensive. Loan terms are too short and turnaround times too long. These problems cause an already-risky enterprise to become even riskier. From the bankers’ perspective, agricultural lending is both risky and expensive. They are reluctant to lend without very high collateral coverage and a high risk premium. When they do lend, they often lose money. The high level of non-performing agricultural loans that the banks are now experiencing represents a serious loss for them – one which will make them even more reluctant to lend in future. Thus, the agricultural finance market is caught in a self-perpetuating cycle of risk and loss, which benefits no one.
In summary, in addition to the normal risks associated with agricultural production – weather, macroeconomic instability, and global price volatility – four factors account for the fundamental problems facing Zambia’s agricultural finance market:
i. A highly-risky lending environment caused largely by unpredictable Government intervention as well as weaknesses in the legal framework;
ii. Limited understanding of agricultural markets and limited expertise in agricultural finance among most banks and other financial institutions;
iii. Lack of appropriate financial products and approaches to help producers invest appropriately and manage risks prudently
iv. Poor risk management practices and limited financial analysis and management capabilities within the agricultural sector.
Steps for addressing these four fundamental issues are detailed in the next chapter.
4. Recommendations and next steps
4.1 Strengthen the enabling environment for Zambian agriculture
Some risks inherent in agriculture, such as weather and global commodity price fluctuations, are to a large extent uncontrollable. Farmers themselves can reduce some of these risks through crop diversification and investment in irrigation but a more systemic approach to reducing risks in agricultural would involve the fostering of a more conducive enabling environment for agricultural growth, which would succeed in reducing many of the Zambia-specific risks which would benefit financial institutions as well as the farming sector – along with Zambian society as whole. There are four main steps that can be taken that can mitigate some of the risks inherent in Zambian agriculture:
a. Reduce Government intervention in agricultural markets and make it more predictable: Ad hoc, unforeseen changes in import or export restrictions, duties and other interventions weaken price signals and making accurate planning impossible. ZNFU and the Bankers Association of Zambia (BAZ) should work together to lobby Government for specific policy changes to reduce market intervention and increase predictability. Analyses that have been carried out by Michigan State University, among others, can provide an empirical basis for demonstrating the benefits of more predictable, lighter interventions.
b. Identify strategies for reducing the costs of agricultural production. Zambia is inherently a high cost environment in which to farm where, as has been demonstrated, margins that can absorb the high cost of financing are not assured. A high dependency on imported inputs and high transport costs from the sources of these inputs, little in the way of economies of scale, high utility costs and a rigorous tax regime all succeed in pushing the costs of inputs to levels higher than in neighbouring countries. It is generally agreed that Zambia’s agricultural potential contribution to economic growth will not be met by satisfying local demand but by fostering a regional export-driven growth environment, yet typically when Zambian commodities are exposed to the regional market in years when production exceeds local demand, they remain uncompetitive. This situation ironically actually exacerbates commodity price volatility as prices swing from relatively high import parity-based prices to significantly lower prices based on export parity
Other than a ‘social’ input subsidy programme by the Government for smallholder farmers, no significant subsidies or concessions exist for Zambian agriculture, and a point of lobby would revolve around the introduction of possible tax, fuel or utility concessions that would contribute to lower costs of agricultural production, greater farm profitability, the expansion of production and regional competitiveness, all of which would further reduce the risks inherent in agricultural financing.
To begin this process, over the next few months, ZNFU, with support from PROFIT, will undertake an analysis of selected agricultural value chains to determine how Zambian producers can become more globally competitive, in order to gain a better understanding of the constraints to competitiveness and profitability.
c. Strengthen the legal and regulatory framework for agricultural finance: Suggested points for further work and joint lobby by the ZNFU and BAZ would include:
i. Passage of the Amendment to the Agricultural Credit Act would establish a more robust platform for agricultural lending by, among other things, strengthening banks’ ability to accept alternative forms of collateral, such as warehouse receipts and crops in the ground.
ii. A modernised bankruptcy regime might provide better protection for debtors and reduce the rate of foreclosure, while also respecting creditors’ rights.
iii. Strengthening of the small claims court and arbitration process would enhance the confidence of lenders that there is speedy legally binding redress in the case of agricultural contract default.
iv. Enabling legislation around leasing would stimulate the sector. PROFIT worked recently with Bank of Zambia to draft new legislation around leasing. Passage of that law would strengthen the framework for equipment leasing and could enable lenders to provide longer-term credit for the purchase of capital equipment without the need for onerous collateral requirements. It would also make steps towards defining a tax regime for leasing that enables leasing products to be extended more appropriately to the SME sector which, it can be argued, is the sector that would benefit most from a dynamic leasing market.
v. Non-traditional forms of collateral need to be examined, including for example, ‘chief’s title’ which could be used to secure loans to farmers without individual and ‘formal’ title to their land.
d. Move towards a more transparent and secure agricultural marketing environment. The Zambian Agricultural Commodities Exchange (ZAMACE) has been in existence for two years, has recorded trades of K170bn ($36m), and provides a structured and transparent platform through which farmers (and other players in the agricultural market) can reduce the risks involved in commodity trade, and ultimately enhance the confidence of financial institutions in the marketing of agricultural commodities by their clients. Some of the benefits that the Exchange provides to the market are:
i. Market access – clients have easy access to a wide range of market players;
ii. Price discovery and transparency – through publicised, widely available trading information and the generation of a neutral reference price;
iii. Market integrity and efficiency - all products traded on the exchange are graded and certified, and contractual terms are standardised and enforceable;
iv. Security of transaction – through a series of insurance products and bank-based guarantees, ZAMACE essentially guarantees settlement of a contract – a buyer will receive delivery and a seller will be paid in accordance with the terms of the ZAMACE contract;
v. Speedy mechanism for redress in the event of default – all ZAMACE contracts specify legally binding arbitration as the standard form of dispute resolution.
ZAMACE is working closely with the Securities and Exchange Commission (SEC) in the formulation of a regulatory framework for the Exchange which will add to the integrity it provides to the market, and the imminent passage of the Agricultural Marketing Act will further entrench the beneficial role of the Exchange in the agricultural sector in Zambia.
4.2 Strengthen understanding and expertise in agricultural finance within banks
Undoubtedly, with more than 37% of agricultural loans in distress, Zambia’s banks are facing a major challenge. But the current crisis also presents an opportunity to improve lending skills. Bankers around the world agree that the best way to learn how to lend safely is to work through problem loans. As noted earlier, all banks in Zambia have some exposure to the agricultural sector, and agriculture will continue to represent an important component of Zambia’s economy for the foreseeable future. In order to maintain a diversified portfolio, banks will have to continue to engage the agricultural sector whilst avoiding the cycle of risk and loss that has occurred with disturbing regularity over the past decade. The Report recommends that banks carry out three broad steps to improve the safety and profitability of their agricultural portfolios:
a. Train lenders in the fundamentals of agricultural economics in Zambia: As noted earlier, some banks have brought in agricultural experts from their foreign offices to work with local lenders, while others have sent staff out to foreign offices to learn about agricultural lending. A third option is to engage third-party agricultural experts, based in Zambia, to educate lenders on the risks and opportunities in the country’s agricultural sector and work directly with lenders to identify and assess potential clients. Also as noted earlier, the current crisis provides an excellent opportunity for credit analysts and relationship managers to learn the pitfalls involved in agricultural lending – and how they might have been avoided. While formal classroom-type training can help, more intensive on-the-job training is needed to develop a solid base of practical skills in agricultural finance. A partnership between ZNFU and BAZ, perhaps, could provide junior and mid-level bankers an opportunity to visit farms and processing operations and learn how they work at first-hand. At the very least, banks should ensure that relationship managers actually visit their borrowers regularly and get to know their operations in as much detail as possible. Knowing one’s customer is a basic rule of prudent risk management.
b. Create specialised agricultural units with in-house agricultural risk assessment skills. Once a bank has built a base of in-house knowledge on agricultural finance, it can create a dedicated team to serve clients in the agricultural sector. Banks in Zambia have a limited pool of talented, experienced personnel to draw upon. A specialised in-house centre of agricultural expertise that acts as a support provider to branches and other lending units would leverage scarce resources efficiently. Also, a specialised agriculture unit will facilitate shorter turnaround times as well as profitable cross-selling of savings and fee-based products that meet farmers’ needs. Finally, the specialised unit, by focusing on the particular needs of clients in agriculture, can foster innovation in risk management and new product development.
c. Engage the agricultural sector to improve understanding, increase information flow, and assess risks. A wealth of experience exist within the farming community in relation to the viability of various business models and even the bankability of individual farming operations, and financial institutions could supplement their in-house knowledge of the sector by creating mechanisms for advisory input and peer review by the farming community.
4.3 Develop and test new financial products and lending approaches to spread, manage and mitigate risks
Agricultural finance can be profitable – even in a country like Zambia – as banks in other countries have demonstrated. But the agricultural sector demands a specialised, innovative approach. Loan terms must be matched to the agricultural cash cycle, for example, and mechanisms must be built in to guard against the risk of unforeseen changes in prices. Examples of such developments could include:
a. The use of non-traditional forms of security, such as warehouse receipts, accounts receivable and forward contracts must be used, given the declining relative value of rural land and buildings. Warehouse receipt financing is a relatively low risk endeavour with crop-in-store being a more liquid and accessible security than land or fixed assets, but passage of enabling legislation is required to stimulate the warehouse receipting market.
b. Equipment leasing could be a promising way to manage risks while expanding finance to the agricultural sector, in particular the relatively ‘unbanked’ emergent farmers that have both the capacity to expand and strong cash-based businesses but low levels of traditional collateral.
c. Developing the agricultural insurance market. Farmers perceive agricultural insurance to be expensive and unreliable in terms of payout assurance, yet reliable insurance is an excellent risk mitigant in the eyes of a lender. This study has not investigated the extent of this market (indeed there is scope of future work here) but Zambian State Insurance Company (ZSIC) and others have products designed for the agricultural market. ZNFU and BAZ might wish to work with ZSIC and other insurers to explore opportunities to expand the use of existing products and develop new ones. FinMark Trust commissioned a study of the market for micro-insurance in Zambia last year – that study could serve as a point of departure for efforts to develop the agricultural insurance market, particularly in relation to the smallholder and emergent agricultural sectors.
d. Developing hedging mechanisms. In more mature agricultural economies than Zambia such as South Africa, an entire financial market has been established around stored agricultural crop through futures and derivative trade. This financial market in turn greatly increases liquidity in the agricultural market and significantly reduces many of the risks in production and trade, and provides lenders with a transparent basis on which to project risk. However, the key inhibiting factor to the expansion of the South African futures market to Zambia or the development of an indigenous price risk mitigation industry is unpredictable state intervention in the commodities market that makes future price projection based on supply and demand fundamentals extremely difficult. Several banks in Zambia purport to offer price hedging instruments, but they complain that farmers have not shown very much interest in hedging – or at least in paying for these services
e. Explore the use of international lines of credit and risk mitigation. The Government and the banking sector can work with its development partners to tailor credit guarantees, lines of credit, and facilities like the EIB loan mentioned earlier to the financial needs of the agricultural sector by sharing risk or extending durations instead of simply providing liquidity.
4.4 Improve Financial Management in the Agricultural Sector
While banks improve their understanding of agriculture, farmers can make themselves more attractive to banks as clients. On-farm investments, like any other, must be considered based on a sound and conservative projection of the returns they are likely to generate. In order to make such projections and otherwise manage their finances prudently, farmers must have a thorough understanding not only of their own fixed and variable costs, and the factors that drive them, but also the dynamics affecting their industry as a whole. Equally importantly, banks must be convinced that a prospective borrower understands his own finances and has the capacity to manage them responsibly. ZNFU and its development partners might wish to enhance the ability of the Union to conduct financial skills training for its members, including sessions on how to approach banks and prepare a successful loan application. To this end, the ZNFU and PROFIT are piloting a financial literacy course for emergent farmers in 2010.
4.5 Proposed Next Steps
This Report is by no means a definitive assessment of the agricultural financing sector, the reasons for the current crisis in the sector and recommendations for their alleviation. It is, however, written with the aim of highlighting some of the key issues and, it is hoped, stimulating discussion, collaboration and action by all stakeholders towards fostering a more constructive partnership between agricultural and financial sectors. There is much work to be done.
In the short term and with the continued aim of investigating some of the structural problems related to agriculture and competitiveness, the ZNFU, with support from PROFIT, will be conducting an analysis of selected agricultural value chains in order to determine how Zambian producers can become more regionally competitive. Also in a bid to understand the wider agricultural financing sector, PROFIT will soon launch a study, in conjunction with FinMark Trust, on supplier and buyer credit within agriculture and other sectors. These two activities should provide a basis for further action to improve access to affordable and appropriate finance.
There are two main areas within agricultural finance that the Report was not able to cover in sufficient depth and require further investigation. Firstly, the severe shortage of long term finance is a serious impediment to the development of the agricultural sector – and quite possibly a major contributor to the current delinquency rates - and requires a more detailed analysis of supply, potential demand and any structural or policy reform that might be required to facilitate access. Secondly, the agricultural insurance market was insufficiently covered by this Report and yet could play a much greater role in mitigating the risks involved in both agricultural production and financing, and a greater assessment of the sector would be required.
While these efforts are underway, PROFIT would strongly encourage ZNFU to engage proactively with the Bankers Association of Zambia to identify areas of common interest, provide a forum for information sharing and feedback, and lobby jointly for changes to Government policy that will benefit both the agricultural sector and the financial sector.
If these recommendations are carried out, and if lenders and borrowers can work together with Government and other stakeholders to solve common problems, then we are confident that the vicious cycle of risk and loss that afflicts Zambia’s agricultural finance market can be reversed. Together, ZNFU, BAZ and the Government can launch a ‘virtuous circle’ of confidence, growth and profit, based on mutual understanding and trust.
