Why Smallholder Finance Isn’t Getting the Investment It Needs
The financial inclusion sector is failing to meet the needs of the world’s poorest. About two-thirds of the World’s poor are farmers, yet only a quarter of their estimated $200 billion financing needs are currently being met by financial service providers (FSPs).
Additionally, agricultural growth is one of the most powerful tools to help end poverty: growth in the agricultural sector is two to four times more effective in raising incomes among the poorest compared to other sectors.
Although financial inclusion continues to grow at a global level, it is doing so more slowly than before. About 1.7 billion adults remained unbanked in 2017, many of them farmers.
For these reasons, we believe smallholder finance (SHF) represents the biggest opportunity for scale and impact in financial inclusion today. To make a lasting impact on poverty, financial service providers (FSPs) must pioneer services and explore new markets to meet the needs of smallholder farmers.
There are a number of broad challenges facing SHF, such as integrating services along the value chain, building partnerships, and managing weather risk. However, the need for more innovative financing to support product development and scale is the most critical and will be our focus for this blog.
The lack of suitable investment options is holding back smallholder finance growth and impact.
FSPs serving the smallholder segment are struggling to expand their reach and reduce the financing gap due to limited availability of appropriately priced and structured capital. The price, risk evaluation and structure of debt funding currently available often does not align with the costs and realities of rural expansion. This prevents FSPs from expanding SHF and disproportionately excludes smallholder farmers from access to financing that could improve their lives.
As a coalition of smallholder finance practitioners, Propagate members often provide additional, non-financial services that enhance productivity, increase farmer sales prices or reduce risk, from improved seeds to crop insurance. However, on core financing, we have identified two common challenges faced by FSPs.
Investors are missing out on one of the greatest impact opportunities in financial inclusion today.
First of all, funding is not available in local currency, and major financial inclusion investors neither wish to take on currency risk, nor provide effective and innovative means of helping to open up local markets. Furthermore, currency hedging is prohibitively expensive. As a result, FSPs are disincentivized from investing in smallholder finance, in favor of higher returns on larger transactions and proven, traditional lending models and urban areas.
Second of all, the structure of funding (e.g. tenor, repayment frequency, collateral and loan covenants) is not aligned with the realities of agricultural lending, and continues to be focused on ‘traditional’ microfinance models providing short term debt to peri-urban client segments. This may be driven by investor restrictions to FSPs on portfolio exposure to smallholder farmers or the type of term and covenants deemed acceptable.
By overlooking investment opportunities in smallholder finance in favor of serving less risky client segments that are easier to reach, investors are missing out on one of the greatest impact opportunities in financial inclusion today.
Why is there a deficiency in investor funding for smallholder financing?
The Propagate Coalition has identified three reasons behind these challenges:
- Perception of risk - Any agricultural lending entails risk, but in Africa risks can be higher because of climate variables.
- Need to support scalable models - Another challenge for investors is that they are seeking programs that will serve large numbers of smallholder farmers and that are rapidly scalable. There is a chicken-and-egg situation here where scalability for the FSPs is partly dependent on having access to appropriate long-term financing.
- Need to demonstrate impact – Investors are also looking for programs that can show impact; however, to date the main focus for SHF product development has been on reaching scale, without sufficient focus on measuring and showing the impact of smallholder financing. FSPs lack opportunities and patient capital (another chicken-and-egg situation!) to test, innovate and prove the impact of SHF products and services, in order to build a strong impact narrative which attracts investment for the right reasons.
What can be done about it?
At the Propagate Coalition, here’s what we think needs to be done:
- More funds - We believe there is a need for more intermediary funds and innovative blended capital investments. For example, smallholder-focused investment funds supported with substantial philanthropic capital to help underwrite foreign exchange risk, or to improve liquidity of local currency investments through genuinely effective guarantees, could have a significant impact on FSPs, and ultimately, farmers.
- More and better data - The Propagate coalition members also support the improvement of the quality, availability and transparency of SHF data. There are three key types of data that can unlock market growth: demand, supply and impact. Existing initiatives have focused primarily on demand-side data, and there is now a growing body of impact data.
However, there remains a gap in the availability of supply-side data, and there is limited access to operationally useful information on SHF product development. The Smallholder Finance Product Explorer, a MIX initiative, aims to address this barrier by catalyzing the development of impactful smallholder finance products across hundreds of financial service providers and helping funders to identify new and innovative providers of smallholder finance to improve capital flows. Propagate members are all submitting data to MIX Market, and supporting the Smallholder Finance Product Explorer.
- Risk mitigation – Many organizations, including Propagate members, are piloting risk mitigation approaches with partners that bring the risks down considerably. FSPs need to continue the testing and evidencing of approaches that mitigate risk and lenders need to be prepared to have some element of risk share alongside the FSPs.
- Better communication - As smallholder finance practitioners with strong relationships with investors, Propagate members are also willing to reinforce the communication between FSPs and investors. We believe that, by increasing the quantity and quality of feedback, FSPs could influence the creation of better lending structures for smallholder investment.
As a first step, we are inviting the investor community to share their thoughts and respond directly to this blog post. Join the debate by contributing to the comments section below.