Agricultural Policy Dialogue Series # 8 Agricultural Finance & Investment in Iraq

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1 Agricultural Policy Dialogue Series # 8 Agricultural Finance & Investment in Iraq January, 2011 This publication was produced for review by the United States Agency for International Development. It was prepared by USAID-Inma Agribusiness team for a consortium led by The Louis Berger Group, Inc.

2 Agricultural Finance & Investment in Iraq DISCLAIMER The author s views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government.

3 Table of Content Current Setting, Constraints and Issues... 1 Reducing Transaction Costs Land Tenure Security, Water Allocation Security and Enforceable Real Estate Mortgages Enforceable Chattel Mortgages Facilitating Commercial Contracts and Transactions... 4 Making Financial Markets Work Private Sector Delivery Mechanisms Jump-Start Financial Markets for Agriculture State Banks are Poor Retailers of Agricultural Credit Second-Story Banking with Public Sector Funds Venture Capital Investment for Agriculture Guarantee Funds... 7

4 This paper discusses constraints, issues and possible options to finance and capitalize Iraqi commercial agriculture. Current Setting, Constraints and Issues Financial institutions and services in Iraq are quite weak. Private sector financial markets are poorly developed and do not serve either the commercial or smallholder agricultural systems 1. Macroeconomic monetary policies that foster high interest rates, combined with high non-commercial and business transaction costs 2, severely constrain investing in or lending to agribusinesses. Except for modest amounts of donor-funded NGO social lending to smallholders, there are no indigenous private sector credit delivery systems targeted to agriculture. Additionally, a state-owned agricultural bank is sporadically provided with government funds that are retailed as production and/or investment loans (often at highly subsidized or zero interest rates) without serious regard for comparative advantage, economic impacts or prospects for repayment. In effect, loans from this state-owned bank often become income transfers. Subsidized activities of this bank nevertheless are a further constraint to private sector interest and willingness to enter the agricultural credit market. Feasibility of improving and expanding agricultural capital investment and credit delivery depends in the first instance on prospects for profitability of production enterprises and other agribusinesses, if and when they move towards optimization of equity and/or debt capital utilization. As political and social stability returns to the country-side (and transaction costs related to non-commercial uncertainties and risks become manageable), enterprise profitability will depend on incorporation into value chains 3 of appropriate productivity-increasing technologies that optimize resource use efficiency to the 1 Agricultural system includes not only primary production, but also all other value-added activities that link the economic value chain from input supply through primary production to final consumption (or export). Thus, it includes activities that provide goods and services as inputs into primary production (backward linked), and activities that add value to primary products as they move to final consumption (forward linked), and supporting services (cross-linked). 2 Transaction costs are costs incurred in making an economic exchange, including monetary and non-monetary costs associated with actual and perceived risks and uncertainties. Such costs may include search and information costs, bargaining costs, and policing and enforcement costs. For credit (loaned or debt capital), these are the costs of lending and collecting, including discounts for perceived risks in the particular environment, e.g., risk of security-related disruptions/costs of protection, weak legal system for contracting and collecting loans, uncertain marketability of secured assets, etc. For equity capital, these are the costs and perceived risks associated with doing business, e.g., risk of security-related disruptions/costs of protection, risks and uncertainties related to input/raw materials supply, unreliable/costly enforceability of contracts and other commercial arrangements, weaknesses and uncertainties in linkages to markets, costs/uncertainties/risks associated with titling and liquidity of assets (lack of developed asset markets), etc. It should be noted that rising water lifts all boats, i.e., dynamic development of commercial agriculture also will stimulate opportunities and markets for smallholder agriculture. 3 Of agricultural production that has a comparative advantage under Iraqi conditions. Agriculture Finance and Investment in Iraq USAID-Inma -1-

5 point of profitability. Generation of surpluses permits reinvestment of net earnings for further enterprise growth. In the short to medium term, this scenario is likely only in the commercial agricultural sector 4. The following discussion focuses on irrigated commercial agriculture, although it also likely is applicable to commercial rain-based agriculture in Northern Iraq. In addition to the existence of reasonably stable political and social conditions, the economic recuperation of irrigated commercial agriculture requires a reduction in transaction costs, i.e., a favorable (or at least not unfavorable) economic and business climate, 1) that encourages entrepreneurs and investors to invest equity (at risk) capital, and, 2) that facilitates access to debt capital on reasonable terms by financially viable production enterprises and other agribusinesses throughout the various agriculture value chains. Given the present dysfunctional state of agricultural capital and credit markets and delivery mechanisms, it is not likely that a private sector-led system will emerge without significant government action to alleviate the constraints mentioned. And worldwide experience (as well as past Iraqi experience) casts serious doubt on the feasibility of encountering a solution through public sector retail delivery mechanisms (e.g., direct retail lending by state agricultural development banks). Reducing Transaction Costs Establishment of a favorable economic and business climate involves taking actions to reduce transaction costs for both investors in and lenders to agricultural enterprises. The objective is to create conditions for and costs of doing business conducive not only to development of competitive private-sector agribusinesses, but also to encourage development of private-sector financial markets and delivery mechanisms serving the commercial agricultural system. This requires attention to the following. 4 Transforming smallholder subsistence-oriented farms into profitable market-oriented enterprises is at best a long term undertaking, even in a favorable economic and business environment. Likewise, although improvement in economic conditions among smallholders may improve the welfare of these self-employed families, it is much less likely to generate significant wage employment or to significantly increase foodstuffs supplies to larger urban markets. In contrast, economic recuperation and economic growth of commercial farms can stimulate rapid wage employment generation, as well as efficiency gains and increased output for urban markets. Growth of commercial agriculture also has dynamic economic multiplier effects, as expanding agricultural production activities increase demand for inputs (backward linkages), and increased output expands value-added opportunities (forward linkages) along the respective product value chains to final consumption. It should be noted that dynamic development of commercial agriculture also will stimulate opportunities and markets for smallholder agriculture. Agriculture Finance and Investment in Iraq USAID-Inma -2-

6 1. Land Tenure Security, Water Allocation Security and Enforceable Real Estate Mortgages Uncertainty is perhaps the greatest enemy of a favorable economic and business investment and lending climate. Willingness to invest in and to lend to commercial production agriculture and other agribusinesses along the various agricultural value chains are closely linked to rights over land, and marketability (maintenance of value) of those rights. A producer who has uncertain tenure to his land is not as likely to invest in permanent improvements (or to practice good husbandry) as is a producer with secure tenure. Nor is the producer with uncertain tenure as good a credit risk, especially since he has little or no asset value to mortgage as security for a loan. Additionally, the value of irrigated land as an asset depends to a considerable extent on the reliability of water rights. Thus, land with uncertain water rights is less valuable than land with secure water rights. Lenders look to the marketability of land at a predictable value when assessing the amount of security provided by a real estate mortgage. Similarly, if the legal system makes it difficult and/or expensive to foreclose on a mortgage, its value as security diminishes in inverse proportion. 2. Enforceable Chattel Mortgages Seasonal and short-term inputs and inventory financing is an essential business practice in a private sector market-oriented commercial agricultural system. For example, it permits farmers to purchase cash inputs to optimize productivity, and it permits suppliers, handlers, processors and distributors to purchase raw materials, as well as to maintain inventories of inputs and processed products for sale, as the case may be. Similarly, it often is good business practice for a producer to borrow to purchase intermediate term assets (e.g., improved breeding stock, machinery or equipment) and repay with interest (or profit-share for Islamic financing) from increased net incomes generated by the resulting productivity and efficiency improvements. Purchasing machinery and equipment on credit also is good business practice for other agribusinesses along agricultural value chains. Securing such movable asset ( chattel ) loans at low transaction costs requires an easily executed and enforceable chattel mortgage (lien) on inventories of inputs and crops (both standing and harvested), as well as on livestock, machinery, and equipment. Enforceability requires that the lender s mortgage lien follow the chattel if it is moved, bartered sold or otherwise encumbered. Agriculture Finance and Investment in Iraq USAID-Inma -3-

7 3. Facilitating Commercial Contracts and Transactions A modern commercial code and an orderly and reliable method of enforcement reduce uncertainties, time and effort in entering into and achieving compliance with commercial transaction commitments. This reduces transaction costs, thus lowering lending costs. It also improves business profit potential, thereby making agribusinesses lower-risk borrowers. Risk also is reduced when a lien has the right to follow burdened assets that are sold, including cases of purchase of encumbered movable assets. It also must provide clarity and efficient enforcement provisions related to numerous other commercial details, such as bonding for commercial warehousing, recording and notification of liens, and summary proceedings for lien verification and seizure/sale of secured assets. Making Financial Markets Work Private Sector Delivery Mechanisms Mitigation of current commercial and non-commercial uncertainties (including perceived uncertainties) related to doing business calls for a comprehensive strategy to jump-start private sector equity investment in and lending to Iraqi commercial agricultural enterprises. Comprehensive strategy formulation might consider the following options: 1. Jump-Start Financial Markets for Agriculture Iraq is fortunate as compared to many developing countries in that the public treasury receives massive revenues from oil exports. Spending these public revenues on consumption or as income transfers (a la PDS food basket), results in short term benefits to Iraqis. However, for long term benefits to accrue beyond the period when abundant and easily accessible oil is available for export, Iraq must invest a substantial part of its oil windfalls in activities that are market-responsive and challenge private sector entrepreneurial talents to achieve competitive enterprise profitability. In the aggregate, this will achieve sustainable growth of the national economy to fulfill future social welfare needs. As postulated elsewhere, a dynamic commercial agriculture sector in Iraq can be the engine for accelerated sustainable development of the national economy. Thus, utilizing government revenues from oil exports to jump-start a dynamic private sector-led agricultural financial (investment and debt capital) market makes considerable economic sense. Agriculture Finance and Investment in Iraq USAID-Inma -4-

8 2. State Banks are Poor Retailers of Agricultural Credit The dustbin of history is full of failed (and re-failed) state-owned agricultural development banks that retailed credit to farmers in developing countries. Some of these banks continue operations, but do so because the government can and does continue to re-capitalize loanable funds and to subsidize operating costs. These banks are subject to political and other pressures that ration and subsidize credit based on non-economic criteria. Such a situation makes it difficult for private sector lenders to compete, since they must cover their costs and earn a surplus to remain in business and to grow services. 3. Second-Story Banking with Public Sector Funds Second-story (wholesale) lending of public funds targeted to commercial agriculture has a much better track record in several countries (including the United States). In Iraq, consideration might be given to converting the State-owned Agricultural Bank into a second-story bank for buying (or discounting) loans made (and co-signed) by private sector lenders. In addition to discounting (or buying) qualifying loans from private banks and other private sector lending institutions (including NGOs), the second-story bank also should include as an important client group, input supply and output marketing/processing agribusinesses. These, in turn, can retail credit (cash or in-kind) to clients, customers, and/or suppliers, as the case may be. With access to a means of financing clients, input supply agribusinesses often find they can rapidly expand sales by offering fertilizer, chemicals, seed and other agricultural production inputs to farmers on short-term and/or open-account credit. Similarly, output marketing and processing agribusinesses can better assure raw materials quality and supplies if they contract to provide to producers cash inputs and technical assistance in return for a commitment to sell production to the agribusiness Such transactions can be on open account or through a more formalized process of contracts and/or chattel mortgages. Financing for this potentially quite effective type of vertical integration of the financing system can greatly reduce transaction costs by discounting (or selling or using as security) open accounts or more formalized financial documents to the second-story bank. Similar arrangements can be made for sales by machinery and equipment dealers to producers and/or to other agribusinesses in the value chain. Here, intermediate term financing arrangements can be by lease-purchase or credit sales secured by chattel mortgages (or retention of ownership) on the product sold (and used as security for on-borrowing from the second story bank). Agribusinesses and dealers discounting debt obligations to the second story facility generally are required to guarantee Agriculture Finance and Investment in Iraq USAID-Inma -5-

9 repayment by co-signing for the debt obligation (i.e., with recourse) in the event the retail credit recipient does not comply with the terms of the primary agreement. This second story approach to financing with public funds can rapidly expand the availability of debt capital to commercial agriculture. Initially, promotional interest charges and/or service fees below market rates, combined with appropriate technical assistance, could be offered by the second story bank in order to jump-start the system and to facilitate good credit decisions by client agribusinesses. Once the system matures sufficiently, wholesale market rates would be charged, and the second story bank could be privatized. In order to assure that the second story operation has the best possible management (and is less subject to becoming politicized), a long term management contract preferably would be arranged (competed) with an international financial institution specializing in wholesale agribusiness lending. A public sector exit strategy likely would be advisable. One option (among others) would be for the second story bank to charge a capitalization fee to client agribusinesses and credit retailers. This fee would be capitalized as bank assets. When this source of capitalization reaches a predetermined level or percentage of total capital, the second story bank could be privatized as a user-owned (or at least majority-owned) entity. Contracting international private sector management expertise is advisable, especially because during the conflict years, Iraq lost many of its best managers and entrepreneurs. Utilizing long-term internationally competed management contracts (with a pre-agreed exit strategy) allows regulated importation of this very scarce professional talent. 4. Venture Capital Investment for Agriculture Consideration might be given to establishing and capitalizing with oil export revenues a venture capital fund for agribusiness investment. Such a fund would invest at-risk venture capital in promising agribusinesses in order to share commercial and business risks with capital invested by private entrepreneurs. A successful and instructive model of a venture capital investment fund for agribusiness purposes is the Chile Foundation. This foundation was capitalized by the Government of Chile under the terms of an agreement with International Telephone and Telegraph (ITT) Company by which compensation for nationalization of the ITT-owned Chilean Telephone Company was paid into a trust fund owned by a newly created development foundation (Fundacion Chile). Fundacion Chile was managed exclusively by ITT with no Government involvement. This fund invested primarily in equity instruments of promising agribusinesses established (or being expanded) by private sector investors/entrepreneurs. The foundation often Agriculture Finance and Investment in Iraq USAID-Inma -6-

10 researched and analyzed promising agribusiness opportunities and sought national and multi-national entrepreneurs as joint-venture owner-partners. This foundation made a major contribution to the success of Chilean agriculture in transforming itself into a highly competitive producer of fruits and vegetables, salmon and other products for national consumption and for export worldwide. As was the case with the Chile Foundation, an important contributor to the success of such a venture capital operation will be contracting world-class administrative, financial and technical management. As already indicated, utilizing long-term internationally competed management contracts (with a pre-determined exit strategy) allows regulated importation into Iraq of this very scarce management resource. 5. Guarantee Funds Consideration might be given to establishing a trust fund to guarantee qualifying agribusiness investments against non-business losses, such as losses from terrorism, criminal violence, vandalism or failure to provide promised public services (e.g., electricity). There is ample worldwide experience to draw on in designing and implementing such a guarantee fund. Agriculture Finance and Investment in Iraq USAID-Inma -7-

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