Strategies for Financing Farm Activities. EASYPol Module 153

Transcription

1 Strategies for Financing Farm Activities EASYPol Module 153

2 Strategies for Financing Farm Activities by Ron Kopicki, World Bank Investment Officer, Washington DC, USA Maria Pagura, Rural Finance Officer, Rural Infrastructure and Agro-Industries Division, FAO, Rome, Italy for the FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS FAO Policy Learning Programme aims at strengthening the capacity of high level policy makers in member countries in the field of policies and strategies for agricultural and rural development by providing cutting-edge knowledge and facilitating knowledge exchange, and by reviewing practical mechanisms to implement policy changes. About EASYPol EASYPol is a an on-line, interactive multilingual repository of downloadable resource materials for capacity development in policy making for food, agriculture and rural development. The EASYPol home page is available at: easypol. EASYPol has been developed and is maintained by the Agricultural Policy Support Service, Policy Assistance and Resource Mobilization Division, FAO. The designations employed and the presentation of the material in this information product do not imply the expression of any opinion whatsoever on the part of the Food and Agriculture Organization of the United Nations concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries. FAO January 2008 : All rights reserved. Reproduction and dissemination of material contained on FAO's Web site for educational or other non-commercial purposes are authorized without any prior written permission from the copyright holders provided the source is fully acknowledged. Reproduction of material for resale or other commercial purposes is prohibited without the written permission of the copyright holders. Applications for such permission should be addressed to: copyright@fao.org.

3 FAO Policy Learning Programme Table of contents 1. Introduction Background Objective and purpose Basic concepts Tradeoffs in supply chain design Supply chain finance and MNC s Risk management Supply chain financial instruments Trade credit Import/export financing Warehouse receipt secured financing Out grower schemes Structured finance Project finance structures Government policy with respect to supply chain development Conclusions: Take away findings Users Notes References and key resource documents Module metadata... 19

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5 FAO Policy Learning Programme 1 1. INTRODUCTION This document suggests a syllabus for one of the modules in the FAO sponsored learning series which deals with investment and resource mobilization in rural economies. The document outlines basic concepts and provides a framework for thinking about various strategies, instruments and institutions for improving access by farmers to financial resources. This module discusses issues and reviews recent developments in this topical area. In addition, it suggests some new approaches for securing additional financial resources for the funding of rural investments. The module relies heavily of several recent studies which treat the topics briefly covered here in more depth 1. Readers can follow links included in the text to other EASYPol modules or references 2. See also the list of EASYPol links included at the end of this module BACKGROUND In recent years a diversity of new products, management processes and business models have emerged which focus on the delivery of financial services to the poor. Some of these methods, models and products involve traditional intermediation, that is the channelling of savings into productive on-farm investments. As we discussed in the previous section of this module saving may be accumulated over more or less extensive areas and they may be channelled into investments which are more or less diversified both in terms of geography and in terms of asset categories. Micro finance institutions and branchless banks have been among the fastest to development in this domain. However, micro financial institutions are highly risky reflecting the high risk nature of farming activities and farm assets. The longer term development of financial institutions seems to be toward larger and more densely networked enterprises, toward ones which are broadly diversified both in terms of sources and uses of finacing. Endemic high risk/ return factors and increased competition seems to be driving rural finance in this direction. In recent years a number of others innovations have emerged in rural financial markets which do not involve intermediation. This long list of innovations includes, third party supply chains management, less activist forms of supply chain financing, farm equipment leasing, secured trade finance, factoring, management of remittances, farm bonds and 1 See section on Further readings at the end of this module. 2 EASYPol hyperlinks are shown in blue, as follows: a) training paths are shown in underlined bold font b) other EASYPol modules or complementary EASYPol materials are in bold underlined italics; c) links to the glossary are in bold; and d) external links are in italics. 3 This module is part of the EASYPol Training Path: Policy Learning Programme, Module 3: Investment and Resource Mobilization, Session 4: Strategies for increasing farm financing resources.

6 2 EASYPol Module 153 Applied Material insurance against various categories of risk. This section reviews several of these categories of financial innovation through a set of case studies. By supply chain or value chain...the two terms are used interchangeably here... We mean the set of commercial actors who deliver farm products to consumers, as well as the set of value adding activities which these actors undertake in a coordinated way. Value chains include all of the economic activities that create value through the several process steps which are controlled with the use of integrated management systems to form interconnected chains including most importantly agricultural production, food processing, order fulfilment and marketing. Processes which take place within value chains are managed in ways which allow them to operate in parallel toward outcomes which are coordinated among all chain participants. By way of contrast processes which take place as a result of arms length transactions between commercial agents take place in series, so that one process is completed before the next process can begin. Supply chains are designed and managed in ways which compress time and reduce net resource requirements to a minimum. They are managed to achieve global objectives in behalf of all participants in the chain so they require a governance structure which is flexible and adaptable to different market and competitive states of the world. Most frequently the global chain objectives which are collectively pursed though joint investments involve a combination of increased economic returns, reduced variability in these returns and enhanced competitiveness through the enhanced collective capacity to deliver greater value for money to consumers. Supply chains or value chains are enabled by technology: by ITC, by specialized management techniques and by management systems. These specialized assets have been developed by and for MNC s and supply chain best management practices continue to be refined and applied for the most part by MNC s whose supply chain management methods define the technology frontier for food marketing and agricultural production. Some of these technologies, however, are being converted to use in providing financing to farm level organizations as the case study of Drum-Net discusses. Research conducted over the past ten years reveals a direct link between effective supply chain management methods and organizational designs, on the one hand, and corporate financial results, on the other. MNC s who have best-in-class supply chain management competencies have been able consistently to realize capital market appreciation between ten and twenty per cent greater than their industry peers. Senior executives in leading organizations have invested in supply chain systems and methods in order to reduce cost, stimulate sales, gain market share and manage risk. An ancillary support industry has grown up around the functions of supply chain management. This ancillary support industry is global in its reach and includes two primary elements: financial services and management systems and software. A large number of financial institutions with global reach have focused new product development efforts on developing specialized financial and trade product offerings which enhance supply chain performance. A number of software and systems integrator have likewise development new systems products which operate flexibly on various telecommunications networks and which effectively integrate commercial processes over long distances. The global supply chain software industry exceeds $10 billion in annual sales..supply chain management

7 FAO Policy Learning Programme 3 systems operate in lieu of contingent results agreements to affect systems of governance and management control which assign specific risks and/or responsibilities to specific supply chain participants. Supply chain organizations can usefully be contrasted, on the one hand, with merged companies which are also vertically integrated and, on the other, with trading partners whose commercial relationships consist of one off arms length transactions. This later set of trading partners typically requires multiple third party interventions or ancillary service support to produce efficient market operations. As a form of industrial organization, supply chains fall somewhere in between arms length transactions and vertical integration through corporate merger. Supply chains are typically more agile, adaptable and frequently more efficient than either of the other two industrial organizational options, particularly in developing countries contexts. Importantly, equities among trading partners which result from supply chain operations are materially affected by their original design and by the strategic agenda of the supply chain integrator. With that said, efficient and competitively resilient supply chains can be designed with support pro-poor outcomes and which can materially advance the development agenda. The design and configuration of these pro-poor supply chains is the subject of another leaning module in this series. Chains can usefully be thought of, from a different perspective, as conduits through which farm products, information, product ownership rights and credit flow from farms to retail customers and back again. These organizational structures typically employ information technologies and management processes which assure that the flow of products, information and cash or credit take place rapidly and without diversion or distortion. In the beginning of the 21 st century supply chains have become the primary institutions through which markets clear over extended geography and over extended cycles of production/procurement/ delivery. They are operate as security systems for delivering financial resources in the form of cash payments, credits and/or risk insurance to specific participants in the chain. This important function is the primary focus of this module. When credits or other forms of financial support are transmitted through value chains, value chain finance can be said to be conducted. Participation in supply chain organizations enhances access to credit both directly and indirectly for small scale farmers and ancillary service providers. Supply chains offer several advantages to financial institutions when compared with farmers and merchants who interact through arms length transactions. Thus, supply chain organizations offer more secure and accessible points of possible cash flow securitization, more assets which can be securitized and more potential collateral than do the stand alone companies/ farm organizations which make up chains. Active value chain undertakings are often more financeable via third party financial service companies than are alone agribusinesses. Thus, value chain finance may and often does involve third party financial institutions, as well as trade credits extended and accepted among chain participants. In order to secure third party financing, value chain organizations or rather the cash flows which pass between them are often encased in special purpose companies. These special purpose instruments are specifically designed from a legal perspective to lower risks incurred by third party financial institutions. Special purpose instruments, for example, may

8 4 EASYPol Module 153 Applied Material include different levels of internal supply chain transaction and they may take ownership of multiple sets of assets which are committed or cross-pledged for the repayment of credits used in behalf of the chain. In other cases, supply chain financing may simply involve trade credits or joint investment of supply chain participants in fixed assets. It this mode of operation supply chain direct financing offers an alternative source of financing to farmers alternative that is to financing through third party financial institutions. In addition to providing credit, value chain finance importantly also allows chain participants to manage risk more effectively. Chains can be thought of as being built around contingency contracts which define and assign responsibilities to particular chain participants for performance which is valuable to the entire chain and which benefit specific participants differently under various conditions. In this way, chains create and enforce mutual dependencies and thus they allow for greater specialization among participants than do simple arms length trading relationships which must be developed and dissolved with each individual transaction and which typically cover very few contingencies. Thus, for example, value chains allow specific categories of risk to be assigned to specific value chain participants based on their unique capacity to manage these risks or, sometimes, based on their superior access to markets for risk insurance or risk hedging instruments. Different actors in farm to consumer value chains have different needs for financial services. Without access to finance for working capital, for example, many farm producers find themselves trapped in low input/ low value planting/ harvesting cycles. When retail or wholesale suppliers of these inputs provide trade credit to farmers value chain financing begins to take place. Other participants in the chain likewise have needs are for short term credits which yet other chain participants are able to satisfy, still others have needs for insurance or for security interests created in the inventories which they hold and still others have needs for longer term credits which can be used to finance fixed assets. Fixed assets (supply chain infrastructure, for example) can often be financed as well by securitizing the cash flows generated through project corporations organized as public private partnerships. All of these financing needs can in one way or another be served through the commercial relationships which bind supply chains actors together. Supply chain management entails giving up control over a business function and trusting other actors to provide that function. The trust which develops between a principal in a chain and actors who provide essential services is critical to the success of the supply chain. Developing a mutually dependent relationship involves coordinating activities between two commercial entities each with different internal structures, information capabilities and operating philosophies. Once such a relationship is developed, however, credit monitoring and enforcement is greatly facilitated. The information exchanged among value chain partners and the knowledge which they share regarding markets, competition and other risk factors allows them to more effectively assess risks together with the rewards associated with providing trade credits and other forms of supply chain finance. Moreover, large scale participants in supply chains are typically better credit risks and can secure financing more easily from third party financial institutions than can small scale participants. Thus, the organization of a chain frequently reduces financial risk simply be improving credit access. As discussed below supply chain structures allow global risks to the chain to be mitigated in other ways as well.

9 FAO Policy Learning Programme 5 Unlike credit provided by and through financial institutions, trade credit extended among trading partners within a chain is typically justified to the principal agent extending the credit based on the net benefits realized through the entire symbiotic commercial relationship and not based solely on the profit realized from expending the credit. For the same reason evaluating the real cost of supply chain credit is more difficult for the party who accepts the credit. Importantly, supply chain credits are limited to the liquidity available to the input supplier or product buyer who offers the credit. With that said chain secured financing is more likely to be provided by financial institutions than other types of unsecured financing. A number of different financing mechanisms/securitization instruments can be designed in and around supply chain relationships which improve the necessary security which financial institutions require and hence increase access of supply chain partners to third party provided credit. Some of these mechanisms include structured finance, asset backed loans and warehouse receipt systems 3. OBJECTIVE AND PURPOSE The overriding objectives of public policy with respect to supply chain are three. They include: i) the development of prototype supply chain organizations which are financial stable and which enhance competitiveness for participants; ii) the increased breath and depth of coverage of supply chain structures whose basic business concept has been tested and proved; and iii) increase the welfare impact and the farm livelihood enhancement outcomes which result from refining and extending supply chain financial models. Significant tradeoffs exist among these three objectives. These tradeoffs are tacitly set through policy making processes and the public private partnership designs which are undertaken by governments. The aim of this module follows from these overriding objectives and includes the following: Develop strategies for the development of new supply chain structures and for roll out of other, already tested structures; Understand the strengths and limitations of various forms of value chain financing; Providing a framework for extending value chain backed credits and for using value chain structures to leverage other categories of third party provided credit; Describing new financial instruments, innovations and new thinking with respect to incremental sources of supply chain financing; and Summarize lessons learned in the institutional planning, financing and implementation of reform of rural financing systems. 4. BASIC CONCEPTS It is widely recognized that financial integration can be as much a source of competitive advantage, as service and product innovation are for modern supply chains. Supply chain interaction allows more productive work to be done with the same or a lesser levels of working capital. Extracting increased value from agricultural and post harvest processes

10 6 EASYPol Module 153 Applied Material and enhancing the efficiency with which available working capital is used have become increasingly essential techniques for twenty-first century businesses in all sectors. However, opportunities to do more productive work with less working capital are particularly attractive in agricultural production and marketing which tends to be particularly working capital intensive. Hence the drive to achieve optimal returns from cash generated within chains; hence, the strong incentive to free liquidity which is tied up in accounts receivable and inventory; hence, the agenda of rationalizing and synchronizing basic business processes; and, hence, the drive to maximize the value for money which is realized though procurement and marketing. Ongoing control of these critical management elements is the first and most important mode of supply chain finance. This form simply entails doing more with less. Working capital is a very important concept in supply chain management. Working capital is the short term investment of cash required to compete the essential processing steps which take place within value chains in advance of the receipt of cash payments. Investments in labor, fertilizers, transport and storage may be necessary for example before a farmer can expect to receive any cash payments. The economic efficiency of a supply chain can be determined by analyzing its cash flow cycle (cash in to cash out cycle) which is associated uniquely with the way work is organized within any given chain. The faster that working capital turns over the more financially efficient a supply chain can be said to be. Internal controls over production scheduling, inventory accumulation and order fulfilment which operate within value chain structures are deployed to regularize and to minimize the level of working capital required to supply just enough finished goods inventory at the retail end of the chain to avoid loosing sales. Every supply chain contains an internal system of controls which can be used to schedule each serial process which is part of the overall chain so as to realize economic objective function which all participants in the chain have committed themselves to realizing. Return on working capital is a particularly good measure of short term value chain efficiency. Moreover, longer term investments in fixed assets are typically justified in terms of chain performance upgrading. That is in terms of their effects in accelerating working capital turnover and increasing near term returns on working capital over a longer implementation timeframe. ROWC analysis can usefully be applied in determining the overall competitiveness of any given supply chain configuration as well as the competitiveness of the business model on which it is based. In general, supply chains which generate returns which exceed the cost of capital available to the strongest chain participant are competitively sustainable and are able to grow. Chains on the other hand whose returns on working capital fall below the cost of capital are actually destroying economic value and are unlikely to be sustained over the long term. All participants in a supply chain are not able to realize the same returns on their investments in working capital. Typically the chain developer or the keystone participant in the chain is able to leverage the assets of other participants to his advantage. Value chains allow participants to realize different equities among participants depending on the strength

11 FAO Policy Learning Programme 7 of their relative competitive positions and the ability of individual participants to secure higher or lower returns through their equity share negotiations. Ex post analysis of the returns realized by specific participants in chains is useful in identifying the relative negotiating strengths or weaknesses of specific supply chain participants and their ability of leverage other participants. In most food retail chains effective market power frequently resides down stream at the retail end. Modern food retail formats, like supermarket chains, are particularly efficient in turning over working capital investments. The economies associated with the rapid inventory turnover which supermarket chains or fast food chains, for example, are able to realize is a significant source of competitive advantage to them. Another important concept in supply chain finance is the concept of securitization. Securitization is the creation of an ownership interest which is backed by an asset of significantly greater value than the interest. Agents which create security interests may either be regulated under general provisions of the law or may be special purpose instruments which are created legally as virtual companies to receive and hold valuable assets. Supply chain financing is particularly amenable to the creation and use of security interests, which may be as simple as a warehouse receipt system or as complicated as a supply chain bond securitized against export revenues generated by supply chain partners. 5. TRADEOFFS IN SUPPLY CHAIN DESIGN Much of performance of supply chains is designed into their operation. Performance parameters are established both in the process to setting governance structures in place and also in the process of codifying and systematizing the coordination of various activities through the mutual adoption of compatible systems. The design of both of these essential supply chain elements entails tradeoffs Hence, analysis of tradeoffs typically precedes any supply chain financing. For example, when sellers establish their credit and payment terms they are concerned not only with risk mitigation but also with sales growth, and, indeed, a significant tradeoff exists between the two which affects directly bottom line performance. For sellers as global supply chains have become an increasingly important source of alternative financing, a range of different strategies can be deployed to support both its sales requirements and its ability and willingness to assume credit risk. In every instance, a seller's strategy for approaching the financing of its supply chain must be driven by its understanding of where it stands competitively within its industry and where it stands in terms of economic power vis a vis is buyers. Broadly speaking, there are three main concerns that determine the feasibility of any financing alternative which might be deployed. These are: risk mitigation, sales growth and liquidity. For those companies who do not require liquidity, increasing the velocity of the order-to-cash cycle may be a more appropriate objective. What seems to be happening globally is the convergence of all three concerns into holistic trade finance solutions which are designed to meet the requirement of individual sellers.

12 8 EASYPol Module 153 Applied Material A vendor who is selling to a customer that has a better credit rating than itself has the option of raising liquidity by selling the underlying assets -- such as receivables and inventory which it is holding. These will ultimately be repaid by the buyer who has a significantly lower cost of capital. The vendor could sell these assets and raise capital at its buyer's cost of capital. By doing so the seller can be assured of compliance with the key covenants which it has committed to financial institutions, such as debt TNW (total net worth). It can also deploy the cash against an investment strategy that will yield an effective economic cost of capital rate of return. Finally, if they are in a high growth-rate industry, it enables them to finance that growth rate without consistently raising more equity or getting caught in a classic overtrading trap. The improved metrics that result from this exercise leads to an increase in the velocity of the enterprise, which has a proven historical enhancement to equity price performance. However, to achieve the kind of ROWC results that investors increasingly expect, companies are being forced to look beyond the traditional tools of factoring and securitization. The reason for this is broadly three-fold. The first is that key buyers in almost all global supply chains are becoming more concentrated, with the result that securitizations are becoming increasingly over-collaterized relative to the amount of funding that can be extracted from them. Second, the large well-rated buyers are almost always strategic accounts. Very few sellers are keen to relinquish control over credit and collections activities on these accounts to a factoring company. And third, the global supply chain is not only sourcing from, but selling into, the emerging markets. Indeed an examination of the sales patterns and forecasts of OECD sellers shows that emerging markets are the fastest growing. The deployment of trade capabilities within the corporate supply chain addresses two primary goals for driving our customers' business. The first of these is the injection of liquidity into the supply chain to balance the conflicting goals of importers (buyers) and exporters (sellers) and to facilitate inventory management objectives. The second is to provide risk mitigation related to either counterparty or country risk. The ultimate goal of integrated trade based financial instruments is to mediate the way that clients acquire, move, monitor and pay for goods within supply chains. Successful deployment of financial supply chain solutions requires close coordination with multiple stakeholders including procurement, logistics, finance, accounting, risk and treasury. In addressing the financial supply chain objectives of our clients the Citigroup approach segments the goals of both our importer and exporter clients. Once tradeoffs are determined a technology foundation can be built to manage processes within the chain in ways which fully reflect the elected tradeoffs. As a result of investments in new technology all links within the supply chain will become progressively more transparent. All chain participants will be able to see the flow of purchase orders, measure vendor operational efficiency and track the flow of the inventory through the supply chain until the goods are delivered to the final buyer. But the need to build, own, and operate is a thing of the past, and has now been replaced with a focus on leveraging the core competencies of alliance partners who specialize in aspects of supply chain logistics management. Through their technology platforms, these partners will give global access to

13 FAO Policy Learning Programme 9 information about the flow of goods and support worldwide order management processes. During the course case studies will be used to develop this concept further. 6. SUPPLY CHAIN FINANCE AND MNC S As agribusinesses develop and analyze strategies for optimizing the cash flow and goods flow within their supply chains, the need immediately comes to the fore to manage counter party risk effectively at every stage in the financial operating cycle. Supply chain finance involves the simultaneous creation of assets and liabilities within the chain and from a global chain perspective this process can be either risk enhancing or risk reducing depending on where and what types of assets and liabilities are created. Investment of working capital in inventory, for example, is almost always value detracting. Supply chain management concerns itself in large part with the management of risks incurred within chains and the sale of risks which cannot be effectively managed within chains outside chains to third party risk arbitrageurs. Typically, leveraging the strongest balance sheets available within chains assures that the cost of capital for the entire chain as a whole remains as low as possible. However, over leveraging partners who have low costs of equity can also have a deleterious effect on the entire chain. Globalization compels corporate finance teams to take on the role of agents of structural change among chain linked partners in order to assure that all of the parts of the chain are working together to create maximum value. The efficient mobilization of working capital within chain linked commercial structures in particular has become an increasingly important competitiveness enhancing tool. Before an organization can hope to rationalize its financial supply chain it needs first to identify all factors which effect working capital uncertainty. Highly visible elements which affect internal cash flow are usually subject to tough negotiating and are specified contractually in detail, and subsequently managed with the help of sophisticated software. However, other indirect elements are frequently left to a more arbitrary decision-making process. Yet these indirect elements can carry substantial costs which are often not fully visible. Consider the vast array of options which exist for transport, hotels, room service, restaurants, phone calls and taxi fares which a single business traveler can use for a single business trip. Difficult to control expenses like these define a kind of financial black hole: They are hard to calculate, to estimate in advance and the fall outside the standard control systems which finance and treasury management teams normally use. This example may seem trivial. However, other cost categories, MRO or maintenance, repair and operations costs, for example, can claim large amounts of cash and when the timing of these discretionary expenditures is left to the idiosyncrasies of purchasing departments or worse yet to the discretion of decentralized decision makers they can significantly impact the overall working capital needs of the entire chain. Consider too what happens when these problems are multiplied over multiple business lines and over extended geographies. Consider the unique set of problems associated with inventory financing. Excess working capital is often found spread along supply chains. These buffer inventories accumulate due to inefficient processes or lack of internal process synchronization. Identifying inventory accumulation points within chains is difficult enough for financial managers, managing these inventories against normative standards is even more difficult. Inventories provide a

14 10 EASYPol Module 153 Applied Material safeguard or insurance against the possibility of break down in process integration. However, the price of this insurance is extremely high. Instead of having data bases which contains rich transaction data and normative standards which they need to minimize working capital costs, financial controllers often work in a grey area, with details of expenditure coming to light only months after purchases have been made and with no normative standards against which they can measure real time performance. In today's complex and competitive environment, control over costs necessitates visibility and visibility entails having access to timely global data, from across all business lines. This requires a readily accessible global data repository and a flexible reporting format which seamlessly integrates with a company's expense management and accounts payable processes. Globalization is a double edged sword for most companies: it expands an organization's networks of supply and demand partners, as well as complicating and diversifying them. The spread of a company's liquidity, credit, payments received and payments outstanding across continents both necessitates the flow of capital beyond the immediate control of the company and it also makes the management of working capital more complicated. Against this background the growing desire of MNC s to integrate all financial aspects of global supply chains is understandable. Integration enables treasurers to continue to drive value creation. In this context isolated financial products or financial management solutions are no longer sufficient, nor are those that do not offer a global capacity. Global banks like Citigroup, which have branches world-wide are in a powerful position to provide treasury and trade finance/trade management services for its MNC clients. In fact, Citigroup has developed a number of supply chain financial services under its Global Transaction Services (GTS) division, which enable MNC s to integrate all aspects of their treasury activities. 7. RISK MANAGEMENT As companies develop and analyze their strategies to optimize the flow of cash and of goods in their supply chains, the need to manage counterparty risk effectively at every stage in the financial operating cycle has become more pressing. Minimum cost sourcing and maximizing cash flow risks no longer satisfy risk adapted NMC strategies. Globalization has compelled corporate financial teams to take on the role of supply chain risk managers in order to drive the value creation. A great deal of research has recently focused on supply chain systems as mechanisms which can be used to mitigate financial and operational risks for chain participants. Much of this work has focused on the need of supply chain managers to anticipate contingencies which can affect supply chain performance and to invest pro-actively in remedies and mitigation measures in advance. Reasonably, an analysis of probabilities, estimated implementation costs and estimated mitigation benefits should ideally precede any investment in mitigation.

15 FAO Policy Learning Programme 11 In general, supply chain risks fall into two categories, one of which involves external contingencies which fall outside the immediate control of the company which is doing the mitigation cost/benefit analysis. The second category involves contingencies which are internal and which are amenable to direct company control. The first category or risk includes the following subcategories: i) manufacturing risk; ii) business risk; iii) planning and control risk; and iv) mitigation failures. The second category of risk includes the following: i) consumer demand; ii) supply chain partner supply; iii) business environmental shocks outside the supply chain; iv) chain partners business risk; v) physical risks. Risk factors can best be described in terms of probability functions. Some risk probabilities are independent of one another in which case they can be analyzed on a stand alone basis and combined to determine joint probabilities. Other risk probabilities are joint and hence the interactions of risk factors are more complex. In these cases interactive effects and simultaneous occurrences need to be analysed in depth. Financial risk analysis in the supply chain context involves several discrete process steps including the following: Map the entire supply chain, assess substitutability for each major supplier and identify potential constraining secondary factors which might limit supplies during supply constrained contingencies. Assess vulnerabilities and evaluate and rank potential risks Identify and cost remedies and next best supply alternatives Complete cost/ benefit assessment Act to modify basis for procurement, nature of risk sharing partnerships and diversification of dependence on a limited number of suppliers. Sourcing globally has become a double edged sword: it expands an organization's networks of supply and demand, as well as complicating both and if diversification in not designed into supply chain networks increasing overall network risk.. The spread of a company's liquidity, credit, and payments received and payments outstanding across continents has both necessitated the flow of capital and made its management more complicated. With the rise of globalization comes a wide range of international political, market and weather related risk factors to be taken into consideration. To name but a few: the implementation of EUROGAP, the accession of the Eastern European states into the European Union, the development of the Single European Payments Area (SEPA) and legislation such as Sarbanes Oxley and the Basel II accord have all had an impact on the financial management of supply chains. Against this background there is a growing demand for monitoring, measuring and integrating all financial aspects of the supply chain, to maintain control of disparate sources of cash and liquidity. Integration enables treasurers to continue driving value creation: isolated products or solutions are no longer sufficient, nor are those that do not offer a global capacity.

16 12 EASYPol Module 153 Applied Material Global banks like Citigroup, with world-wide branch offices, and competencies both in working capital management and trade finance/trade services, has developed a number of solutions, available from its Global Transaction Services (GTS) division, that enable organizations to integrate all aspects of their business management activities. GTS develops specialized risk management solutions in conjunction with customers, which combine global coverage with regional and local support, high quality customer service, and critical analysis and consultancy. 8. SUPPLY CHAIN FINANCIAL INSTRUMENTS A number of different forms of supply chain finance are worth considering in greater detail. These include the following: 9. TRADE CREDIT Trade credits are the most frequently used form of supply chain financing. The UK s Credit Management Research Centre estimates that trade credits for the entire UK economy exceed primary money supply (M1) by 150%. In less developed country trade credits may be less significant but still important sources of financing. Trade credits most often assume the form either of accounts receivables and of pre-paid sales and are frequently provided to farmers either by vendors who sell farm inputs or by buyers who purchase farm outputs. Various approaches have been tried to expand farm trade credits in developing as well as developed countries. Companies like Orbian have emerged which provide credit enhancements in the form of receivables warehouse services and stand by financing for receivables which have been approved through the warehouse for payment. In Africa the Rockefeller Foundation has experimented with securitizing and insuring farm input trade credits which fertilizer importers provide to retail stockists in an effort to increase use of fertilizer. Third party insurance is typically not available to cover trade credit risks, in developing countries, but may be worth considering in appropriate contexts. In some developing countries secondary markets operate in which receivables can be factored (sold at a discount). This is another way in which trade credit financing can be expanded. Today, NMC s are using receivables-based finance programmes that include bills discounting, invoice discounting and payment protection. These programmes are tailored to meet the individual requirements of customers, enabling them to accelerate cash flow from sales and mitigate and minimize counterparty credit and political risk, while minimizing the need for letters of credit or bank guarantees - which potentially enables companies to affect a true sale of receivables. During the course case studies will be used to develop this concept further. 10. IMPORT/EXPORT FINANCING A specific category of trade credit which deserves special comment is international trade credits. According to the WTO, the world's total annual import/export volume in merchandise and commercial services increased by more than 40 per cent in the past five

17 FAO Policy Learning Programme 13 years: from US $14.4 trillion to US $20.5 trillion. Projections indicate that even these levels will increase substantially over the next three years. At the same time, trade participants around the world are reducing the number of suppliers and customers with whom they deal to core vendors who are also supply chain partners. As this process progresses the need for traditional trade documentation and for traditional third party trade assurances has likewise declined. With increased penetration of the internet into emerging markets, suppliers who once relied on faxes and phone calls to accept and complete orders are now engaging fully with the customers on the other side of the world. State-of-the-art order-to-cash, purchase-to-pay fulfillment platforms have made it possible to speed and secure their trade flows. As a result a dynamic shift has taken place in transaction formats at both ends of the supply chain shifts which affect both importers and exporters. Specifically, there has been a noticeable transition from letter of credit (LC) to open account trading, which has enabled savings and enhanced efficiency throughout the purchasing cycle. Within domestic markets, open account trading has always existed. Until recently, however, major barriers such as a lack of transparency and apprehension about cross-border risk have limited international open account trade. But these concerns have now been greatly diminished thanks to increased financial knowledge, and, again, technological advancements: both buyer and seller recognize the benefits that include reduced costs and improved efficiencies through cross-border open account trading. This transition to open account has seen greatest movement within the Europe, Middle East, and Africa (EMEA) region, particularly within the EU and the new accession countries including Poland, Hungary and the Czech Republic. The market dynamic towards open account is supported by the latest *SWIFT data which shows negligible growth in the trade letter of credit message category, at a time when overall global trade has substantially increased. Combined with the large increase of import/exports globally, this supports the argument that global trade, and the corresponding corporate supply chains it supports, is moving aggressively to open account. Feedback from the market-place indicates that manufacturers and retailers on the buy-side of the sourcing relationship no longer want to use existing credit facilities and inefficient LC processes for purposes of procurement. Clearly the "pull model" emerging around the world, whereby vendors hold goods on their own balance sheet, means many companies are manufacturers in name only -- outsourcing as much of the supply chain as possible. An example of the efficiency gains from a straight financing perspective are illustrated below in a typical seller scenario: Post production capital illustration US$500,000,000 annual volume of supplier shipments 30 days transit inventory = 30/365 * $500MM = $41MM 15 days VMI inventory = 15/365 * $500MM = 521MM 60 days A/R terms = 60/365 * $500MM = $82MM

18 14 EASYPol Module 153 Applied Material Total capital required = $144MM 1. Old way: Supplier capital cost 12% = $17.3MM 2. New way: Efficient financing cost 8% = $11.5MM 3. 8MM savings or 33% efficiency gain equals 1.2% margin on $500MM program volume. For many organizations the key issue from a working capital optimization standpoint is supplier finance. Companies on the buy side of any transaction face the dual pressure of ensuring that their suppliers are sufficiently well financed to ensure uninterrupted delivery while cutting costs and delivery schedules to generate efficiencies. Even in the most sophisticated markets the pressure is on to extend payment terms from 30 to 60 and even 90 days, while encouraging suppliers to provide more and more of the buyer's working capital. However, suppliers are only willing to go this far. The standard trade finance programmes, which have provided an innovative solution in the past, have their limitations in the global economy. In countries where letters of credit have historically facilitated trade flows, the availability of the necessary bank instruments to provide credit enhancement and finance against buyer default is declining as traders move to open account terms. Furthermore, trade financing can be hard to come by in many areas of the world -- certainly on terms that would be regarded attractive to supplier companies short of credit. During the course case studies will be used to develop this concept further. 11. WAREHOUSE RECEIPT SECURED FINANCING A warehouse receipt is an asset backed security, the paper equivalent of the farm commodity to which it corresponds. Warehouse receipts are negotiable and can be redeemed, at any time, for inventories of the same grade and value as those for which they were originally written. They facilitate the conversion of illiquid farm product inventories into cash and they improve the tradability and liquidity of underlying commodity markets. Warehouse receipt systems allow farmers to create bankable collaterals through the deposit of non perishable commodities in warehouses which third party asset managers control in the interest of holders of the negotiable receipts. The unique merits of this system are its simplicity and its transparency. Warehouse receipts can be redeemed upon their presentation to warehouse managers who are empower by law to create security interests and regulated through public warehouse commissions in order to assure the fail safe holding of these inventories. Warehouse receipt systems require that commodity grades and standards be generally accepted within the trading community. They are best developed in collaboration with commercial bankers, so that their operations fully satisfy commercial banker s prudential control requirements. During the course case studies will be used to develop this concept further. 12. OUT GROWER SCHEMES Out grower or contract farming schemes involve the development of mutually beneficial relationships between farmers, on the one hand, and, on the other hand, providers of farm

19 FAO Policy Learning Programme 15 inputs and merchandisers of farm outputs. A number of different business models have been developed which fall generally under the rubric of out grower schemes. These appear to work best for export crops and for dairy production. All contract farming business models manifest the same general attributes of functional specialization and mutual dependence in the value added functions provided by farm producers and principals in order to improve revenue and production yields. In these models responsibility for providing inputs, technical assistance, order fulfilment and marketing support typically falls to the principal. In some cases third party financial institutions also become involved in out grower schemes by providing credits to principals who they then on lend to out growers. During the course case studies will be used to develop this concept further. 13. STRUCTURED FINANCE Structured Finance covers a wide range of complex loan transactions which entail arranging for loan repayment under conditions which subject financial institutions to make to minimize default risk. Structured finance instruments provide ways for greatly reducing the importance of borrower credit-worthiness, for example, by securitizing payment streams before they are claimed by creditors. In structured finance transactions the borrower is often a Special Purpose Entity (SPE) which may own the receivables due to the borrower. The SPE is typically subject to very strict convenants and restrictions. In addition its cash flow may be managed directly by the financial institution which provides the credit. 14. PROJECT FINANCE STRUCTURES Project finance is a kind of structure finance. Finacing is provide to and resource taken under project financing against the cash flows generated by a limited liability project coropration. This form of financing is typically longer term and it is used most frequently to support investment in infrastructure. However, it can be applied as well to the development of supply chains in developing countries where it provides an effective insturment for linking public and private financing sources and for engaging private investors with specialzed supply chain management expertise in the development and management of pro-poor and pro-development supply chains. To this end, the proceeds from project financing can be used to engage the services of supply chain management groups whose expertise can be applied to reducing transaction costs, diversifying market dependence, improving gross margins, improving product quality and reducing order fullfillment time. During the course case studies will be used to develop this concept further. 15. GOVERNMENT POLICY WITH RESPECT TO SUPPLY CHAIN DEVELOPMENT Value chains are specialized business models which transform the dominant production function at the sector level within economies when they succeed. Supply chain development destabilizes sectors and accelerates competitive emulation of new and better supply chain based business models.

20 16 EASYPol Module 153 Applied Material However, in developing countries innovative value chain structures most often require active development and public investment in order to emerge. They typically take shape in response to exogenous factors which overturn existing competitive balances such as new market entrants, the emergence of new business models, technology changes which prove the viability of new industrial structures or financial incentives tied to public policy. Moreover, supply chains when they do emerge without some form of government involvement are rarely pro-poor or pro-small scale farmer. However, there exist three broad strategies for government support of pro-poor supply chains. These include: i) investing in social capital. Social capital is inculcated ultimately in new forms of industrial organization and in new forms of enterprise governance which facilitate the internalization and reduction of transaction costs among commercial partners. ii) Investing more broadly in the rural business environment. More specifically this category of investment included supply chain infrastructure as well as systems of regulation and of third party conflict resolution which reduce the threshold costs associated with effective integration of processes which span farm to market process steps; iii) developing and offering transactions to technically qualified supply chain integrators. Joint public private investment in supply chain structures, assets, specialized management competencies and/or specialized technical expertise can be offered to strategic investors in return for their active participation in competitiveness enhancing farm to market chains. Examples can be sited of each of these general approaches. Most donor and government sponsored supply chain development to date falls into the first category where the objective is to develop farm based industrial organizations which can perform the non traditional functions of supply chain management and which can develop internally the specialized management functions required to continue the learning process through which specialized management skills are refined. Numerous examples might be cited of demonstration projects and/or of supply chain incubators whose underlying development rationale is precisely this: to accelerate institutional learning from a farm base. One of the most successful of these projects which is worth noting is the World Bank sponsored program in Senegal which is designed to accelerate institutional learning and organizational innovation among horticulturists with an export orientation. The program attempts to capture the benefits which it has realized under a brand: Origin Senegal which is used jointly by project participants who also share the use of a number of specialized services each designed specifically to improve export competitiveness into a number of targeted European markets. The second approach is less targeted and more amorphous. It simply sets the stage for private sector investment without explicitly directed intervention. An example of an effectively executed policy which falls into this second category of intervention is the sugar industry regulatory policy which Tanzania developed and set in place before the privatization of its sugar industry. The sugar regulatory framework which operates in Tanzania defines the respective and inter related responsibilities of three sets of stakeholders: i) local small holder farm organizations which operate in each region in which a sugar refinery and supporting plantation has been transferred to private ownership, ii) private refinery operators; iii) local government entities. The regulatory framework mandates that a contract be developed through collective bargaining among the participants and it empowers a representative body to adjudicate and arbitrate differences among the