VALUE CHAIN APPROACH TO RURAL FINANCE

VALUE CHAIN APPROACH TO RURAL FINANCE ROMAN KOSODIY, ANNA BONDARENKO ABSTRACT Our research deals with analysis of Ukrainian agricultural enterprises and financial service providers, which are considered as links in a larger system or chain, that supplies goods and services to local, regional, and global markets. We suggest, that developments in enterprises and the financial sector in a value chain complement and build on each other. We explore financial flows within the value chain among the chain participants, as well as potential linkages between the chain participants and third party providers of finance (such as financial institutions) to improve growth of the chain. Keywords: agricultural finance, value chain financing. 1 INTRODUCTION Today new production and marketing relationships have evolved due to economic globalization and commercialization of agriculture, both of which have penetrated rural areas in most CEE countries. As a result, changes are taking place in farm production systems, distribution channels, financial markets and use of information technologies in the food industry. These changes often require capital-intensive investments. However, rural finance, despite several efforts of donors, governments and private investors to improve it, still remains very challenging and is generally weak in developing countries. Gaps exist between supply and demand for rural finance. An inefficiency gap between the potential supply and current achievements, an insufficiency gap between legitimate demand and potential supply, and a feasibility gap between political expectations and legitimate demand are common. Under existing conditions, it is necessary to develop an additional tool in the toolkit of methods, used to study rural finance issues from both supply and demand side perspectives, because we believe that development of sound financial systems is one of the important compo- Sumy National Agrarian University, Ukraine. E-mail: romkos2000@yahoo.com Sumy National Agrarian University, Ukraine. E-mail: anna.bondarenko@mail.ru

2 Poster Paper presented at IAMO Forum 2008 nents, that facilitate smooth flow of commodities from producers to consumers. Such tool can help to identify interventions in order to develop rural finance, as well as to identify gaps and opportunities for improvements in outreach, sustainability, and impact for specific clusters and subsectors. We introduce one of the approaches to studying of rural finance value chain approach (sometimes referred to as supply chain analysis), which helps to analyze the value, added by actors, involved in each link, related to rural economic activities and clusters of activities, that convert raw materials into finished products and market them. Understanding the conditions, under which value chain finance works or doesn't work, is useful for governments and donors, as well as for lenders, agribusinesses and producer organizations, interested in improving the supply of and access to finance for rural producers. 2 METHODS We use information and data on Ukrainian farms, agricultural markets, as well as the data, provided by financial intermediaries, which are involved in agricultural finance. We also assessed the efficiency of potential customers of financial institutions in the agricultural sector of the Sumy Oblast, and defined the market niches, which may look promising for further integration of financial intermediaries into market for the agricultural finance. 3 AGRICULTURAL VALUE CHAINS FINANCING IN UKRAINE Ensuring financial access for agriculture production in Ukraine and to rural areas in general has always been difficult. The challenges include: high transaction costs for both borrowers and lenders; high risks; lack of reliable financial information about rural households (compounding transactions costs and risk); and financial products ill suited to the financial flows of the borrowers or lenders. As a result, share of investments in agriculture in total investments decreased from 21,4% in 1990 to 5,7% in 2006. At the same time, agricultural sector remains one of the important sectors of the Ukrainian economy, accounting for approximately 10% of GDP. Ukraine has excellent conditions for agriculture, which make sure, that it has the potential to become one of the major agricultural countries in Europe. Hence, it is clear that significant efforts need to be undertaken to live up to its potential (VERZIJLENBERG, VONDELING, SCHRIJVER, 2008). Integration into dynamic and efficient value chains is an important strategy for financing rural farming industries. In addition to improving farmers' access to market information, technical

Value Chain Approach to Rural Finance 3 support and technology, value chain integration reduces risks and increases access to financial services. Value chain finance can be defined as the flow of financing within a subsector, among value chain actors, for the purpose of getting product to market. Value chain finance, according to this definition, requires a relationship and exchange among value chain actors (JANSEN, 2006). The current interest in value chains and value chain finance is to determine whether value chain relationships can be better understood and exploited in order to address the key constraints for rural and agriculture finance mentioned above. Agricultural value chains in Ukraine can be segmented in a number of ways. In our research, agricultural value chains are represented by input suppliers, producers, processors and retailers. We have segmented agricultural sector based on the type of organization in a legal form, and further refined the sector on the basis of types of operations and size of land use. In such a way we classify Ukrainian agricultural producers into two broad categories: individual and corporate farms (figure 1, table 1). Figure 1. Agricultural value chain financing in Ukraine SOURCE OF FINANCING national retailers global retailers exporters banks banks, leasing companies, state financial support banks, leasing companies processors/ traders banks, leasing companies, state financial support producers* corporate sector private entities with strong commercial orientation that operate mainly at leased land Industrial farming highly commercial, often also combined with processing and marketing over 10,000 hectares Agricultural enterprises highly commercial 2,000-10,000 hectares banks, leasing companies, state financial support banks (working capital financing), credit unions, state financial support individual farms typical family operations private farms mainly commercially oriented size for crop farming: up to 2,000 hectares household plots subsistence oriented with sale of surplus size for crop farming: 0.5-100 hectares credit unions, cooperatives self-help groups, family and friends input suppliers banks, leasing companies *according to IFC classification

4 Poster Paper presented at IAMO Forum 2008 Table 1: Sources of value chain financing in Ukraine level of source commercialization Value chain elements Input suppliers Producers Individual farms Corporate sector household plots up to 100 ha private farms up to 2,000 ha agricultural enterprises 2,000-10,000 ha industrial farming over 10,000 ha Processors / traders National retailers Exporters Global retailers Sources of financing financing banks leasing companies credit unions through input suppliers Depending on the Depending on the supplier (from type of supplier sufficient to limited (from sufficient to access) limited access) are perceived as too risky limited access working capital financing (< 1 year) working capital financing (< 1 year), small number of enterprises have access to long term loans for equipment (3-5 years) all financial needs are satisfied, have access to long-term financing (up to 10 years) all financial needs are satisfied all financial needs are satisfied all financial needs are satisfied No possibility to use this service limited access small number of enterprises have ample opportunities to attract leasing companies sufficient access (leasing of agricultural machinery) sufficient access (leasing of food processing equipment, trucks) financial support from state tax remissions family and friends sufficient access - none none rarely used credit unions are too early stage of development to serve the needs of smaller farms credit unions are too early stage of development to serve the needs of smaller farms sufficient access rarely used none sufficient access sufficient access sufficient access rarely used - none State Support Fund, different types of compensations on competitive basis different types of compensations on competitive basis different types of compensations on competitive basis different types of compensations on competitive basis exempted from tax, as they are mostly subsistence oriented fixed agrarian tax or if not compliance to criteria for fixed agrarian tax, regular tax regime fixed agrarian tax or if not compliance to criteria for fixed agrarian tax, regular tax regime fixed agrarian tax or if not compliance to criteria for fixed agrarian tax, regular tax regime none limited access limited access rarely used rarely used rarely used sufficient access is not used - limited access none is not used sufficient access is not used - export subsidies none is not used sufficient access is not used - none none is not used - level of access to financial sources (from sufficient to poor) Small number of large corporate enterprises (> 10,000 ha) have ample opportunities to attract foreign investors, as well as banks and leasing companies to provide finance. Their main loan facilities are organized off-shore, creating less dependency on specific local conditions (or impediments) that limits access to finance through the Ukrainian financial sector (VERZIJLENBERG, VONDELING, SCHRIJVER, 2008). Limited access to finance particularly hampers the development of private farm sector (especially the farms between 50 ha and 2,000 ha), as well as the smaller corporate farms. The commercial banking system is insufficiently developed to serve the needs of the smaller farms, whereas credit unions are at a too early stage of development to serve the private farming sector. Both the larger private farms, as well as the smaller corporate farms appear to have more access to finance through input suppliers.

Value Chain Approach to Rural Finance 5 Tax laws, which apply to both private farms and agricultural enterprises, contain favorable conditions for agricultural legal entities through simplified tax obligations. Private households are exempted from tax, as they are mostly subsistence-oriented. 4 SOURCES OF VALUE CHAIN FINANCING IN UKRAINE 4.1 Banks In Ukraine, only few banks provide services to the agricultural sector. These include Raiffeisenbank Aval, Bank Nadra, Privatbank, Ukrsotsbank, Creditprombank. However, most of these banks almost do not provide start-up capital and investments in modernization of existing capacities in agricultural enterprises. Finance is predominantly short term (up to 12 months). Taking into account extreme shortage of investments in modernization of agricultural machinery and technologies, banks usually provide loans for financing current operations in enterprises rather than for investments. Share of long term loans for small businesses does not exceed 9% of the total volume of extended loans. High costs of long term loans limit the demand for them (BONDARENKO, KOSODIY, MISHENIN, 2007). Moreover, most banks provide finance only to farms with the size of more than 100 ha. Smaller farms are perceived to be too risky (VERZIJLENBERG, VONDELING, SCHRIJVER, 2008). As regards financing of processing companies, they are offered short-, mid- and long-term loans. Some banks provide finance to processing companies up to ten years (figure 2). Figure 2 Financial products, offered by Ukrainian banks in agricultural sector BANKS, WHICH PROVIDE SERVICES TO AGRICULTURAL SECTOR Raiffesenbank Aval Bank Nadra Privatbank Ukrsotsbank Creditprombank OFFERED FINANCIAL PRODUCTS for agricultural producers for processors Financing of Working capital (< 1 year) Long-term loans for equipment (3-5 years) Short-term loans (< 1 year) Mid-term loans (2-3 year) Long-term loans (up to 10 years) Hence, actual financing of agricultural enterprises by banks mainly consists of collateralized financing of working capital (loan is provided maximum often up to 70% of the collateral). At the same time, agricultural clients often lack sufficient collateral. The lack of adequate collat-

6 Poster Paper presented at IAMO Forum 2008 eral along with information asymmetries, high transaction costs, inefficient system of contracts fulfillment, as well as risk, related to agricultural production and governmental policy, are the main obstacles to the efficient financing of agricultural sector by banks. The situation gets worse because of heavy dependence on short term customer funding and absence of additional risk mitigation instruments in place. Banks are hesitant to provide long-term financing to the agricultural sector not only because they perceive the agribusiness sector as to risky, but also because they lack long termfinancing. One of the solutions can be system of state refinancing through agency that attracts funding by issuing bonds, guaranteed by state. Another option is to attract long-term financing from international institutions. However, this would imply the Ukrainian government to first lift the moratorium on agricultural land and to establish the cadastre. As to present day, government has failed to resolve the land issue in Ukraine and even enabling initiatives such as land registration have not been complete yet. For agricultural enterprises, especially for the private farms, this posses a major constraint in acquiring access to finance, for land is not accepted by financial institutions as collateral. 4.2 Leasing companies International practices has proven that leasing is an effective investment mechanism and an important component of the economic and investment policy. Its share in investments into fixed assets comprises approximately 30% in well-developed market economies and 10-15 % in other countries. However, in Ukraine it is only 1,2 %, but it is showing high growth indicators (VERZIJLENBERG, VONDELING, SCHRIJVER, 2008). During 2004-2006, the number of leasing companies increased almost by 200%, while the value of the portfolio of leasing agreements increased by 340% and amounted at the beginning of 2007 to UAH 3601 million (USD 716 million) (figure 3).

Value Chain Approach to Rural Finance 7 Figure 3 Development of Ukrainian leasing market 70 60 amount of leasing companies leasing portfolio dynamics 4000 3500 50 +30 % 65 3000 amount of companies 40 30 20 +47 % 34 50 2500 2000 1500 1000 UAH, millions 10 500 0 01.01.2005p. 01.01.2006p. 01.01.2007p. 0 Source: RESULTS OF THE RESEARCH OF THE UKRAINIAN LEASING MARKET Although leasing in Ukraine has shown significant growth rates in recent years, agri-leasing is a relatively new instrument and still underdeveloped. Leasing in agriculture still holds moderate position in the leasing market, despite the enormous need for replacement of agricultural equipment. Only 20% of leasing companies offer agricultural machinery (figure 4). Agricultural sector is considered as the most risky for leasing companies compared to other sectors. Figure 4. Distribution of leasing companies by the types of leased assets cars trucks other production equipment (except for food processing) passenger vehicles computers food processing equipment agricultural machinery buildings (structures) medical equipment publishing equipment telecommunications equipment planes water and railroad means of transportation 21 % 28 % 18 % 01.01.2007p. 01.01.2006p. 01.01.2005p. 0% 10% 20% 30% 40% 50% 60% 70% 80% Source: RESULTS OF STUDY OF THE UKRAINIAN LEASING MARKET

8 Poster Paper presented at IAMO Forum 2008 At the same time, there is a great demand in the Ukrainian leasing market for agricultural machinery, because the level of provision of the Ukrainian agriculture with this machinery is very low. Starting from 1990, the number of agricultural machines decreased twofold. Deterioration rates of machines exceed the rates of their renewal by 10 times. Available tractors and combines do not satisfy the technological need. Availability of tractors in agricultural enterprises amounts to 57 %, grain combines 51 %, combines for corn and beet 52 %, tillage and sowing machines 92 % (MACHINERY IN AGRICULTURE). As a result, load per unit of machinery in Ukraine is 5-10 times higher, than in the developed countries, and several times higher the set standards (figure 5). Figure 5. Load per unit of machinery in certain countries 350 300 320 arable land per tractor area under grain per combine hectares per unite of machinery 250 200 150 100 50 0 90 60 53 50 28 14 5 Ukraine USA France Germany Source: MACHINERY IN AGRICULTURE Situation in agriculture is complicated by the fact, that 90% of agricultural machinery are worn out. For example, the level of deterioration for tractors exceeds 72%, for combines 75-98%. High level of machines deterioration requires considerable expenditures for repairs, while total costs for renewal increase annually by 5% and exceed UAH 2 billion. According to studies, conducted by the Institute of Mechanization and Electrification of Agriculture, in order to satisfy the needs of the agricultural sector regarding machinery, there is a demand for annual supply of 42000 tractors and 8700 grain combines (MACHINERY IN AGRICULTURE). Therefore, there is a great potential market for leasing of agricultural machines. Many domestic leasing companies are interested in entry into this market. However, growth rates for agricultural lease portfolio are insufficient. For example, in 2006 leasing companies provided for lease USD 16 million of agricultural machinery (figure 6). At the same time, agricultural

Value Chain Approach to Rural Finance 9 specialists estimate, that agricultural companies would require USD 8-10 billion just to replace their existing agricultural equipment. Figure 6 Portfolio of leasing companies by types of assets, which are provided for leasing cars trucks other production equipment (except for food processing) passenger vehicles computers food processing equipment agricultural machinery buildings (structures) medical equipment publishing equipment telecommunications equipment planes water and railroad means of transportation 80 683 22 118 27 741 01.01.2007p. 01.01.2006p. 01.01.2005p. 0 200000 400000 600000 800000 1000000 1200000 1400000 UAH 000's Source: STUDY OF THE LEASING MARKET IN UKRAINE Negative influence on the development of the agricultural machines leasing market also comes from the government s actions, aimed at support of agricultural enterprises, because these interventions result in distortions in this market. Interest subsidies for bank loans create unequal conditions for competition in the agricultural finance market for leasing companies. Loan subsidies allow farmers to buy equipment at a reduced interest rate, if the equipment is financed through a bank loan. However, the main impediment for farmers is not the cost of funds, but access to finance. However, since most of the farms, applying for a loan, are refused by the banks due to the lack of collateral, they are not able to attract sufficient formal sources of finance. At the same time, leasing is more flexible compared to the bank loans, and is much more convenient for small businesses. Therefore, government programs, aimed to promote the development of agriculture and agrifinance (such as the partial interest rate compensation and services, provided by Ukragroleasing), fail to reach the small and medium-sized private farmers, for which these programs were originally aimed. In general, this program failed to address the existing reluctance of commercial banks to deal with agricultural enterprises (VERZIJLENBERG, SCHRIJVER, 2008). VONDELING,

10 Poster Paper presented at IAMO Forum 2008 5 MARKET NICHES IN THE FIELD OF PROVIDING SERVICES TO THE AGRICULTURAL SECTOR OF UKRAINE Therefore, we may conclude, that financially sustainable institutions (especially the banks) are reluctant to finance agricultural sector, especially the important group of commercial farmers with the size between 50 to 2,000 ha. However, for these individual farms in Ukraine, the share of land used amounts to more than 41%, while the share in total agriculture production is estimated to be more than 69 % (VERZIJLENBERG, VONDELING, SCHRIJVER, 2008). Furthermore, there are interesting results of the study of efficiency of agricultural enterprises in the Sumy Oblast based on DEA-analysis (fig. 7). According to this analysis, small enterprises (with area up to 5000 hectares) the most efficient (based on resource allocation). Figure 7 Distribution of efficient agricultural enterprises by their size (area of agricultural land) efficiency scale, % 1400% big 1300% 1200% 1100% 1000% 900% 800% 700% 600% 500% 400% 300% 200% 100% 0% 0 1 2 3 4 5 6 7 8 9 10 land, ha 000's efficiency line When developing this model, we analyzed the results of 377 agricultural enterprises (approximately 100%) from all 18 districts of the Sumy Oblast. In order to analyze efficiency, we used enterprises statements for the year of 2006, provided by the Department of Statistics of the Sumy Oblast. When calculating efficiency scales, we used data regarding production of 12 types of products (y km, m = 1, 12): grain and grain legumes, sunflower, soybeans, sugar beets, other crops, pork, beef, milk, other products of animal farming. According to our research, the efficiency level may be partially explained by the influence of such factor as the size of the enterprise. For example, in 55% of efficient enterprises the area

Value Chain Approach to Rural Finance 11 of agricultural lands does not exceed 1000 hectares. Area, used by 75% of efficient enterprises, does not exceed 2000 hectares. Only 8% of efficient enterprises have total land area of more than 3000 hectares. This trend may be explained by the fact that we do not measure the efficiency of agricultural enterprises be means of input-oriented DEA model, that is from the point of view of optimal allocation of resources (how much can we decrease the use of production factors, leaving the production result unchanged). However, use of resources in small enterprises is always more efficient compared to the allocation of resources, which is common for large enterprises. That s why, each currency unit, which works in small business, will have higher return compared to large enterprises. However, this also witnesses on the ability of small agricultural producers to a higher price for financial resources, because they obtain higher return from the loan. It means that the price of financial resources may partially cover the costs, related to increased risk or high transaction costs. And in contrast to the general opinion, farmers and rural households are ready to pay even high interest rates for the access to finance. For example, in order to obtain loan without collateral, a typical rural entrepreneur pays to the bank 24-36% of annual interest rate. Annual interest rates for collateralized loans are somewhat lower 16-17%. CONCLUSIONS Therefore, we see, that bank institutions, leasing companies and formal financial sector increasingly cooperate with large agricultural producers, processors and global retailers. Small agricultural producers depend, mainly, on government s financial support and informal finance. Conditions in rural areas help to explain the gap in rural financial services. Providing services to small agricultural entrepreneurs typically faces high transaction costs. Information, necessary to assess a borrower s ability and willingness to repay a loan, is difficult and expensive to obtain. Collateral is more limited, often less documented, and more difficult to liquidate, increasing provisioning and foreclosure costs for financial institutions. Financial institutions, that historically blurred the distinction between grants and loans, have helped to create a credit culture, in which rural residents may be less willing to repay their loans. Agricultural finance creates an additional set of costs and risks, from its seasonality and requirements for longer terms, to the fact that many borrowers will face the same production and price risks.

12 Poster Paper presented at IAMO Forum 2008 Moreover, with regard to the development of both agricultural sector, as well as the agrifinance sector, the role of the government is regarded rather ambiguous. On the one hand, the Ukrainian government has initiated a number initiatives, aimed to spur the development of both the agricultural sector and agri-finance sector. On other hand, unpredictable government interference and its failure to solve some major impediments are perceived to hamper the development of both sectors. REFERENCES BONDARENKO, A., KOSODIY, R., MISHENIN, Y. (2007). Development of Innovative Technologies in Rural Finance, Sustainable Rural Development: What is the Role of the Agri- Food Sector? / Editors: Martin Petrick and Gertrud Buchenrieder. Institute of Agricultural Development in Central and Eastern Europe (IAMO), Halle (Saale), Germany, p. 113-127. FRIES, R., AKIN, B. (2004). Value Chains and Their Significance for Addressing the Rural Finance Challenge, Accelerated Microenterprise Advancement Project, Microreport No. 20, р. 1-4 JANSEN, A. (2006). Value chain finance: Financing to and within value chains, USAID // www.cgap.org/.../documents/cg2006/presentations/africaday_theme6.pdf VERZIJLENBERG, W., VONDELING, W., SCHRIJVER, B. (2008). Ukraine Rural Finance Study, Final Report for: Ukraine Agri-Finance Study (UAFS): Analysis of the potential, risks and challenges of agricultural finance in Ukraine, RIAS BV, p. 8-14 EXPRESS RESULTS OF STUDYING THE UKRAINIAN LEASING MARKET 2007, Leasing in Ukraine, No. 3, р. 1-5, 2007. MACHINERY IN AGRICULTURE (prepeared by Analytical and Consulting Center of UNDP), Leasing in Ukraine, No. 2, р. 6-9, 2007.