FOOD POLICY REVIEW 4

Synopsis

Rural Finance for Food Security for the Poor: Implications for Research and Policy

Over the past three decades, rural financial policy in developing countries has often sought to improve access of the poor to credit through supply-oriented and subsidized credit institutions. The lessons learned from the widespread failure of state-run rural credit programs; the existence of thriving informal financial institutions providing credit, savings, and insurance services to the rural poor; and recent institutional innovations in microfinance have led the authors of this food policy review to consider the current role of public action in developing rural financial markets.

In Rural Finance for Food Security of the Poor: Implications for Research and Policy, Food Policy Review 4, the authors take a fresh look at the role of rural financial policy in improving household food security and alleviating poverty. They develop a conceptual framework for relating access to financial services to food security and review empirical findings on household demand for financial services. They explore the potentials for linking informal lenders (relatives, credit groups, and moneylenders) with the formal financial systems (banks and cooperatives). Then they review the constraints to development of rural financial markets and ways to circumvent these constraints by examining innovative institutions, especially those that include participation by the poor themselves.

Given seasonal agricultural income and a multitude of risks affecting income generation and consumption, access to financial services can contribute to improved income generation and consumption stabilization, thereby addressing the transitory and chronic food insecurity of many poor households in developing countries. The objectives of this review are to examine these potentials for improved food security, to derive implications for policy and institutional design, and to point out future avenues of research.

How Rural Finance Can Improve Household Food Security

Households experiencing or anticipating food shortages may deal with the problem in a number of ways: they may diversify their crops and off-farm income sources, sell assets, seek to increase their savings, or borrow from relatives, moneylenders, or formal markets. The poorer the household, the more severe the consequences of a food shortage can be: as their assets and borrowing options become depleted, these households may slip into chronic food insecurity.

Access to credit, savings, and insurance services could improve transitory and chronic food insecurity in three ways. First, credit or savings can provide capital for financing inputs, labor, and equipment for income generation. This is the traditional argument for rural financial policy. Second, access to credit and liquid financial savings services enables households to adopt more effective precautionary savings strategies. In addition, insurance services can reduce the cost of bearing risks, thereby enhancing the households’ capacity to invest in more risky but also more profitable technology and enterprises. Third, financial services could more efficiently stabilize consumption of food and other essential goods during lean times. All three functions help alleviate food insecurity. The first largely addresses chronic food insecurity, the third helps prevent transitory food insecurity, and the second can affect both. Rural financial policy for enhancing household food security, therefore, implies the availability not only of credit for agricultural production or off-farm microenterprises, but also of financial services that respond to the demand for precautionary savings as a means of smoothing sharp fluctuations in income to help rural households manage their finances more efficiently and to accumulate assets.

Constraints to Development of Rural Financial Institutions

Although the poor’s demand for credit, savings, and insurance services to increase income and stabilize consumption is clear, it is particularly difficult for commercial banks with their conventional lending and savings systems to meet this demand and at the same time cover their costs. The poor seldom have assets to offer as collateral, are often illiterate, live in remote areas far away from the nearest bank branch, and borrow and save in small amounts (which raises the costs per transaction). As a consequence, a large share of rural households in developing countries lack access to credit and savings services.

Informal lenders circumvent some of these and other constraints. Much remains to be learned from them. Informal institutions can obtain information about the reputation, wealth, and indebtedness of potential clients at much lower cost than socially and physically distant bank or government agents. While the poor lack physical capital for collateral, they can usually offer social capital by having their peers guarantee contract compliance. But the informal market also has major weaknesses, rooted in its fragmentation and geographical isolation, which, in addition to other shortcomings, make it unable to mobilize large sums of capital and to lend it to different sectors or regions. Combining the strengths of the informal and formal markets holds promise for improving the poor’s access to financial services.

Financial Institutions for and by the Poor

Member-based institutions at the community level, such as credit groups, cooperative societies, and village banks, can exploit the cost advantage that informal institutions have by incorporating or building on some of their screening, monitoring, and enforcement mechanisms. International and national nongovernmental organizations, financially supported by donors and governments, have been the leaders in much of the experimentation and development in the field in the past 15 years, and new types of institutions, some of them described in this review, have emerged. While these new institutions often serve the landless, or cater to credit demand related to off-farm microenterprises, they also demonstrate the potential for sustainably expanding access to agricultural credit for poor smallholders and tenants. More investment in agricultural finance seems warranted, given that most of the poor in developing countries depend directly or indirectly on agriculture.

Key factors for success in developing and linking member-based institutions with the formal sector are

• a macroeconomic and financial sector framework enabling market-based allocation of resources;
• the provision of financial products that effectively respond to the diverse demand for savings and credit options, especially stressing the poor’s demand for precautionary savings and insurance services;
• the employment of locally adapted collateral substitutes such as peer pressure, obligatory savings, or character references, which reduce transaction costs for screening, loan disbursement, and repayment, including the risk of loan default;
• market-based savings and lending interest rates in order to attract savings deposits, to cover administrative and capital costs, and to avoid rent-seeking of better-off groups; and
• flexibility in decisionmaking and incentives for program compliance at the grassroots level.

Implications for Research and Policy

So far, few rural financial institutions for the poor have reached significant levels of outreach. Most of them depend on subsidies, although some at a modest level. Recent research analyzing the impact of these institutions indicates gains in improved income, food security, and educational and nutritional status. If rural financial institutions contribute to the objectives of economic efficiency and more equitable distribution of income and assets, they perform a worthwhile task for public policy. It is in this light that contemporary publications on this subject argue that public support for building financial institutions for the poor is justified if subsidies can be phased out after the initial years of institution-building and if the long-term financial sustainability of the institution appears achievable.

From a policy perspective, public support for building rural financial institutions ought, in principle, not be judged on the prospect of achieving financial sustainability of the institution itself, but on the economic sustainability of the public investment. Economic sustainability of a policy implies that scarce public funds are used to maximize social returns. In many rural settings of developing countries, long-term support for building and maintaining rural financial institutions that serve the poor may have higher benefit-cost ratios in both the short and the long run than some other competing policy instruments. A cost-benefit evaluation of public investments in rural financial institutions, however, has so far not been undertaken, largely because rigorous quantitative assessments of the welfare benefits of access to financial services are lacking. More research quantifying the benefits could contribute to better informed policy design and implementation.