State-owned Development Finance (SDFI): the Political Economy and Performance Assessment

1. State-owned Development Finance (SDFI): the Political Economy and Performance Assessment Jacob Yaron jyaron@verizon.net Rome, March 19-21,2007

2. Issues to discuss • History until 1985-90 • State owned development banks • Interest rate policy • Microfinance and access to finance of the rural sector • Conclusions

3. History: The policy and institutions until 1985-90 • Directed, subsidized credit • State owned development banks • Poor financial performance • Poor loan collection • Often, the well to do, influential borrowers benefited from the lion’s share of the “grant element” in the subsidized loans • Financial outcome of SDFIs- meaningless or misleading

4. Objectives of Intervention in Rural Financial Markets Poverty Reduction Food security Growth The agriculture can not pay “regular” interest rates Agriculture is a “priority” sector The agriculture sector is very important in terms of its share of GDP, employment and export All countries support the sector-if we will not the sector will die

5. Characteristics of Rural Finance • High risks • - Seasonal fluctuations • - Covariance risks (yield and price) • - Small size of production and fragmented markets • -Lack of traditional collateral • Poorly complementary insurance and labor markets • Lack of physical and human infrastructure

6. The Daunting Dilemma of Lending Interest Rates Budget • Under hard budget constraints a choice is inevitable Unsubsidized lending interest rates can serve a high share of the rural population with no subsidy per $ lent Highly subsidized lending interest rates can serve only small number of clients with high subsidy per $ lent

7. Interest Rate Policy • Objectives • - Growth • - Poverty reduction • For Growth • - “Higher”, unsubsidized lending interest rates contribute to a better resource allocation. Scarce funds would be lent to high return investments, thereby accelerating growth.

8. For Poverty Reduction… • General: The use of artificially low, subsidized lending interest rates is very tempting and widely used. • However, subsidized lending rates are inefficient in fighting poverty because: • - Most of the poor don’t have access to credit and therefore don’t benefit from the subsidy.

9. Figure 1: Effect on a DFI’s ROA and ROE Based of Changing the Interest Rate Charged on its Borrowed Funds Key Assumptions: equity equals 10 percent of total assets, the average annual yield obtained on total assets is 20 percent, and administrative expenses are six percent of total assets.

10. Index of Growth in Rural Credit and Grains Production (1967=100) US$ Index 800 600 700 500 600 US$/ton* 400 Grains production 500 400 300 Rural credit** 300 200 200 100 100 0 0 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 Agricultural Production Soars Even as Formal Agricultural Credit Declines in Brazil in 1985-1999 Note: * Nominal credit values were adjusted by the general price index for domestically available goods, then converted by the avg. 1999 exchange rate of R$1.8428/US$1; ** Units of credit (US$) per ton of grains produced Source: Central Bank of Brazil, as reproduced in Moysés Kessel: “O Crédito Rural no Brasil”, Nota Técnica, BCB-DEPEC. 2001

11. Microfinance and agriculture • Microfinances, usually when active in rural finance serve: • Clients with diversified sources of income • High population density • Clients with short production cycle that generate cash flow that allows frequent loan repayments • Clients that are not adversely influenced by seasonality

12. Recent changes • Tailoring procedures and products to production cycles • Applying risk management techniques that reduces creditor risk • Applying technologies and alternative delivery mechanisms aiming at enhancing outreach and saving operational cost • High population density and tough competition among urban MFIs are important factors that e ncourage agricultural lending

13. Facilitating agriculture credit- MFIs • Capping the % of agricultural lending of OLP allows risk mitigation • Lending to households with diversified sources of income including primary agriculture • Matching disbursements and repayments t o the production cycle • Flexible collateral requirements • Technological innovations (ATM, point of sale, debit and credit cards) • Using existing delivery mechanism (post offices, retailers, mobile credit officers)

14. The transaction cost of microfinance • MFIs have very high transaction cost as a share of their OLP (compared to regular, urban banks) • Innovations needed to reduce substantially these cost and facilitate high growth rate of rural microfinance • Administrative cost of 124 old, young and new (urban and rural) MFIs were 31%, 38% and 40% of OLP • The adjusted combined financial cost and credit risk of these MFIs were less than 10 % of OLP (excluding opportunity cost of equity capital) source-MicroBank Bulletin, 2005)

15. Risk mitigating instruments • Whether insurance • Minimum commodity price insurance- by creating a joint product of a loan and a put option • Combination of the above- guarantees income (yield and price risks are mitigated) • These insurances rely on the markets-- a sheer contrast to the “administrative” instruments that poorly performed and were highly subsidized (state owned crop insurance and artificial agricultural price support schemes).

16. BRI-Village bank in Indonesia-BUD • Was established in 1983 replacing the poorly performed subsidized, directed credit to rice growers- BIMAS program • Is a profit center in a state owned bank • Is considered the flagship of the rural microfinance industry in the world • Introduced and continued to apply the “best practices” in microfinance

17. The BUD’s key elements of success • Autonomy (charging “high” lending rates, paying substantial bonuses to employees). • Incentives to staff and clients • Adequate products’ pricing (saving yield, 0%-16%) • High growth rate of rural GDP • Financing all rural activities not only agriculture • Benefiting from existing infrastructure, while changing drastically the “rules of the game”

18. BUD -Indonesia • Outreach 1985 1990 1995 • Average annual OLP ($ million) • 162 562 1178 • Number of outstanding loans (million) • 1.0 1.9 2.3 • Average outstanding loan amount ($) • 162 296 512 • Average annual deposit volume ($ million) • 49 685 2382 • Number of deposit account (million) • NA 7.3 14.5 • Average deposit amount ($) • NA 94 164 • Average annual deposit value/ average annual OLP: 0.31 1,22 2.02

19. BUD- Financial performance

20. BUD (continued)

21. BUD (continued)

22. Conclusions • The “traditional” approach of subsidized, poor performing state owned bank is wasteful, yielding limited outreach and highly subsidized systems. • Effective Microfinance financial intermediation has a great potential to reach the rural poor • New technologies, procedures and particularly risk mitigating instruments can facilitate access to financial services to many small farming households.