CHAPTER SIX

6. AGRICULTURAL FINANCE & RURAL CREDIT MARKETS

6.1 Introduction
Finance can be defined as the art and science of managing money. Finance is concerned with the
process, institutions, markets involved in the transfer of money among and between individuals,
businesses and governments.
Not all rural finance is agricultural or microfinance and not all agricultural finance are rural.
Yet financial service providers offer:
 rural finance (financial services used in rural areas by people of all income levels),
 microfinance (financial services for poor and low-income people), and
 agricultural finance (financing of agriculture-related activities, from production to
market)
often have overlapping objectives and opportunities.
The clients served by microfinance are often the same clients or households that would benefit
from increased rural or agricultural finance. The financial systems approach in micro and rural
finance which emphasizes a favorable policy environment and institution-building has improved
the overall effectiveness of rural finance interventions. But numerous challenges remain,
especially in financing agribusiness.

6.1.1 Why do People Demand Credit in Rural Areas?

Loans, notes, bills of exchange, and bankers' acceptances are some of the credit instruments
financing agricultural transactions. Banks lend to farmers for a variety of purposes, including:
1. Short-term credit to cover operating expenses;
2. Intermediate credit for investment in farm equipment and real estate improvements;
3. Long-term credit for acquisition of farm real estate and construction financing; and
4. Debt repayment and refinancing.
6.1.2 Types of Rural Credits
There are three types of rural credits:
1. Short-term loan/credit: A short-term loan is one kind of rural credit that is taken for a
brief private or business capital requirement. It is a type of credit that requires a borrowed

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 principal amount and interest percentage to be repaid at a given date, the course of which
may be maximum up to one year.
A short term loan is a worthy but an expensive option, particularly for small companies or
basically for startups that are still not qualified for a credit line from a bank.
2. Medium-term loan/credit: A medium-term loan is the loan that has a repayment
duration between 2 to 5 years or less than 10 years. Medium-term loans are an excellent
option for small firms that are looking for a traditional way of credit with a set repayment
duration and anticipated amounts.
The loan amount an individual receives may differ based on the cash flow, credit rating,
and various other factors.
3. Long-term loan/credit: The repayment duration of a long-term loan is usually 5 to 20
years or even more in a few exceptional cases. In any business, long-term finance is
essential to create permanent assets that will return over a period of time.
Especially in the agriculture sector, long-term investment comprises land levelling,
fencing, sinking wells, permanent repairs on land, acquisition of heavy machinery such as
tractors, etc. All the suggested long-term investments need large numbers of funds.
Although they have a considerable potential to give profits in the future, private farmers
do not have the money to make such costly investments as they either have no savings or
have very little savings.

6.1.3. Advantages and Disadvantages of Credit

Advantages of Credit
Modern economy is said to be a credit economy. Credit is of vital importance for the working of
an economy. It is the oil of the wheel of trade and industry and helps in the economic prosperity
of a country in the following ways:
1. Economical: Credit instruments economize the use of metallic currency. They are cheaper
than coinage. The metal used in coins can be used for other productive purposes.
2. Increases productivity of capital: Credit increases the productivity of capital. People having
idle money deposit it in banks and with non-bank financial institutions which is lent to trade and
industry for productive uses.
3. Convenient: Credit instruments are a convenient mode of national and international payments.

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They help in transferring payments with little cost and without the use of actual money from one
place to another quickly.
4. Internal and external trade: As a corollary to the above by facilitating payments quickly,
credit helps in the expansion of internal and external trade of a country.
5. Encourages investment: Credit is the payment along which production travels, and that
bankers provide facilities to manufacturers to produce to full capacity. Credit encourages
investment in the economy. Financial institutions help mobilizing savings of the people through
deposits, bonds, etc. These are, in turn, given as credit to trade, industry, agriculture, etc. which
lead to more production and employment.
6. Increases demand: A variability of cheap and easy credit increases the demand for goods and
services in the country. This leads to increase in the production of such durable consumer goods.
These raise the standard of living of the people when they consume more goods and services.
Consumption loans by banking and non-banking financial institutions coupled with the use of
credit cards have made these possible.
7. Utilizes resources: Credit helps in the proper utilization of a country's manpower and other
resources. Cheap and easy credit encourages people to start their own businesses which provide
them employment. Agriculture develops when farmers get seeds, fertilizers, pumping sets,
tractors, etc. on credit. Similarly transport, communications, industry, mines, plantations, power,
etc. develop with the help of credit.
8. Price stability: Credit helps in maintaining price stability in a country. The central bank
controls price fluctuations through its credit control policy. It reduces the credit supply to control
inflation and increases the supply of credit to control deflation.
9. Helpful to government: Credit helps the government in meeting exigencies or emergencies
when the usual fiscal measures fail to fill the financial needs of the government. Government
resorts to deficit financing for economic development by creating excess credit.
Disadvantages of Credit
Credit is a dangerous tool if it is not properly controlled and managed. The following are some of
the defects of credit:
1. Too much and too little credit harmful: Too much and too little of credit are harmful for the
economy. Too much of credit leads to inflation which causes direct and immediate damage to
creditors and consumers. On the contrary, too little of credit leads to deflation which brings

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down the level of output, employment and income.
2. Growth of monopolies: Too much of credit leads to the concentration of capital and wealth in
the hands of a few capitalists. This leads to growth of monopolies which exploit both consumers
and workers.
3. Wastage of resources: When banks create excessive credit, it may be used for productive and
unproductive purposes. If too much of credit is used for production, it leads to over capitalization
and over production, and consequently to wastage of resources. Similarly, if credit is given
liberally for productive purposes, it also leads to wastage of resources.
4. Cyclical fluctuations: When there is an excess supply of credit, it leads to a boom. When it
contracts, there is a slump. In a boom, output, employment and income increase which lead to
over production. On the contrary, they decline during a depression thereby leading to under
consumption. Such cyclical fluctuations bring about untold miseries to the people.
5. Extravagance: Easy availability of credit leads to extravagance on the part of people. People
indulge in conspicuous consumption. They buy those goods which they do not need. With
borrowed money, they spend recklessly on luxury articles. The same is the case with
businessmen and even governments who invest in unproductive enterprises and schemes.
6. Speculation and uncertainty: Over issue of credit encourages speculation leading to abnormal
rise in prices. The rise in prices, in turn, brings an element of uncertainty into trade and business.
Uncertainty hinders economic progress.
7. Black money: Excessive supply of credit encourages people to amass money and wealth. For
this they tend to adopt underhand means and exploit others. To become rich, they evade taxes,
conceal income and wealth and thus, hoard black money.
8. Political instability: Over issue of credit leading to hyper-inflation leads to political instability
and even the downfall of government.

6.2 Bases of Credit

Numerous factors influence the creditworthiness of a farmer. Credit managers usually talk of the
seven C's of credit: character, capacity, collateral, capital, condition, courage, and competition.
1. Character: Character or integrity is the most important factor of confidence. The first step in
selling one's credit to a lender is to be honest in all business and personal dealings, because the
confidence factor is vitally important.

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2. Capacity (or risk-bearing ability: Risk-bearing ability measures whether the farm operation
can withstand financial losses without being forced into liquidation or insolvency. If production
and prices decline and losses occur, they must be absorbed or covered by equity capital or net
worth. The basic document used to measure the risk-bearing ability of the farm business is the
balance sheet. The key ratios used in the analysis of risk-bearing ability are those related to total
assets, or debt to equity. These ratios show the proportion of the business financed with debt
compared to owner's equity and thus indicate the claims by others on the asset if liquidation
should
occur.
3. Collateral: Collateral security is any security (other than personal security such a guarantee)
taken by a bank or lender when it tends to make an advance to a borrowing customer, and which
it is entitled to claim in the event of default. Hence, the presence or absence of collateral matters
to get credit.
4. Capital (or repayment capacity): A lender wants to be paid in cash; he has little interest in
repossessing the security or collateral as satisfaction of the debt obligation. The ability to repay a
loan is consequently an important determinant of whether credit should be extended and is
influenced by the income-generating capacity of the business; the liquidity of the farm as
indicated by the balance sheet, and the cash flow of the firm. In short run an indication of
repayment capacity is that if current assets are not sufficient to pay current liabilities a repayment
problem will very likely occur as an indication of repayment capacity in short run. In long run
the key issue is whether there is sufficient revenue after paying for operating expenses, family
living, and farm expansion to repay any debt obligation.
5. Condition (or return): It is a combination of all the relevant facts about an agribusiness firm
and its situation in the existing economic environment. The basic question with respect to returns
is whether or not the use of credit will add to potential profits. Only if the profits of the business
will be increased will there be additional income available to make principal and interest
payments on the borrowed capital. Two questions are of interest in evaluating income or returns.
The first is the issue of whether the planned use of credit is the most profitable use in the farm
business. The
second question with respect to the returns is whether the farm business is generating an
adequate income to compensate for contributions of family labor and management as well as for

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equity accumulation. The profitability of the entire farm operations must be evaluated to assess
the possibility of income generated from profitable enterprises to cover losses on unprofitable
ones.
6. Courage: This is the courage of the credit executive when faced with a difficult decision
making situation.
7. Competition: The extent of competition to extend credit also matters to get credit. If there is
no sufficient number of competitors involved in the financial market (in credit extension), getting
credit may be difficult and vice versa.
6.3 Sources of Rural Credit
Finance is essential for a business’s operation, development and expansion. Finance is the core
limiting factor for most businesses and therefore, it is crucial for businesses to manage their
financial resources properly. The main source of credit for many farmers and agribusinesses is
other agribusinesses along the value chain including input suppliers, traders, and processors.
Moreover, the clients’ own savings and credit from financial institutions continues to play a role
in agricultural production.
Suppliers of rural and agricultural finance:
1. Value Chain Actors: exporters/wholesalers; processors; local traders; producer groups;
farmers; and input suppliers.
2. Financial Institutions:
o banks (commercial, agricultural banks, state development banks)
o non-bank financial institutions
o not-for-profit MFIs, which tend to work with poorer clients' credit unions and agricultural
cooperatives
Finance is available to a business from a variety of sources both internal and external. It is also
crucial for businesses to choose the most appropriate source of finance for its several needs as
different sources have their own benefits and costs. Sources of finance can be classified based on
a number of factors. They can be classified as Internal and External, Short-term and Long-term
or Equity and Debt. It would be uncomplicated to classify the sources as internal and external.
I. Internal sources of finance: Internal sources of finance are the funds readily available within
the organization. Internal sources of finance consist of:
 Personal savings

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 Working capital
 Retained profits
 Sale of fixed assets
2. External sources of finance: External sources of finance are from sources that are outside
the business. External sources of finance can either be:
 Ownership capital or Non-ownership capital
A. Ownership capital: Ownership capital is the money invested in the business by the
owners themselves. It can be the capital funding by owners and partners or it can also be
share bought by the shareholders of a company. There are mainly two main types of
shares. They are:
- Ordinary shares
- Preference shares
B. Non-ownership capital: Unlike ownership capital, non-ownership capital does not allow
the lender to participate in profit-sharing or to influence how the business is run. The
main
obligations of non-ownership capital are to pay back the borrowed sum of money and
interest. Different types of non-ownership capital:
o Debentures o Factoring
o Grant o Hire-purchase
o Bank overdraft o Invoice discounting
o Venture capital o Lease
o Loan
6.4 Characteristics of Rural Credit Markets
Agricultural activities, which are pursued by a large share of rural populations, are subject to
climatic risk and risk of price fluctuations to a much greater extent than urban economic
activities are. Accordingly, income levels are more subject to fluctuations, as well as being
lower, than those in urban areas. Rural borrowers are less likely to have tangible, documented
collateral than urban borrowers are.
Rural credit markets do not seem to work like classical competitive markets are supposed to
work. Interest rates charged by moneylenders may exceed 75 percent per year, and in some
periods credit is unavailable at any price. Neither the traditional monopoly [by moneylenders]

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nor the perfect markets view can explain other features of rural credit markets which are at least
as important and equally puzzling as high interest rates:

1. Informational Constraints
• Fundamental feature that creates imperfections in credit markets is informational constraints.
Informational gaps occur at two basic levels:
A. There is lack of information regarding the use to which a loan will be put.
B. There is lack of information regarding the repayment decision.
There is limited knowledge of:
• Innate characteristics of the borrower that may be relevant in such a decision
• The defaulter’s subsequent needs and activities, which place limits on his incentive to default.
• All the important features of credit markets can be understood as responses to one or the other
of these informational problems.
2. Segmentation
• Credit markets are segmented. Interest rates of lenders in different areas vary by more than
plausibly can be accounted for by differences in the likelihood of default. Many credit
relationships are personalized and take time to build up. Usually, a rural moneylender serves a
fixed clientele, to whom he lends to on a repeated basis, He is extremely reluctant to lend outside
this circle. Most often, a moneylender’s clients are from within his village or from close by, so
that the moneylender has close contact with them and is well informed about their activities and
whereabouts.
Repeat lending—a phenomenon in which a moneylender lends funds to individuals to whom he
has lent before (or has otherwise close interactions with) is very common. Hence rural credit
markets exhibit a tendency towards segmentation
3. Interlinkage
• An extension of segmentation: interlinked credit transactions. A majority of village
moneylenders do not pursue usury as their sole occupation. Most of them are also wealthy
landlords, shopkeepers, or traders dealing in the marketing of crops. Given market segmentation,
landlords tend to give credit mostly to their tenants or farm workers, traders favor lending to
clients from whom they also purchase grain, thus segmentation often takes place along
occupational lines.

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The complementarity of some production relationship facilitates the credit relationship.
Interlocking of markets— people conduct their business in different markets (land, labor, credit,
etc.) with the same trading partners, and make the terms of transaction in one market depend on
the terms and conditions in the other.
4. Interest Rate Variations
• Segmentation has a natural corollary: informal interest rates on loans exhibit great variation,
and the rates vary by geographical location, the source of funds, and the characteristics of the
borrower and lender.
• High interest rates are not necessarily the norm in informal credit transactions. Low or even
zero-interest loans from traders are not uncommon.
• The absence of interest is deceptive: given the interlinked nature of many of these transactions,
interest may be hidden in other features of the overall deal (such as the price at which a trader
buys output from the farmer or the implicit wage at which a laborer is required to work off an
ostensibly interest-free loan).
• The disparities in interest rates pose a puzzle: why don’t clever and enterprising agents borrow
from lenders who charge comparatively lower rates and lend that money to borrowers who are
paying and are prepared to pay much more? Answer: segmentation and the informational
variations that cause it.
5. Rationing
Rationing: upper limits on how much a borrower receives from a lender. By rationing, we mean
that at the going rate of interest, the borrower would like to borrow more but cannot. In this sense
credit rationing is a puzzle: if the borrower would like to borrow strictly more than what he gets,
there is some surplus here that the moneylender can grab by simply raising the rate of interest.
This process should continue until the price (interest rate) is such that the borrower is borrowing
just what he wants at that rate of interest.
So why does rationing in this sense persist? Rationing includes the complete exclusion of some
potential borrowers from credit transactions with some lenders. That is, at the going terms
offered by the lenders, some borrowers would like to borrow, but the lender does not lend to
them. In this sense rationing is intimately connected to the notion of segmentation.
6. Exclusivity
• Exclusive dealings. Moneylenders typically dislike situations in which their borrowers are

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borrowing from more than a single source. They insist that the borrower deal with them
exclusively; that is, approach no other lender for supplementary loans. Particular dealings are
often (though not always) bilateral, and Informational, locational, and historical advantages often
tend to confer on lenders the blessings of a “local monopoly”, which they exploit.
OTHER CHARACTERSTICS
• The formal and informal sectors coexist, despite the fact that formal interest rates are
substantially below those charged in the informal sector.
• Interest rates may not equilibrate credit supply and demand: there may be credit rationing, and
in periods of bad harvests, lending may be unavailable at any price.
• There is a limited number of commercial lenders in the informal sector, despite the high rates
charged.
• In the informal sector interlinkages between credit transactions and transactions in other
markets are common.
• Formal lenders tend to specialize in areas where farmers have land titles.

6.5. Agricultural Credit Policies In Ethiopia: After Financial Liberalization

The development of the financial sector in Ethiopia has a long history and included an array of
banking and non-banking institutions. The financial system comprised of commercial banks,
development banks, specialized financial institutions, cooperatives, insurance companies, etc.
The organizational structure, management and ownership of these financial institutions as well as
their performance have been changing under the different regimes. Ethiopia should give priority
to the peasant agriculture in its national development efforts since development cannot take place
without giving special considerations to the majority of the rural population.
Financial liberalization is an extremely important component of a successful development
strategy. Both economic theory and practical experience suggest that financial liberalization can
stimulate economic development. It is advocated that financially repressed systems should
abolish or relax interest rate controls; eliminate or greatly reduce controls on allocation of credit;
switch to market based indirect methods of money supply control; and develop money and
capital markets.
Following financial liberalization, market determination of the interest rates is expected to result
in positive real interest rates. These in turn will increase the resources available to the financial

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system, since bank deposits offering competitive return will attract savings that were previously
held outside the formal financial sector. Moreover, positive real interest rates will provide an
incentive for borrowers to invest in more productive activities, thereby improving the
productivity of the economy as a whole. Consequently, financial liberalization should lead to an
increase in both the quantity and the quality of financial intermediation by the banking system.
Following the overthrow of the Derge regime, changes in economic policies as well as political,
administrative and institutional structures began to be introduced by the new government. Hence,
several policies, legal, regulatory, supervisory and institutional reforms have been undertaken by
the new government. The government adopted a World Bank/IMF supported structural
Adjustment Programmes (SAP). The policy reforms involved among other things, reducing
budget deficits and government reliance on domestic bank borrowing, developing more flexible
monetary policy instruments, liberalizing interest rates, and improving efficiency of financial
intermediation by removing distortions in financial resources mobilization and allocation.
Financial liberalization in Ethiopia began at the end of 1992. The financial reform undertaken in
Ethiopia include elimination of priority access to credit, interest rate liberalization, restructuring
and introduction of profitability criteria, reduced direct government control on financial
intermediaries and limits bank loans to the government, enhancement of the supervisory,
regulatory and legal infrastructure of the NBE, allowing private financial intermediaries through
new entry of domestic private intermediaries (rather than privatization of the existing ones) and
introduction of treasury bills auction markets. As a result of the liberalization, nominal interest
rates on deposits and loans were raised by 60 – 90% and 58-144% in 1992, respectively.
Prior to 1992, the interest rate charged to farmers’ cooperatives was 5 percent which is below the
rate of savings deposit (6 percent). Financial institutions were obliged to pay interest margin on
deposits from their own sources. Lending rates which were between 4.5 and 9.5 % were raised to
11-15% depending on the sector until September 1994. Deposit rates which ranged between 1 &
7.5% for time deposit, and 6% for savings deposits were raised to 10-12%. Discrimination of
credit access and interest rates by type of ownership (i.e. between state owned enterprises,
cooperatives and private firms) were eliminated. Sectoral interest rates discrimination was
reduced, and domestic establishment of private financial institutions was allowed and
encouraged through proclamation number 29/1992 (NBE, 1992).
Further liberalization eliminated sectoral discrimination of lending rates, which had continued

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(favoring agriculture and housing construction with reduced rates). Since January 1995, the NBE
switched to a policy of floors on deposits and ceilings on lending rates, allowing banks to set
interest rates (NBE, 1995). These rates combined with low inflation resulted in positive real
rates. Further interest rates liberalization was taken in 2001/02.
The government saw the need to review the interest rates to encourage savings through the banks
and to create a disincentive to forestall speculation and uneconomic use of savings by borrowers.
The interest rate policy was reviewed with the following objectives:
(1) to keep the general level of interest rates positive in real terms in order to encourage savings
and to contribute to the maintenance of financial stability;
(2) to allow greater flexibility and encourage greater competition among the banks and non-bank
financial institutions to enhance efficient allocation of financial resources – in particular, the
policy strove to ensure that funds flowed into those areas that are most productive.
Hence, the NBE revised the floor for saving deposits downwards to 3% from 6% in 2001/02 with
an intention of encouraging investment and boost economic activity. Lending rates quickly
followed suit as the minimum lending rate charged by commercial banks went down from 10.5%
to 7.5% in the same period.
The liberalization also raised nominal yields on treasury bills and bonds to 12% and 13%
respectively, since 1992. Later a government securities market was established in January 1995
through the introduction of monthly (later biweekly) auction of 91 days' treasury bills with 28
days and 182 days bills added in 1996. Treasury bills are now on offer to financial institution,
business firms as well as the general public. Interest rate liberalization was accompanied by other
reforms including the floating of the exchange rate and trade liberalization.
The government also sought to strengthen the legal and technical capacity of the central bank to
carry out its regulatory and supervisory functions. The 1960 Civil Code with respect to sale of
bank collateral has also been amended in 1997 by proclamation (FDRE, 1997). This amendment
provides for an agreement with the borrower authorizing lending banks to sell directly and
quickly collateral from delinquent borrowers. This contributed to the effectiveness of
enforcement of credit
contracts. In addition, restructuring of the financial institutions was felt necessary to promote
competition, reduce government ownership and control, balance the type of institutions
(commercial banks, development and household savings banks), and upgrade services.

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The state owned banks were restructured financially and operationally. Changes in corporate
governance have been introduced: banks have management autonomy and their own boards;
management have been replaced and reorganized; new incentive schemes have been introduced;
and banks are to operate in a competitive environment using commercial criteria. Banks are no
longer required to specialize their credit services to certain sectors of the economy. They also no
longer face restrictions on the types and sources of deposits they accept. Banks are also
decentralizing loan decision making in order to reduce transaction costs of borrowing and
reducing screening hence transaction costs of lending. Entry restrictions into banking were lifted
for domestic banks. Entry rules and guidelines have been drawn.
The lending approaches of banks to target beneficiaries could be both a direct type and a two tier
system. The direct type is in which the Bank extends credit directly to the end user. This could be
an individual person or organization such as cooperatives, government or private enterprises
which have legal entity. In the two tier approach, the Bank transfers its financial resources to end
users through other bodies such as cooperatives and peasant associations. In the case of the first
type, the credit beneficiaries enter loan agreements with the bank and are responsible for
repayment of the borrowed loan, whereas in the case of the latter other intermediaries such as
cooperatives or associations sign a loan contract with the bank and channel the borrowed fund to
their members or end users.
In the case of rural Ethiopia, regional governments act as intermediaries between banks and
farmers. These governments use their federally allocated budget as collateral to borrow from
banks and on lend these funds to farmers for the purchase of agricultural inputs. This procedure
has enabled banks to lend a great deal of money to farmers. Nevertheless, there have been cases
of default, which have necessitated repayment out of the budget allocations of the regional
administrations.
However, the inability of the formal financial sector to provide adequate financial services to
small farmers and the poor in general continued even after the reform. A study by the National
Bank of Ethiopia (1996) concluded that CBE and DBE have only catered for insignificant
demand for credit of small farmers. The bulk of financial services provided to small and micro
enterprises in rural and urban areas, therefore, mostly originated from the informal sector such as
Iqqub, money lenders and friends” (NBE, 1996).

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