Session 5: Risk Mitigation in Agricultural Investment ... · Session 5: Risk Mitigation in...

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© FAO January 2008

Mitigation of Investment Risk

Module 3: Investment and Resource Mobilization

Session 5: Risk Mitigation in Agricultural Investment

F A O P o l i c y L e a r n i n g P r o g r a m m e

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By

of the

FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS

Mitigation of Investment Risk

Calvin Miller, Senior Officer, Agricultural Management, Marketing and Finance Service, Rural Infrastructure and Agro-Industries Division, FAO, Rome, Italy

About EASYPol

The EASYPol home page is available at: www.fao.org/easypol

This presentation belongs to a set of modules which are part of the EASYPol

Training Path Policy Learning Programme – Module 3: Investment and Resource Mobilization, Session 5: Risk mitigation in agricultural investment

EASYPol has been developed and is maintained by the Agricultural Policy Support Service, Policy Assistance and Resource Mobilization Division, FAO.

http://www.fao.org/tc/easypol

http://www.fao.org/easypol/output/browse_by_training_path.asp


http://www.fao.org/tc/tca/capacity_en.asp

http://www.fao.org/tc/tca/capacity_en.asp

http://www.fao.org/tc/tca/

http://www.fao.org/

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FAO Policy Learning ProgrammeModule 3: Investment and Resource Management


Objectives

After reading this module, you should know about :

Requirements for rural investment

Understanding levels of risk

Risk mitigation products and approaches

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Definitions1

Investor – an individual, institution or company who commits money to investment products with the expectation of financial returns,

Goal: Minimize risk while maximizing return

Risk – The quantifiable likelihood of loss or less- than-expected returns.

1 www.investorwords.com

Examples:Currency risk, inflation risk, country risk, mortgage risk, liquidity risk, market risk, interest rate risk, credit risk, systematic risk, business risk

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Requirements for rural investment

Supportive operating environment

Attractive and resilient returns to investment

Ability to assess and mitigate risk

Suitable financial products and services

Conditions to be successful• Profit and resiliency – make a profit and build assets in good

times and draw against and insure against losses in bad times.

• Financial service options – ability to obtain financial resources as needed

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Key challenges for rural investment

Vulnerability ConstraintsSystemic RiskMarket RiskCredit Risk

Operational ConstraintsInvestment ReturnsLow levels of Assets and Investment

SeeSee notes notes forfor detailsdetails

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Key challenges for rural investment

Capacity Constraints

Technical Capacity and Training Risk

Social Exclusion Risk

Institutional Capacity Risk

Economic Environment Constraints

Infrastructural Capacity Risk

Political and Social Interference

Regulatory Risk

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Risk at three levels

1. Enterprise/Business Risks

2. Financial Institution/Investor Risks

3. Macro/enabling Environment Risks

Finance and investment are tools for rural development– with many associated risks

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1. Farm enterprise/ agribusiness risk

Market stability and alternatives

Competitiveness in the marketplace

Production uncertainty

Price predictability and profitability

Resources and environment

Asset risk

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2. Financial institution/investor risk: Client lending/Investing risks

Client enterprise/business risks

• Enterprise ROI

• Capital rotation

• Profitability and reinvestment

• Capacity, skill and technology

• Repayment capacity

Client loan risks

Client and household

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Five “C’s” for client loan analysis

Character

Capacity

CapitalCollateralConditions

Integrity and Temperament

• Management• Technical • Human and Labor

• Loan terms• Production cycle• Markets


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2. Financial institution/Investor risk: Portfolio risks(2)

Market sector stability, competitiveness and trends

Systemic and unpredictability risks

Institutional/investor profitability risk

Transaction and operational cost risks

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Risks 3. Macro/enabling environment

Macro economic environment

Currency risk

Country/regional risk

Land tenure risk

Market risks

Competitiveness risk

Market vulnerability risk

Social and political risks

Country A

Currency rating = B3

Bank deposits = Caa3

Country LT Rating = B1

Risk Premium = 4.5%

Country BCurrency rating = A1

Bank deposits = A1

Country LT Rating = Baa2

Risk Premium = 1.3%

* Moody’s country ratings


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Responses for agricultural investment risk mitigation

Risk mitigation tools and approaches for:

A. Production Risk

B. Price Risk

C. Market Risk

D. Finance

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A. Mitigating Production Risk

Diversification – production and location

Infrastructure and technology – irrigation, storage, R & D

Indexed Insurance – weather or yield

Farm/agribusiness techniques and technologies

Access to timely inputs

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A. Mitigating production risk(2)

Right POP – “package of practices” and varieties

Financial Services

Farmers

Input Supply

Output Market

Training & Extension

People’s Organization

Research and Technology

Financial services bundled with technical assistance, technology and marketing

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B. Tools for managing price risk

Contract farming - interlinked credit-input-output marketing systems

Trade finance – input and output

Commodity exchanges

Forward contracting

Hedging: futures and options

Some tools are best used at the agribusiness level, but small farmers also benefit from these indirectly by having more stable prices and consequently more access to finance.

Service intermediaries, ex. DrumNet, can also facilitate their use.

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Price risk mitigation through value chain approaches

Competitiveness

Value chain linkages

Secured pricing

Product diversification

Market and technical guidance

Input Supplier

Commercial Banks

MFIs, Cooperatives,

NGOs

Farmers

Input Suppliers

Producer groups

Producer groups

Medium/Large Exporters &Processors

Commercial Banks

MFIs, Cooperatives,

NGOs

Local Traders & Processors

Farmers


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Hedging for price risk mitigation

BROKER

COMMODITY EXCHANGE Buying Bids

FUTURE DEALS

FARMERS BUYERS

NGO/GOTech Ass.

BROKER

SellingBids


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Market price

Producer’s sales price

Put priceFloating priceincl premium

paid

Put strike

Commodity price risk mitigation

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C. Approaches for mitigating market risk

Information

Long-term market trends

Current and future prices

Commodity and product information

Trade and market development

Increasing elasticity with open trade

Commodity exchanges

Market access

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S1

S2

D

P2

P1

Slope of demand curve influenced by:

• Transport infrastructure

• Consumption pattern diversification

• Storage capacity

• Available finance to traders

• Market institutions (e.g., warehouse receipt systems)

• Barriers to internal and regional trade (e.g., export/import tariffs, permits)

Increasing trade elasticity


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Price unpredictability

Maize grain prices are generally less predictable in countries that restrict grain trade than in countries having open borders1

Controlled trade countries – high/low ratio average = 168% (range = 63 to 625%/yr)

Open border countries – high/low ratio = 77% (range – 43 to 129%/yr)

1Yearly data from 1994 to 2006 in Malawi and Mozambique

Example:

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D. Tools to mitigate financing risks

Due diligent loan analysis

Portfolio and product diversification

Strategic linkage partnerships

Collateralization – warehouse receipts, futures contracts

Credit guarantees

Enabling environment – adequate policies, fiscal responsibility


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Rural products for differentiated groups

Products for farmers Investment loans Warehouse receipt loans Trader loans

–to the trader–to the clients linked with trader

Futures and options Insurance products

– indexed crop and livestock insurance– health and property insurance

Products for non-agr. or transition rural households

Multi purpose loans:– flexible microenterprise and trade loans– lines of credit and multipurpose use loans– emergency and consumption loans

Multiple, easy access, savings products

RemittancesHealth and property insurance

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Trade credit

Trade / seasonal credit

ProductReceipt

Key

Warehouse receipts: Map of product, receipt and credit

Highlights:

•Warehouse receipts are a financial product structured to reduce lending risk. The feasibility of its use depends upon the government policies and enforcement and on the effectiveness and capacity of the warehouse managers.

•Inspection and licensing authority may be public or private

•There should be multiple warehouses and banks serving the market

Traders and FarmerOrganizations

Exporter/ Wholesaleror Processor

Inspection &

Licensing Co.

Bank

Insurance Co.

Warehouse

Farmers

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Warehouse receipts - preconditions

Legal and regulatory requirements re: rights and responsibilities of participants, title and transferability of goods, use of receipts for collateral

Commonly accepted grades and standards

Trustworthy certification and inspection service

Market information

Legal and regulatory expertise re contracts, commercial code, financial regulations

Financial institution acceptance of instrument

Contract enforcement – both through legal means and education

A warehouse receipts system requires private and public interventions. The first step in the development of this kind of financing is the development of warehouse space that can be used by a range of producers and processors, not just to a few large operations, accepted standards and adequate policies.

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Other investment enhancement mechanisms

Investment funds

Special Purpose Vehicles

Guarantee Funds

Capital enhancement guarantees

Legal reserve requirements

Major catastrophe insurance


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Responding to the future

Promoting healthy rural enterprises and business

Profitable businesses can absorb risk

Market competitiveness promotion

Conducive tax and business environment

Use of risk management tools to reduce vulnerability

Hedging, futures, etc.


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Promoting Investor Capital Risk Mitigation

Capital enhancement

Liberal financial sector with progressive collateralization policies

Credit guarantees

Guarantees and enhancements if required as incentive for risk of unknown

But,

Not appropriate tool to deal with systemic nor market risks

Have high unit cost/lack of economies of scale

Responding to the Future


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Caution with good intentions to enhance investment

Directed Development (revolving) Funds

Not an appropriate risk mitigation approach

Lack specialized financial management expertise and structure

Lack sustainability and can damage rather than support long- term investment

Subsidies

Cost-benefit, equity of benefits, sustainability

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Summary: New mitigants are required

Price Risk • Use of market basedprice instruments

• Couple with Loan Agreement• Hedge portfolio or each loan• Use microfinance institutions • International banks and brok-erage houses are partners

• Capacity building programs

Measures Methodology

Crop/Weather Risk • Index based Weather Insurance

• Rely objectively on specific weather events

• Compare measurable, objective,correlated risk to yields/incomes

• Conducive policy and regulatoryenvironment a must

• Use innovative structures

• Capture cash flows• Use “organized” intermediateagencies

Collateral Risk

Governments and TA providers have to play in key role in ‘importing’ innovative successful practices

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Risk mitigation strategies: Ex ante risk mitigation strategies

Informal risk management Formal risk management

Agricultural production strategiesAdvanced cropping techniques

Diversification of income sourcesCrop income / Livestock mixOff farm activities / seasonal labor

Consumption /income smoothing Precautionary savings & buffer stocksCredit access

Risk sharing with othersMutual help supportCrop sharing arrangements

Price and market riskContract farming, forward contractsFuture contract and price optionsStorage (Warehouse receipt finance)

Production riskWeather/production insuranceCatastrophe insurance

Public strategiesEducation /trainingPest management systems / conservationInfrastructure supportGood regulatory environment

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Risk mitigation strategies: Ex ante risk mitigation strategies

Informal risk management Formal risk management

Income smoothing mechanismsSale of assetsSale of labor

Risk sharing systemsRemittancesSeasonal migrationMutual aid

Coping with shocks: private mechanismsLending – leasingRestructuring finance obligations

Public / private mechanismsCash transfer Social assistance and social funds

- Risk reduction strategies are developed prior to risk events to reduce the potential risk

- Risk coping strategies reduce the impact of a loss after the risk event occurs

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Further readings

Miller, Calvin, 2007. Risk Mitigation and Management for Agricultural Investment, workshop background paper, Module: Investment and Resource Mobilization.

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Links to Module 3 : Sessions 1-8

Session 1: Investment in agriculture & rural development

Session 2: Environment for private investment in agriculture & rural development

Session 3: Sources and uses of financial resources

Session 4: Strategies for increasing farm financing resources

Session 5: Risk mitigation in agricultural investment

Session 6: Sector-wide approaches (SWAps)

Session 7: Socio-economic & livelihood analysis

FAO Policy learning programme

Module 3: Investment and Resource Management

FAO Policy learning programmeCapacity Building Programme on Policies and Strategies for Agricultural and Rural Development



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