Well-functioning financial markets are essential for the growth of firms, including commercial farms. But maybe not in the way you might think.
Much of the discussion about barriers to enterprise growth has traditionally focused on access to credit since the early days of the microfinance sector. This line of thinking makes the assumption that the main reason smallholder farms in developing markets aren’t producing more is because they lack the capital needed to invest in more inputs or products. Indeed, a growing body of evidence on microcredit suggests that the question of the impact of access to credit on small businesses is not cut and dry: Some studies find positive effects on profits and the number of new ventures created (for example, see Banerjee et al. 2015 and Attanasio 2014), while others find more modest effects on business outcomes (see Banerjee, Karlan, and Zinman 2015).
Now imagine a scenario in which a farmer has access to the capital he or she would need to increase production, but just chooses not to. They’re acting irrationally, right? Not necessarily. In a recent study in northern Ghana (Karlan, Osei, Osei-Akoto and Udry), researchers took a closer look at the barriers to investment faced by small-scale farmers, and found something interesting. Agriculture in this region depends on rainfall as its principal source of water, and years with low rainfall can be disastrous for farmers. In a series of experiments, researchers randomly assigned farmers to receive cash grants, rainfall index insurance or a combination of both. Rainfall insurance is a particularly interesting product as it relies on observable measures of rain and removes adverse selection.
The research team found that the offer of rainfall index insurance led to larger farmer investments and riskier production choices than just providing cash. Farmers had been growing less maize, which is highly sensitive to rainfall, because they didn’t have the tools needed to effectively manage that risk, meaning that for them, the rational decision was to choose a less lucrative planting strategy in favor of a more certain payout.
Many farmers who received the insurance product without an accompanying cash grant were able to find the resources necessary to make increased investments in their farms, either cultivating more land than usual or choosing different types of crops, when they knew that they would be protected against the threat of low rainfall. This result suggests that liquidity constraints may not have been as much of a barrier as originally thought, meaning that a credit product would not have been the most impactful financial tool here to increase production. Indeed, the offer of a cash grant, either with an insurance product or alone, failed to create as much of an impact in farmer decision-making.
These findings are hugely important to development practitioners and policy makers working to understand the role that financial inclusion can play in achieving development goals. Smallholder farmers are sensitive to the risk surrounding their investments, and in the absence of appropriate insurance products, will make decisions to limit risk, which may simultaneously limit potential profitability. Insurance products may be more appropriate than credit products for some farms as the most effective financial tool to support growth. Credit can facilitate investments in agricultural inputs or infrastructure that will enhance production, such as the addition of an irrigation system, but ultimately these investment choices will either enhance risk (more potentially failed outputs) or will not guarantee protection against weather-related risk in the same way that an insurance product can.
Many policy makers are beginning to understand the role of risk management tools in promoting productivity. In India, for example, 9 million farmers are covered by a compulsory, publicly subsidized weather-based crop insurance scheme (see Clark et al. 2012). However, important challenges remain to the scale-up of rainfall index insurance. This study found that 40% to 50% of farmers demand rainfall insurance when offered at an actuarially fair price, but pricing and trust continue to be barriers to increased take-up. For example, farmers may not trust that they will receive a payout when due, but farmers who saw peers receive payouts were more likely to buy insurance themselves in later seasons. Companies should also continue to test innovative delivery channels, such as mobile money, as a way to bring down costs and guarantee more attractive pricing.
Efforts to improve financial markets in underserved localities, such as northern Ghana, must include an understanding of stakeholders’ risk management needs, not just access to credit, to effectively support increased productivity. Correcting this market failure will further enhance the ability of financial services to foster broader economic growth.