For over 6 million Pakistani smallholders with 10 acres of land or less, financing options are very limited and prevent them from building assets over time. Most cannot or will not go to banks because doing so would require using land as collateral, repaying loans in strict monthly installments, and paying penalties if payments are late. Moreover, it can be hard to find a bank close to home and, once there, the queues can be long and approvals lengthy. Microfinance institutions may offer the option to pay back a loan in lump sum, but amounts are deemed too small for significant investment.
Instead, farmers tend to do what has been done for centuries: use Artees, middlemen who have long responded to their agricultural and personal financial needs.This informal system has been passed on from one generation to the next, often placing farmers in perpetual debt.
Artees directly provide farmers with seeds and fertilizers, and collect the equivalent amount in crops at harvest time. The daily market rate prevails at settlement, which is right after harvest when prices are at their lowest. The Arti will store and then sell the crops a few weeks later, when market prices have risen by 25% to 30%. Shortly afterward, when the next crop’s seeds, fertilizer, pesticides and other inputs are needed, the farmer often does not have enough liquidity to cover it and his family’s household needs. As a result, he reverts to the Arti for another round of financing. According to some estimates, Artees finance at least 50% of smallholders in Pakistan.
A better alternative
Since 2009, farmers in Punjab have had another financing option called Salam, which seeks to give them a bigger role in the decision-making. It is offered by Wasil Foundation, a Pakistani NGO and winner of the 2013 Islamic Microfinance Challenge. Salam financing is an advance purchase agreement against future delivery of a crop. It is well adapted to farmers’ needs and innovative in several ways:
- Wasil provides financing in cash, and gets reimbursed in crops at harvest time. The price is set at the time of financing and is negotiated between the farmer and Wasil based on the previous year’s price and weather forecast.
- The farmer is able to choose seeds and fertilizers of higher quality, at the time and from retailers of his choice. His yield increases as a result, reportedly by at least 15% to 30%.
- At harvest, the farmer delivers to Wasil a volume of crops equivalent to the financing amount, at the negotiated price. He then sells whatever remains on the open market. Similarly to the Arti, Wasil sells the crops when prices have increased, deriving its profits from the open market.
- Under Wasil’s financing plan, farmers keep at least half of the expected yield, whereas Artees typically leave 20%-30% – just enough to cover a family’s own consumption needs.
According to Wasil, the benefits of Salam financing are sufficient to allow farmers to build assets and sustain themselves above the poverty line within five financing cycles, or roughly three years. For now, Salam is only offered for wheat and rice, because of their relatively predictable price and easy storage.
The business model
The Salam offering is sustainable for Wasil, even at a small scale. Wasil has only financed about 1,200 Salam contracts until now, with a maximum outreach of 430 farmers at any point in time. Yet, it is already generating profits from this activity. Gross margin on Salam varies per crop and per year but has averaged 30%. Based on actual cash flows, this is equivalent to an internal rate of return of 45%, which should be sufficient to sustainably grow the Salam portfolio, currently representing 10% of Wasil’s total assets.
The $100,000 Wasil won through the Islamic Microfinance Challenge has had a multiplier effect. The money has been used to purchase land and build a warehouse in Gojra, about 200 km southwest of Lahore. The warehouse can store up to 800 tons of crops, with potential to expand to 2,300 tons (the largest financing, in May 2014, had led to Wasil collecting 870 tons of crops). This will allow Wasil to meet increasing demand. It will also no longer need to rent warehouses, which are not adequate for storing crops. The award also attracted other funders interested in Islamic finance, allowing Wasil to leverage an extra financing of $80,000 from local institutions, such as Ihsan Trust and Akhuwat. Another positive impact is that half a dozen institutions in Pakistan are now piloting Salam products.
How to replicate?
Salam is replicable, but several factors affect its success:
- The available storage facility should be adapted to the type of crop financed. For instance, wheat is easy to store, rice has to be dried before storage, cotton requires tight control over humidity levels, etc.
- Financing a commodity through an advance purchase agreement is sustainable for a provider when prices are either stable or trending upward, which is the case of wheat in Pakistan thanks to Government crop support. But a decrease in the crops’ price at harvest time could leave the financier with significant losses. Wasil partly hedges this downside by setting aside 2% of the financing amount.
- Smallholders may be tempted to sell their crops directly on the open market at harvest time if prices are more attractive than the pre-agreed contractual price. Wasil mitigates this side-selling by offering to give back any profits it makes beyond 30% of the agreed-upon price. This may enhance client retention, but it also limits profits.
- Crops should be protected from damage and hazards, before and after harvest, with the farmers benefiting from crop insurance and the financier from inventory insurance. The latter is deemed unavailable for Wasil, who bears the post-harvest storage risk over a two-month period.
- Scaling up requires significant upfront investment in working capital and storage facilities. To reach 10,000 farmers, Wasil would need at least $6.5 million in portfolio financing.
- Legal requirements should be well understood. When implementing Salam, Wasil realized it needed special licensing to store crops or to move them from one district to another.
Wasil’s experience is specific to Punjab, and could possibly be extended to other areas in Pakistan with prevailing similarities. Further piloting and research is nevertheless required to understand under what conditions it can be replicated in other countries and for other crops. For instance, it is unclear whether Salam would be sustainable if farmers do not have access to irrigation water. Standardized accounting principles and performance measurements are also critical for understanding the potential of such financing products. In the meantime, Wasil’s offering remains an interesting one to monitor, both for smallholders and those seeking to support them.
Well it a good article. I want to add a little bit in 3rd world nations specially in Pakistan & india just to avoid taking loan from the bank they have another option which is informal lending. They use to take loan from a third party and the procedure to make the payment is to pay the amount in Lumpsum. If you fail to do so then you have to pay the interest or the markup amount.
Secondly instead of taking a loan from Banking & Financial sector and putting that to move towards the modern tools of agriculture or to extend the capital they use to spend on unnecessary requirements like marriages or construction of their homes etc. When makes their debt burden even higher because now he have to manage his daily expenses along with the Markup amounts.
Until & unless the proper amount shall not be spent at its proper place then microfinancing shall never exceed the expectation of the people.