Academic journal article Journal of Risk and Insurance

Crop Price Indemnified Loans for Farmers: A Pilot Experiment in Rural Ghana

Academic journal article Journal of Risk and Insurance

Crop Price Indemnified Loans for Farmers: A Pilot Experiment in Rural Ghana

Article excerpt

ABSTRACT

Farmers face a particular set of risks that complicate the decision to borrow. We use a randomized experiment to investigate (1) the role of crop-price risk in reducing demand for credit among farmers and (2) how risk mitigation changes farmers' investment decisions. In Ghana, we offer farmers loans with an indemnity component that forgives 50 percent of the loan if crop prices drop below a threshold price. A control group is offered a standard loan product at the same interest rate. Loan uptake is high among all farmers and the indemnity component has little impact on uptake or other outcomes of interest.

INTRODUCTION

Farmers face a particular set of risks that complicate the decision to borrow. Factors that are almost entirely unforeseeable and outside of their control, such as crop prices and weather patterns, have an enormous impact on farmers' fortunes--and on their ability to repay any loans they have taken. As such, some farmers are believed reluctant to take loans to finance seemingly profitable ideas for fear of not being able to repay. Paradoxically, from a bank's perspective, these may be excellent clients. They are so trustworthy that they are not borrowing out of fear of default. Can a loan product with a component that mitigates farmers' risk successfully encourage farmers to take, and benefit from, credit? What type of individuals is more likely to borrow when some of the risk is mitigated? And lastly but equally importantly, how does the mitigation of risk change farmers' investment decisions, such as the purchase of inputs?

Most of the theoretical literature on the impact of credit constraints on productivity focuses on supply-side constraints. In a recent departure, Boucher, Carter, and Guirkinger (2008) argue that in the presence of moral hazard, farmers will prefer not to borrow even though the loan would raise their productivity and expected income. Using panel data from Peru, they identify these "risk rationed" (as opposed to quantity rationed) households as households who never tried to access the formal market because of the high risk associated with borrowing due to consequences of default, and show that risk rationing adversely affects the productivity of these households. Based on this, they argue that improvements in the insurance offered to these households would increase their willingness to participate in formal credit markets and raise household welfare.

As farmers weigh their ability to generate sufficient crop revenue to repay loans, one of the primary risks they face is price variability, which can be very high between and within growing seasons. In terms of price risk management, Morgan (2001) reviews the literature on reducing price risk through support and stabilization measures (e.g., International Commodity Agreements). Price support--often through marketing boards--has been a common but generally unsustainable policy. Because of the risks and politics involved in maintaining international boards, there has been a broad trend to liberalize agricultural markets, shifting price risk onto producers and traders, and furthermore, the boards typically are only setup for dominant export crops.

Due to these difficulties with International Commodity Agreements, Morgan (1999, 2001) outlines theoretical justification for the demand for futures markets and other risk-management tools in developing countries but suggests that few systems are implemented successfully in practice, due to frequently unsatisfied infrastructural requirements.

Although in theory the most efficient approach, futures markets are not readily available for many farmers and crops, in particular for farmers in developing countries. Carter (1999) surveys the literature on reducing price variability through derivatives such as futures and options markets. Such markets remain relatively uncommon in developing countries, however, and even where they exist, they are primarily accessible to large-volume producers and traders rather than smallholder farmers (Varangis and Larson, 1996). …

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