Low cost credit: The missing link to grow the productive and SME sectors

It is common knowledge that access to low cost credit is, among other things, vital to the development of the productive sector and the ‘Small Medium Enterprise’ (SME) industry in Vanuatu.

This belief is printed in all national development plans from CRP to the Vanuatu 2030 People’s Plan (page 7 and 16) and emphasized in most medium and long term thematic policies and strategies associated to the development of the productive sector. See for example the current Vanuatu Agriculture Sector Policy (pages 15 and 25); the Vanuatu Forest Policy 2013-2023 (page 31); the Vanuatu National Coconut Strategy 2016-2025 (pages 14 and 22); or the Vanuatu National Industrial Policy (page 14). Many government initiatives to address affordable credit in the past failed or ceased due to various reasons. Well-known examples include the Development Bank of Vanuatu (DBV), the Vanuatu Credit Union League (VCUL), and the Rural Economic Development Plan (REDI). Only the Vanuatu Agriculture Development Bank (VADB) established in 2006 is still operational but it is unable to deliver low cost credit. So today, almost 40 years after independence, low cost credit remains a concern at national level.

On the cost of credit, according to the Financial Services Demand Sides Survey Vanuatu (2016, page 9), 41 percent of the top 20 percent quintile of the survey sample, cited ‘too expensive’ as the reason for not having a bank account. The Reserve Bank of Vanuatu QER of December 2016 (page 56) shows that commercial banks charge between 4.7 percent and 28 percent interest rate for lending to individuals. Page 54 of the same QER shows that there are 420 existing bank loans related to agriculture as of end December 2016, 9 bank loans for forestry, and 2 existing loans for fishery related enterprise. Of those 420 agriculture loans, 13 were priced at more than 18 percent interest rate per annum. It’s worth noting that formal lending to agriculture, forestry and fishery account for only 1 percent of the total number of formal bank loans, even though around 75 percent of the populations are engaged in those activities.

On the determinants of lending rates, in practices, the lending interest rate charged by a bank depends on three factors: (i) the base-rate which is usually the inter-bank rate generally set at a certain percentage point below the policy rate of RBV, (ii) the overhead cost and the desired profit target of the bank, and (iii) the client’s credit score, which measure the ability of the client to repay the bank loan. Beside the inter-bank rate, RBV has no influence over the other factors.

When lending to individuals, banks price credit based on the assessment generated by their credit score system. The better the credit rating of a client, the lower the interest rate charged on the loan; and the poorer the credit rating, the higher the interest rate charged on the loan. The practice of pricing credit in banks is different from that of multilateral development banks (MDBs) when lending to governments. With MDBs, the interest rate charge on loans to a country is lower when the credit rating of that country is poor; and the interest rate charged is higher for countries with better credit rating. This difference in practice is normal because of two different objectives: banks are profit makers while MDBs are financers of development. In the case of Vanuatu, since, among other things, the performance of the economy depends on the performance of the productive sector and SMEs, it makes sense to give concessional credit to these two sectors because they engage the vast majority of the population.

The credit score for the low-income segment of the population has always been low due to various factors ranging from lack of acceptable guarantee, limited record of formal credit history, limited record on money management competencies, and other factors. Political risk and country risk also has some effect on lending rates. The bottom line is that the credit score system used by formal lenders makes it difficult for those engaged in informal sector to obtain affordable credit. In other word, it is near impossible for commercial banks to provide low cost credit to finance the productive sector.

There are a few lessons to be learned from what the government did in the past. On one hand, the experience of the defunct DBV and the still-active VADB suggests that limited presence in rural areas limits the reach of viable banking services to rural areas. Besides, branch banking is perceived as an inefficient form of banking model in context where population density is low and scattered. This is the reason why VADB is unable to offer low cost credit and unable to grow the productive sector. On the other hand, the experience of the defunct REDI and VCUL suggests that the success of such program requires effective capacity development, medium or long-term financing support, and effective supervisory and monitoring measures.

In relation to acceptable guarantee, the government enacted the Personal Property Services Act (PPSA) in 2008 to address the collateral issue with mainstream banks. The PPSA allows farmers to register their moveable assets at VFSC in exchange for a certificate. The certificate can then be used as collateral for a bank loan. The PPSA failed to deliver low cost credit and to reach farmers in remote rural areas. Fact is, unimplemented or poorly-implemented development initiatives do not benefit the people and the country.

RBV recently announced two major development initiatives, but their implementation remains challenging. Eight years ago, the concept of financial inclusion was introduced to remedy the limitations and adverse effects of microfinance lending on the livelihood of small-borrowers. The main ideas include raising financial competence of clients and their confidence on the formal financial system through financial educations and financial consumer protection. It also intended to enhance competition and transparency in the financial system through improved regulation. The expectation is that more competition in the financial system would drive down the cost of financial services, and thus grow the SME and productive sector. But so far financial inclusion initiatives remain mostly in discussion and planning stage.

RBV also announced the Import Substitution and Export Financing Facility (ISEFF) two years ago. The intention of the ISEFF was to improve the country’s balance of payment by providing low cost back-to-back lending facility to specified clients (mainly in the productive and SME sector) through banks. The introduction of the facility is a demonstration of a big step taken by RBV towards the development of the productive sector. But like the financial inclusion agenda, the ISEFF facility is still generally in discussion and planning stage. Implementing ISEFF through the formal banking system implies limited reach to remote rural areas due to the limited presence of profitable bank-branches in remote rural areas.

Any design of financing framework for growing the productive sector must consider the context of the country and that of small-scale farmers in addition to the experience of DBV, VADB, REDI and VCUL. The rural economy is characterized by low population density and long distance from urban centers. Also, farmers in the islands are faced with deferred income, volatility in production and earnings, and exposure to severe climate conditions. A coconut planation for example takes five to seven years before it starts generating revenue. Cattle farm, at least four or five years. The ISEFF initiative proposed by RBV solves the low-cost credit and collateral problems. But the design of implementation would determine its reach to remote rural farmers.

Fiji, for example, offers a combination of financial products and services to grow its productive sector. Aside from commercial bank loans, small-scale farmers can also obtain credit from the Fiji Development Bank. In addition, Reserve Bank of Fiji introduced the Import Substitution and Export Financing Facility (ISEFF) in 2010 to provide low-cost credit to specific clients through commercial banks operating in Fiji. The facility allows approved lenders to borrow funds from Reserve Bank of Fiji at 1 percent interest rate and on-lend it to specified clients at 5 percent. The ISEFF in Fiji has been fully functional since 2010.

The ISEFF promoted by RBV has the potential to grow the productive sector if implemented using a combination of approaches including the use of technologies and working in partnership with existing public and private institutions that have a strong presence in the six provinces. The combined strategy will allow both the farmers in the urban peripheries and those in remote areas to benefit from low-cost credit under ISEFF. However, the success of such arrangement will depend on few other key factors namely the introduction of a national identity system, a well-functioning credit bureau, capacity development, long-term funding support and effective monitoring mechanism. Section 10 of the Vanuatu Financial Transition Reporting Act of 2000 requires clients to have a national identity document to access banking services. A credit bureau will provide real financial position of borrowers and keep client indebtedness in check. Capacity development, long-term funding support and effective monitoring mechanism will avoid the same fate experienced with REDI and VCUL.

It is understood that affordable finance itself is not sufficient to assure growth of the productive sector. Capacity building, incentives to invest, irrigation infrastructure, transport infrastructure, and of course, good trade policy to guarantee the market for our local products, are equally important.

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The views expressed here are my own and does not necessarily reflect that of the Asian Development Bank or the Reserve Bank of Vanuatu.

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