II: Institutional and Process Innovations in Serving Rural Clients

Finance Through Food and Commodity Value Chains in a Globalized Economy

Johan F.M. Swinnen^[1] and Miet Maertens^[2]

Introduction

The growth of value chains and the associated spread of quality standards has triggered a vigorous debate in the development community over their impacts on poor producers in developing countries.^[3] Quality requirements in value chains affect farms through several channels. First, ever-more rigorous public quality requirements in richer countries are imposed on imports and consequently have an impact on producers and traders in exporting nations (Jaffee and Henson, 2005; Unnevehr, 2000). Second, global value chains are playing an increasingly important role in world food markets and the growth of these marketing channels, which are often vertically coordinated, is associated with increasing quality standards (Swinnen, 2007). For example, modern retailing companies increasingly dominate markets in fruits and vegetables, including urban markets in many poorer countries, and have begun to set standards for food quality and safety in this sector wherever they do business (Dolan and Humphrey, 2000; Henson et al., 2000). Third, rising

investment in processing in developing countries also has induced demand for higher-value and higher-quality commodities from local producers in order to serve the high-end income consumers in the domestic economy or to minimize transaction costs in their regional distribution and supply chains (Dries et al., 2004; Reardon et al., 2003).

The development implications and the impact on small farmers has been actively debated. On the one hand, agriculture in developing countries, and exports of agricultural commodities, are seen as a very important potential source of propoor growth. On the other hand, tightening food safety and quality standards, both from private and public sources, strongly affects domestic and international trade, and value chains (Jaffee and Henson, 2004). Some have argued that they reinforce global inequality and poverty as: (1) they introduce new (non-tariff) barriers to trade; (2) they exclude small, poorly informed, and weakly capitalized producers from participating in these high-quality supply systems; and (3) because large and often multinational companies extract all the surplus through their bargaining power within the chains (Augier et al., 2005; Reardon and Berdegué, 2002; Unnevehr, 2000; Warning and Key, 2002).

A key concern is that the process of vertical coordination will exclude a large share of farms, and in particular small farmers. Three reasons are mentioned for this. First, transaction costs favor larger farms in value chains because it is easier for companies to contract with a few large farms rather than with numerous small ones. Second, when some amount of investment is needed in order to contract with companies or to supply high-value produce, small farms are often more constrained in their financial means for making necessary investments. Third, small farms typically require more assistance from the company per unit of output. The concern of the exclusion of small farmers is often voiced and raised in studies on the impact of the growth of high value chains, which regularly emphasizes the shift to larger, preferred suppliers and the exclusion of small farms (e.g. Reardon and Berdegué, 2002).

However, there is considerable debate and uncertainty about the validity of these arguments, and more generally about the welfare implications of high value chains (Swinnen, 2007). First, while quality and safety standards indeed make production more costly, at the same time they reduce transaction costs in trade, both domestic and internationally. In other words, besides barriers, standards can also be catalysts for trade (Maertens and Swinnen, 2010). Second, recent empirical studies show that smallholder participation in global value chains is much more widespread than initially argued and that the situation is actually very diverse, as we shall see later in this chapter. Small farmers are dominant participants in modern value chains in countries and sectors as diverse as domestic horticultural value chains in Asia (e.g. China), cotton chains in Central Asia (e.g. Kazakhstan), horticultural exports from Africa (e.g. Madagascar) and various value chains (dairy, barley) in Eastern Europe (e.g. Poland). There are also cases where farm structures in modern value chains are mixed, for example in vegetable exports from eastern Africa (e.g. Senegal); or where large farms dominate, such as in fruit and vegetable value chains in southern and eastern Africa, and grains and oilseeds in the former Soviet Union (e.g. Russia and Kazakhstan). Recent evidence also shows that important changes may occur over time within a chain, but the direction is equally diverse: small farmer participation declined in some cases (horticultural exports in Senegal) and increased in other cases (tea in Sri Lanka).

There is less evidence on the third issue, which is the rent distribution within these value chains. Empirically, most studies have focused on the exclusion issue and very few studies actually measure welfare, income, or poverty. The few studies that do measure welfare effects find positive effects for poor households in developing countries that may participate either as smallholder producers or through wage employment on larger farming companies (Maertens and Swinnen, 2009; Maertens et al., 2011; Minten et al., 2009). What is remarkable is that these strong benefits occur in several of these cases despite the fact that smallholders and rural workers face monopsonistic processing, trading, and retail companies.

To understand these welfare effects it is important to realize that the introduction of higher quality requirements has coincided with the growth of value chain finance (VCF) and technology transfer (Dries et al. 2009; Miller and Jones 2010, Quiros 2007; Swinnen 2007). Contracts for quality production with local suppliers in developing countries not only specify conditions for delivery and production processes but also include the provision of inputs, credit, technology, management advice, etc. (Minten et al., 2009; World Bank, 2005). The latter are particularly important for local suppliers who face important local factor market imperfections

– another key characteristic. In particular, imperfections in credit and technology markets are typically large, which implies major constraints for investments required for quality upgrading, especially for local firms and households that cannot source from international capital markets. However, the enforcement of contracts for quality production and value chain finance is difficult in developing countries that are often characterized by poorly functioning enforcement institutions. These enforcement problems can add significantly to the cost of contracting and may prevent actual contracting from taking place and inhibit value chain financing.

The first part of this chapter discusses the development of value chains and the inclusion of small farmers. The second part discusses the development of valuechain finance within these value chains.

• [1] Professor of Economics and Director, Centre for Institutions & Economic Performance (LICOS), Catholic University Leuven.
• [2] Assistant Professor, Department of Earth and Environmental Sciences, Catholic University Leuven.
• [3] The arguments and empirical evidence in this paper cover areas that are traditionally referred to as “developing countries”, “transition countries”, and “emerging countries”. Many of the arguments are valid across these regions; where they are not, the differences will be specifically identified.