The impact of extension and ecosystem services on smallholder’s credit constraint

Abstract

On formal credit markets, access to formal credit and reasonable credit terms of smallholder farmers in rural sub-Saharan Africa is limited due to adverse selection. Financial institutions operating in rural areas often cannot distinguish between borrowers (farmers) that are creditworthy and those that are not, thus, allocate limited resource to agriculture to reduce credit risk. In the presence of limited business quality signaling by smallholder farmers, financial institutions shall demand for collateral and/or offer unfavorable contract terms. Moreover, agricultural productivity of rural sub-Saharan Africa, dominated by subsistence or small-scale farmers, is also negatively impacted by the adverse effect of climate change. A strategy that may make the farming practices of smallholder farmer’s climate resilient and profitable may also improve smallholder farmer’s access to formal credit. This study investigates to what extent participating in ecosystem and extension services (EES) programs signals business quality of smallholders, thus granting them credit accessibility. We collected data on 210 smallholder farmers in 2013, comprising farmers that receive payments for ecosystem services (PES) and farm management training from the International Small Group Tree Planting Program (TIST) Kenya to test the aforementioned theory empirically. We use game theory, particularly a screening and sorting model, to illustrate the prospects for farmers with EES to access formal credit and to improve their credit terms given that they receive PES and banking services training. Furthermore, the PES’ long term duration (10 – 30 years) generates stable cash-flow which may be perceived as collateral substitute. Results suggest that smallholder farmers in the TIST program were less likely to be credit constraint compared to non-TIST farmers. Distance to market, education, livestock and farm income are factors that determine access to credit from microfinance institutions in rural Kenya. Amongst farmers that have obtained loans, those keeping business records enjoy more favorable formal credit conditions. These farmers were observed to pay ca. 5 percent less interest rate in microfinance charges. For TIST farmers, this type of farm management practices may be attributed to the banking services and other training they receive within the program. While the availability of classical collateral (farmlands) and PES may reduce interest rate, the latter was found to be statistically insignificant. This research underlines the importance of an effective extension services in rural areas of developing countries and the need to improve gains from conservation agriculture and ensuing PES. The benefits associated with EES and PES may encompass agricultural financing.