CREDIT CONSTRAINT AND ITS IMPACT ON FINANCIAL PERFORMANCE OF SMALL FARMERS

Agriculture, in most cases, requires a significant start up investment to begin operations as well as to continue operations. Credit is one of the most important factors in agriculture because it allows farmers to have access to capital and meet their cash obligations required during various stages of production cycle in agriculture. Agricultural production is characterized by a production cycle where inputs are transformed into outputs with considerable time lags due to the biological processes involved as well as subject to whims of weather, pests and diseases (Conning and Udry, 2005).

Credit markets create value through loans characterized by an exchange of cash (or goods) now with a promise of repayment in the future. This promise can be backed up with additional restrictions which determines the rights and behavior of the parties involved. However, the promise can sometimes be broken by the borrower. This state of imperfect information (asymmetry) causes lenders to screen prospective borrowers so as to determine who is likely to repay loan as promised.

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Lenders on the other hand, have to monitor the use of funds to ensure that they are used for activities that guarantee loan repayment (Von Pischke, 1991; Dowd, 1992). On farmers stand point, payment for materials and purchase of inputs such as seeds, fertilizer and labor should be met, in most cases, readily through cash or liquid assets during respective stages of preparation, planting, cultivation and harvesting. Note that these payments are required to be completed during times when limited or no income is earned from agriculture.

Therefore, most cash income is earned typically after some time of crop harvest. In addition to initial investment, farmers have challenge to meet liquidity requirements in production process during time lag between planting and harvesting. With adequate access to credit, farmers can purchase inputs as needed and reach the optimum level of production. However, when access to credit is limited, the amounts and combination of inputs used by farmers may not be optimum which leads to suboptimal productivity and outcome. The marginal contribution of credit therefore allows input level used to be close to the optimal level, thereby increasing yield and output (Feder et al., 1990).

Few previous studies in agricultural economics have assessed the importance of reducing credit constraints. For example, research finds that production is 3% lower in credit constrained compared to credit unconstrained farmers (Briggeman et al., 2009). It should be noted that agriculture is an important sector for rural economic development and an access to credit enhances farmers’ ability to adequately use resources in order to increase productivity (Adera, 1995) and expand scope of production. For example, access to credit allows farmers to purchase new machineries, improved seeds and fertilizers, and other inputs to expand scale of production (Akwaa-Sakyi, 2013). Aside from increase in productivity and income, access to credit contributes to social-being improvement especially in the area of health and education (Miller and Ladman, 1983). Ahma (2010) argues that access to credit allows farmers to venture into new areas of economic activities, increase their sources of capital, and manage risks associated with agriculture. As important as access to credit is to farmers, they face a number of challenges in accessing credit and apparently, difficulty in accessing credit at a competitive rate as well as lower returns on investment causes limitations to undertake profitable investments or to take maximum advantage of market opportunities leading to reduced revenue and growth opportunities.

Some challenges faced by farmers in accessing credit include: information asymmetry, high transaction costs involved in accessing credit, and strict collateral requirements which cannot be met by majority of small farmers. Some other challenges include: a) limited access to short term loans, b) low profitability of farming and farm related activities resulting to insufficient liquid assets, c) less developed or expensive mechanisms for going under agreements and commitment, and d) low prices of agricultural products and higher marketing costs leading to lower profit margins (Kirechev, 2011). The lower competitiveness of agricultural produce especially in international markets and the insufficient subsidies to local farmers reduce the profitability of economic activity (Kirechev, 2011). Some scholars also argue that the high transaction costs attached to information gathering and credit history is also a major constraint affecting mostly small farmers as well as entrepreneurs (Guirkinger, 2008; Guirkinger and Boucher, 2008; Boucher, Guirkinger and Trivelli, 2009; Fletschner, Guirkinger and Boucher, 2010).

Moreover, there is also a segmentation in rural financial market. The major financial institutions tend to serve well equipped farmers with a high degree of credibility while farmers with lower incomes with low collateral ability rely on some informal sources of finance and small cooperatives. Also, in situations where there are inadequate tools to reduce risks such as insurances or guarantees, financial intermediaries such as commercial banks or investment banks either do not provide financial services to rural small farmers or they develop risk coping mechanism such as contracts by sharing of responsibilities or by providing loans to groups of farmers or entrepreneurs. The lack of sufficient competition and the manifestation of less interest on the part of specific group of intermediaries who are meant to serve as middlemen between financial providers and the farmers can lead to monopoly of power which can make financial services more expensive (Kirechev, 2011) Limited supply of medium and long term loans is slowing the economic development of small businesses in rural areas, particularly farmers. The cultivation of perennial crops, livestock, construction of irrigation facilities and the purchase of machineries requires substantial investment and long payback period which increases the risk faced by credit institutions. This naturally leads to a decrease in the desire for medium and long term lending. Medium and large scale farmers have greater flexibility in regards to medium and long term credit financing however, making long term investments by small farmers and entrepreneurs is usually very rare which prevents the introduction of new technologies, modernization of equipment and provision of greater opportunities for profit. Thus the growth of the most of the small farmers is inhibited. It should be noted that farmers have opportunities and roles in various economic activities, diversification of resources, preservation of environment, as well as improvement of the quality of life.

One of the important policy concerns is to increase agricultural productivity, given limited resources, to meet the ever increasing demand for food as a result of increase in population. However, reaching a maximum level of output using a given level of input varies as a result of varying resource endowments and access to credit by farm households. Hence, difference in efficiency levels. Small farmers have limited internal capacity to finance their farm operations due to limited resources they command. As a result of this, access to sufficient credit is vital to their farm operations (Dicken, 2007). Credit constraints have direct as well as indirect impact on farm productivity and efficiency. Directly, it can affect the purchasing power of farmers to purchase farm inputs, finance operating expenses in the short run as well as make farm related investments in the long run. Indirectly, it can affect the risk behaviors of farmers, which also affects technology choice and adoption (Boucher, Guirkinger, and Trivelli, 2005; Eswaran and Kotwal, 1990). According to Binswanger and Deininger (1997), an unequal distribution of initial capital in environments where financial markets are imperfect and credit is not easily accessible can prevent a large number of small farmers from making productive decisions and investments. A credit constrained farmer is more likely to invest in less risky and less productive rather than in riskier and more productive technologies (Dercon, 1996). Such risk behavior limits the effort of the farmer from attaining maximum possible output. Although a couple of studies have recognized the impact credit constraints has on productivity (e.g., Blancard et al., 2006; Petrick, 2005; Barry and Robinson, 2001; Färe et al., 1990; Lee and Chambers, 1986), some other studies argue that access to credit cannot create productive opportunities, particularly in the presence of other binding constraints. Credit cannot build the roads needed to bring the crop to market; credit cannot discover the farming technology that does not exist; credit cannot generate key inputs that are not available; credit cannot create or destroy comparative advantage or change consumer preferences (Masuku, Raufu and Nokwanda, 2014).

Even though there are some previous studies showing the impact of credit access on farm productivity and a few studies on efficiency, studies about the credit role, constraint, and actual impact on financial performance are limited. Some studies that examined the role however, are not quantitatively appropriate especially in Tennessee which ranks 32nd among the states in the United States for total agricultural production and listed as one of the most economically competitive states in the country.

Agriculture in Tennessee is dominated by small farmers with more than 42 percent of Tennessee’s total land area as farms, with cropland accounting for more than 63.6 percent of farmland. Tennessee agriculture accounts for about 9% of the state’s economy, generates $57.6 billion in output and employs about 250,000 Tennesseans in agricultural production (Tennessee Ag Stats, 2015). With the above statistics, it is evident how important small farmers are to Tennessee’s economy as well as to the United States’ indirectly. The impact of access to credit on small farmer’s productivity and performance in Tennessee cannot therefore be overlooked because of their huge contribution to the state’s economy.

This research aims to analyze the relationship between access to credit and financial performances of small farmers in Tennessee. With a hypothesis that credit constraints reduce farmer’s productivity and financial performance and relaxing constraint leads to improved financial performance, we investigate whether credit constraint significantly affects financial performances of farmers, especially small farmers in Tennessee. To examine this, we analyzed and assessed: a) characteristics of credit constrained and credit unconstrained farm households, b) factors influencing credit constraint with likelihood of each factors associated with credit constraints, and c) impact of credit constraints on financial performance. We used gross sales as a proxy for financial performance while we estimate impact equation.

A Review of Current Government Policies in Rural Financing

Agricultural sector in the United States is made up of mostly small rural farmers who continuously require finance for their agricultural activities from capital market. However, the capital market is characterized with imperfections such as information asymmetry which makes government intervention very important. The government intervenes in agricultural capital market in several ways by providing guarantees to banks for loans, by setting up credit institutions solely for agricultural purposes and providing subsidies to farmers. The question to be asked is that are these programs set up as a result of capital market failure or pressure from people in the agricultural sector to provide subsidies? Do the policies resolve issues? Does it induce market distortion? If it induces market distortion, how large are these distortions and do they affect allocative efficiencies and incentives?

One major government policies used in supporting agriculture in the United States is farm subsidies however, not directly to support farmer’s income or production but usually indirectly. The US government subsidizes heavily on oil seeds, grains, cotton, sugar and dairy products while other agriculture products such as beef, pork, poultry, hay, fruits, tree nuts and vegetables which account for about half of the total value production receives only minimal government support. It should be noted that subsidies are paid by the government hence, it tends to increase budget deficit or induce increased government borrowing which will have negative implication on inflation and nominal rates. Also, the funds used for subsidies can be invested on public goods or infrastructure which will at the long run stimulate agricultural sector development (Johan and Hamish, 1997). Some other Economists criticized farm subsidies for several other reasons such as: (a) farm subsidy transfers income from taxpayers and consumers to wealthy farmers, imposes net losses on society (Alston, James and Jennifer, 2002), (b) impedes opportunities for more open international trade in commodities, leading to net costs on global economy (Johnson, 1991; Sumner, 2003). Farm subsidy supporters on the other hand, argue against the above claim. Farm subsidy supporters on the other hand suggest that subsidy programs help to stabilize agricultural commodity markets, assist low income farmers, encourage rural development, ensures food security, and compensate for monopoly in farm input supply and farm marketing industry. However, there have been no clear conclusion among economists about net overall benefits or costs (Gardner, 1992; Johnson, 1991; Wright, 1995).

Another important government intervention is the creation of specialized agricultural credit institutions such as Farm Credit System (FCS), Farm Service Agency (FSA), State Agricultural Development programs, and Community Supported Agriculture (CSA). The USDA Farm service agency provides finance to rural farmers through multiple loan programs and also manages a land contract program which provides guarantee to land owners who sell properties to beginning or socially disadvantaged farmers. The FSA provides loans (up to $300,000) and microloans (up to $50,000), emergency loans, marketing assistance loans, farm storage facility loans and rural youth loans for youths between 10 to 20 years to establish and operate income producing projects. FSA also provides Noninsured Crop Disaster Assistance Program (NAP) for crops that are ineligible for federal crop insurance which is a risk management tool that helps reduce financial losses when natural disasters cause a loss of production or prevented planting. The NAP provides financial assistance to producers of non-insurable crops to protect against natural disasters that result in lower yields or crop losses, or prevent crop planting. The NAP covers losses exceeding 50% of expected production and 55% of average market price; up to 65% of expected production and 100% of average market price (USDA fact sheet, 2017).

Farm Credit System (FCS) loans money directly to individuals to purchase land and farm equipment. It also provides loan for operations and insurance purpose. Farm credit has different programs to suit young, beginning and small farmers. Farm credit categorizes a small farm as one with less than $250,000 in yearly production, young farmers are those 35 years or younger, and a beginning farmer is one with less than 10 years of experience (FCS fact sheet, 2016)