Subsidy back in fashion?

For a long time the consensus has been that investment by development finance institutions (DFIs) should be on 'commercial terms'. Low-cost loans risk propping up weak businesses and crowding-out private investment. There is a case for using public money to increase the supply of credit in developing countries, the argument goes, but not for reducing its cost.

When applied to African agriculture this argument is weak. Firstly, many agribusinesses operate in environments where there are market failures – such as underfunded research institutions, poor infrastructure and inexperienced farm management and labour – which makes it difficult to compete with farmers in other parts of the world. In these situations there is a sound economic rationale for public subsidy to help business get established and achieve the economies of scale which allow them to become competitive.

Secondly, the cost of commercial finance in rural Africa – often more than 25% interest for local currency loans – is prohibitive especially for primary agriculture which is generally a low margin business. For smallholder farmers the cost of credit is higher still – often 40-50% or more – which reflects the high transaction costs of making small loans to large numbers of disbursed clients. Insisting the DFIs lend on the same terms as commercial banks will not stimulate more investment in agriculture. Credit lines simply go undrawn.

Thirdly, there is no shortage of commercial capital looking for opportunities in the African agriculture sector. More than $2 billion of dedicated private equity has been raised since 2010. If there were investment opportunities that could give a reliable 25% + return then the private sector would already have taken them up. There is little benefit in increasing further the supply of credit when the problem is not a lack of capital but a lack of “investment-ready” opportunities (i.e. businesses with a solid business plan, quality management on the ground and some sort of track record).

Interestingly, the ideological opposition to subsidies seems to be on the wane. As Europe struggles to escape austerity more attention has been given to the role of the state in stimulating growth and encouraging entrepreneurship. Industrial policy is back in fashion.

A recent report by Demos titled The Entrepreneurial State points out that in many cases states have been the catalyst to develop and invest in new technologies. Many of the most innovative young companies in the USA were funded not by private venture capital but by public grants such as through the Small Business Innovation Research programme ($30 billion disbursed since the 1970s). The algorithm behind Google was funded by a public sector National Science Foundation grant.

AgDevCo’s view is that African agriculture will not develop with commercial finance alone. There are simply too many hurdles for start-up businesses. There is a strong economic rationale for subsidising agribusiness in its early-years, as long as there is an exit strategy. The DFIs should be doing more to catalyse private investment by increasing the supply and reducing the cost of credit for early stage agriculture businesses.