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RISK IN AGRIBUSINESS

Our daily lives and business operations are filled with risk. People make risky decisions at all levels in an organization, ranging from individual responsibilities to collective decisions made at Board level. On a personal level we take risks crossing the road, travelling by train and making investment decisions. From a business perspective, risk is managed at many levels – operational, marketing, legal and financial. Traditionally, much risk inherent in a business operation has been managed through insurance.

 

Risk means different things to different people. At its simplest, risk can be considered as uncertainty of outcomes, based on probabilities. In finance, risk refers to the likelihood that we will receive a return on an investment that is different from the return we expected to make. Thus risk includes not only the bad outcomes, but also good outcomes. Risk management is the systematic ongoing process by which an organisation identifies, prioritizes and implements programmes to reduce the chance of negative outcomes on a business.

Risk is inherent in agriculture since it mostly depends on the vagaries of nature. Agriculture today is a business proposition and no more regarded as a way of life. Therefore, any decision pertaining to resource organization, allocation, production planning and enterprise selection are all-important areas of farm decision making. Risk is a phenomenon when we realize that outcome of an event is very important but unsure about the occurrence of it. Usually the deviation from any expected value is regarded as a risky proposition. Risk is inherent in every form of enterprise, but its intensity in input-output relation in agricultural production is comparatively high. Host of factors usually influence and affect agricultural production most of which are beyond the control of decision makers. Several biotic and a biotic factors contribute towards variability in farm production which is usually termed as risk factors. The important abiotic factors like rainfall, humidity, temperature and certain biotic factors like pest infestations, diseases cause large-scale variability in agricultural production. Besides these, price is an important variable, which results in variability in farm returns.

 

Farmers face a number of risks which are often interconnected. Five types of risk are generally considered in agriculture, according to their sources:

  • Production risks, concerning variations in crop yields and livestock production, affected by a range of factors: weather conditions/climate change, pests, diseases, technological change as well as management of natural resources such as water
  • Price and market risks, associated with variability in output price (mostly), also input price variability and integration in the food supply chain (with respect to quality, safety, new products, etc.)
  • Regulatory risks connected with the impact of changes in agricultural policies (e.g. subsidies, regulations for food safety and environmental regulations) or trade policies: a change in government action, which is at odds with what farmers expected, may have a negative impact on their income
  • Technological risks associated with the adoption of new technologies
  • Financial risks resulting from different methods of financing the farm business, subject to credit availability, interest and exchange rates, etc.
  • Human resource risks, associated with unavailability of personnel.

Price risk and production risks are usually considered the most important in agriculture

Risk management starts with decisions on the farm and at the household level: which outputs to produce, how to allocate land, which inputs and techniques to use. Diversification of activities on and off-farm normally contributes to reducing risk. The level of the farmer’s integration in the food supply chain also affects the degree to which the farmer is impacted by price volatility. Vertical integration – when the farm controls a commodity across two or more levels of activity – typically reduces risks associated with a variation in quantity and quality of inputs (backward integration) or outputs (forward integration). Vertical integration is more common in the livestock sector (integration backward into feed manufacturing) or in the fresh vegetables sector (integration forward into sorting, assembling and packaging). Accumulating financial reserves is obviously another simple risk management strategy. Risks associated with frequent events which do not cause large losses, such as normal fluctuations in prices and production, are managed on the farm. Events which are infrequent but lead to severe damage to a whole region (e.g. floods, droughts or disease outbreaks) typically fall under the catastrophic risk layer, for which market solutions have played a less important role, mostly due to high public involvement. Between these two layers, financial markets and insurance provide solutions.

Strategies to mitigate include:

— risk transfer (e.g. to derivatives market),

— risk pooling (e.g. in insurance),

— Diversification in production (different activities or different crops).

 

The process of risk management can be divided into a series of actions:

  1. The identification and cataloguing of risk
  2. The quantification (assessment) and prioritization of the risks identified
  3. The development of programmes and actions to tackle risks: this can involve contingency plans and/or the outsourcing of risks to a third party. Risk tolerance boundaries should be established.
  4. Continuous evaluation of risks and the monitoring of existing programmes for effectiveness.

 

Risk coping mechanism:

Farmers adopt some risk coping mechanisms to reduce loss. Farmer’s risk coping mechanisms are of two types viz.

  1. Ex ante
  2. Ex post

Ex ante coping mechanisms are designed to exploit low correlation among activity returns for stabilization of total income. The ex ante coping mechanisms adopted by farmers are crop diversification, varietal diversification, income diversification, temporal adjustments etc. On the other hand, farmers also adopt some mechanism to reduce loss after its occurrence (expost mechanism). Farmers adopt ex post mechanisms such as selling of animals, implements and other assets like selling of land, jewelry etc. and sometime take up extensive vegetable cultivation in order to make-up the loss caused by flood. Besides these, farmers also resort to measures like reduction of food consumption, and reduction in number of meals per day as compared to normal year, postponement of medical treatment, curtailment of social obligation, non-maintenance of house, curtailment of expense on education, migration to other places, migration to non farm activities, mortgage/borrowing etc.

Attitudes towards risk

Risk acceptance implies that a risk taker is willing to accept some risks to obtain a gain or benefit, if the risk cannot possibly be avoided or controlled. The acceptance level is a reference level against which a risk is determined and then compared. If the determined risk level is below the acceptance level, the risk is deemed acceptable. If it is deemed unacceptable and avoidable, steps may be taken to control the risk or the activity should be ceased. The perception and the acceptance of risks vary with the nature of the risks and depend upon many underlying factors. The risk may involve a “dread” hazard or a common hazard, be encountered occupationally or non-occupationally, have immediate or delayed effects and may effect average or especially sensitive people or systems.

Risk aversion is the control action, taken to avoid or eliminate the risk, regulate or modify the activities to reduce the magnitude and/or frequency of adverse affects, reduce the vulnerability of exposed persons, property or in this case urban systems, develop and implement mitigation and recovery procedures, and institute loss-reimbursement and loss-distribution schemes.

 

Risks Associated with Agricultural Lending

Financial institutions face four major risks:

  1. Credit or loan default risk – refers borrowers who are unable or unwilling to repay the loan principal and to service the interest rate charges. Risks and uncertainty are pervasive in agricultural production and are perceived to be more serious than in most non-farm activities. Production losses are also impossible to predict. They can have serious consequences for income generation and for the loan repayment capacity of the borrowing farmer. The type and the severity of risks which farmers face vary with the type of farming system, the physical and economic conditions, the prevailing policies, etc.
  2. Liquidity risk – occurs when a bank is not able to meet its cash requirements. Mismatching the term of loan assets and liabilities (sources of loanable funds) exposes banks to high liquidity risks. Agricultural lending implies high liquidity risks due to the seasonality of farm household income. Surpluses supply increase savings capacity and reduce demand for loans after harvest and deficits reduce savings capacity and increase demand for loans before planting a crop. Also, agricultural lenders face particular challenges when many or all of their borrowers are affected by external factors at the same time. This condition is referred to as covariant risk which can seriously undermine the quality of the agricultural loan portfolio. As a result, the provision of viable, sustainable financial services and the development of a strong rural financial system is contingent on the ability of financial institutions to assess, quantify and appropriately manage various types of risk
  3. Interest rate risk – risk that a loan will decline in value as interest rates change.
  4. Foreign exchange risk – defines exposure to changes in exchange rates which affect international borrowings denominated in foreign currency.

 

Risks from Changes in Domestic and International Policies

Production and Yield Risks

Yield uncertainty due to natural hazards refers to the unpredictable impact of weather, pests and diseases, and calamities on farm production. Risks severely impact younger, less well-established, but more ambitious farmers. Especially affected are those who embark on farming activities that may generate a high potential income at the price of concentrated risks – e.g. in the case of high input monoculture of maize. Subsequent loan defaults may adversely affect the creditworthiness of farmer borrowers and their ability to secure future loans.

Market and Price Risks

Price uncertainty due to market fluctuations is particularly severe where information is lacking and where markets are imperfect, features that are prevalent in the agricultural sector in many developing countries. The relatively long time period between the decision to plant a crop or to start a livestock enterprise and the realization of farm output means that market prices are unknown at the moment when a loan is granted. This problem is even more acute for perennial tree crops like cocoa and coffee because of the gap of several years between planting and the first harvest. These economic risks have been particularly noticeable in those countries where the former single crop buyer was a parastatal body. These organizations announced a buying price before planting time. Many disappeared following structural adjustment reforms and privatization of agricultural support services. Private buyers rarely fix a blanket-buying price prior to the harvest, even though various interlinked transactions for specific crops have become more common today. These arrangements almost always involve the setting of a price or a range of prices, prior to crop planting.

Risk of Loan Collateral Limitations

Problems associated with inadequate loan collateral pose specific problems to rural lenders. Land is the most widely accepted asset for use as collateral, because it is fixed and not easily destroyed. It is also often prized by owners above its market value and it has a high scarcity value in densely populated areas. Smallholder farmers with land that has limited value, or those who have only usufruct rights, are less likely to have access to bank loans. Moveable assets, such as livestock and equipment, are regarded by lenders as higher risk forms of security. The owner must provide proof of purchase and have insurance coverage on these items. This is rarely the case for low-income farm households. Moreover, there are a number of loan contract enforcement problems, even when borrowers are able to meet the loan collateral requirements. Restrictions on the transfer of land received through land reform programmes limits its value as collateral – even where sound entitlement exists. In many developing countries the poor and especially women have most difficulties in clearly demonstrating their legal ownership of assets.

Moral Hazard Risks in Distorted Credit Cultures

Potentially serious risk problems have arisen from the effects of failed directed credit programmes. The impact on the loan repayment discipline is pervasive. Borrowers, who have witnessed the emergence and demise of lending institutions, have been discouraged from repaying their loans. Further people have repeatedly received government funds under the guise of “loans”. Loan clients have been conditioned to expect concessional terms for institutional credit. Under these circumstances, the incidence of moral hazard is high. The local “credit culture” is distorted among farmers and lenders. Borrowers lack the discipline to meet their loan repayment obligations, because loan repayment commitments were not enforced in the past. Lenders, on the other hand, lack the systems, experience and incentives to enforce loan repayment. There is also an urgent need to change bank staff attitudes and the poor public image of financial institutions in rural areas. Another effect of a distorted credit culture on the risk exposure of agricultural lenders is the priority that borrowers give to repaying strictly enforced informal loans. These are settled before they comply with the obligations associated with “concessional” institutional credit. This is explained by the fact that losing the access to informal credit is viewed as more disadvantageous than foregoing future bank loans (due to the uncertain future of rural financial institutions). Very often informal lenders have stronger enforcement means than banks.

Risks from Changes in Domestic and International Policies

Policy changes and state interventions can have a damaging impact on both borrowers and lenders. For the latter they can contribute significantly to covariant risks. Many low-income economies under structural adjustment programmes have slashed their farming subsidies. This has had, for instance, a serious effect on the costs and the demand for fertilizer. Reducing government expenditures as an essential part of structural adjustment programmes may also affect employment opportunities in the public sector. Costs may even reduce agricultural production levels, if extension services are suddenly discontinued.

 

References

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Clark, B. M., Detre, J. D., D’Antoni, J., & Zapata, H. (2012). The role of an agribusiness index in a modern portfolio. Agricultural Finance Review, 72(3), 362-380. doi:http://dx.doi.org/10.1108/00021461211277231

D’Antoni, J.,M., & Dean Detre, J. (2014). Are agribusiness stocks an investor safe haven? Agricultural Finance Review, 74(4), 522-538

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