Financing fairer trade

Getting access to finance is difficult for small entrepreneurs in developing countries. Without reliable access to the financial system, many developing country producers are struggling to participate in global trade.

In this blog post*, I will take a closer look at attempts to provide easier access to finance for fair trade producers. Organisations such as Shared Interest and Triodos Bank offer schemes which aim to provide direct loans to smaller producers. Separately, other potential innovations involving fair trade intermediated bonds or fair trade certification for futures contracts is also discussed.

Innovation in trade finance shouldn’t only be about providing easier access to capital for producers. Rather it is important to consider how financial markets can be adapted to be more inclusive of smaller entrepreneurs in developing countries.

Access to finance in the developing country context doesn’t just have to mean microcredit – we can think more broadly about how the wider financial system can be reshaped to enable more capital to reach entrepreneurs and business people in developing countries.

The fair trade finance sector is still in its infancy and there is a need to find a mainstream audience for such initiatives. While coming up with an all-encompassing solution would naturally be appealing, incremental and more nuanced innovation is probably the more realistic route. A pragmatic approach which considers the current market structures is more likely to enable widespread adoption.

Shared interests

Two leaders in the field of fair trade finance are Shared Interest and Triodos Bank. Both organisations have schemes which are designed to lend directly to small producers in developing countries. The aim is to help to provide adequate cash flows for producers especially around harvest periods where expenses can be high, yet payments from buyers have yet to be received.

As highlighted in this excellent blog post detailing both groups’ activities, small producers are typically underserved when it comes to trade finance:

In particular it wants to focus on the ‘missing middle’ in low- and middle-income countries. This refers to agricultural businesses requiring finance in the $25,000–$2 million range (and sometimes higher), which is too large for microfinance and often does not qualify for loans from local commercial banks.

One of the aims of Shared Interest is to provide greater certainty for fair trade producers and buyers in terms of their access to finance. As highlighted in their very informative 2014 social accounts, borrowing from Shared Interest enables a narrower range of interest rates for borrowers. This is illustrated in Figure 1 where the interest rates for Shared Interest loans are compared with interest rates sourced from external finance providers by producers who access the scheme.

Figure 1: Interest rates charged to Shared Interest borrowers

Source: Shared Interest, CURRENTLY UNDER DEVELOPMENT.

In all 4 regions depicted in Figure 1, the maximum interest rate is lower for borrowers from Shared Interest. Further, in 3 out of 4 regions, the mid-point interest rate is lower (note that the West Africa sample was relatively small at only 35 observations in total). Crucially, Shared Interest loans are unsecured, whereas the majority of externally provided loans were secured, meaning that lenders have a claim over the borrower’s assets in the event of default. Usually, unsecured loans charge higher interest rates, but this is not the case for borrowers working with Shared Interest.

However, a challenge for Shared Interest is that it’s an expensive business to run. The reason for this is due to the large number of relatively small loans being provided and underwritten, which explains why commercial banks tend to avoid the sector. For example, in 2014, the group made 2,712 payments with a total value of £48 million – roughly £17,000 per payment. As a result, while Shared Interest has delivered on its targeted returns for its investors, the modest excess return is unlikely to attract those whose primary motive is profitability.

Similar challenges have been faced by Triodos where the limited size of their funds and the requirement for hands-on involvement with borrowers has resulted in muted financial returns for investors.

As mentioned, cutting costs isn’t feasible as the relatively small size of loans requires significant interaction with borrowers. Alternatively, securing loans against the assets of borrowers goes against the ethos of the socially responsible nature of the schemes, and would be costly to enforce.

Fairtrade bonds?

So what’s the solution? How can fair trade finance move beyond the realm of the well-intentioned to attract a wider audience?

With interest rates at or near record lows in most developed countries, profit motivated investors are seeking alternative ways of achieving higher income-oriented returns. Investments targeting fair trade finance would be a move up the investment risk spectrum (due to liquidity and credit risk considerations), but the returns on offer may be attractive when compared with government bonds.

A greater volume of investments would result in increased scale which may be of benefit to the returns offered by Shared Interest, Triodos and others including the Fairtrade Access Fund. However this would assume that the cost per loan would fall with a higher volume of loans, something that wouldn’t be guaranteed given the high costs of underwriting.

What this indicates is that a more radical solution may be required. Would it be a step too far for certification bodies such as Fairtrade International to act as a financial intermediary for producers? The scheme could work as follows:

1. Fairtrade works in conjunction with an investment syndicate to issue a bond. Members of the syndicate would likely include development banks, but could also extend to commercial banks.
2. The bond would be partly underwritten by the syndicate, potentially enabling a higher credit rating.
3. The proceeds from the bond issue are lent to fair trade producers. Fairtrade already interacts with the producers on a regular basis as part of the certification process. This means that the producers who are borrowing from the syndicate are known to Fairtrade and their needs can be verified as part of certification.
4. Profits (losses) from the lending activities are shared between the syndicate and the investors by way of higher (lower) interest payments. Beyond a certain threshold, excess profits could be distributed back to the producers or passed on as lower borrowing interest rates.

What I’ve proposed is obviously overly simplified and would require a lot of technical tweaks. Nevertheless, the proposal deals with two issues which may be holding back greater access to finance for fair trade producers:

• A syndicated approach can result in larger amounts of capital being raised which can then be lent to producers. Large bond issues may be viewed more favourably by institutional investors and fund managers.
• Costs of underwriting loans to producers can be limited by incorporating the underwriting into the certification process.

In addition to the investment related risks of setting up such a scheme, there is also clearly a reputational risk for Fairtrade International if they were to take part. Would consumers and producers view Fairtrade as a pawn for yield-seeking investors? Or would the access to a bigger pool of lower cost finance have wider benefits for producers?

The costs and benefits would clearly have to be carefully weighed up by all involved.

Fairtrade futures contracts?

As I’ve noted in an earlier blog post, many of the commodities produced in developing countries are traded on global financial markets through futures contracts. Coffee, cocoa, sugar, gold and many other commodities, which are available for Fairtrade certification, are also widely traded on international financial markets for both hedging and speculative purposes. The rights and wrongs of the financialisation of commodities is better left for others to opine, but the fact is that futures markets are a key part of the global commodity supply chain, so I’ll focus on the pragmatic approach for the moment.

An important technical feature of commodity futures is the contract specification. For example, the main global Arabica coffee benchmark futures contract is the Coffee ‘C’ contract traded on the Intercontinental Exchange (ICE). The specification for this futures contract stipulates terms including the quality or grade of the coffee, the country of origin and the delivery location.

One possible way to broaden the use of Fairtrade certified coffee would be to lobby the ICE and the International Coffee Organization (ICO) to include Fairtrade certification as part of the coffee contract specification. The same could be applied to other commodities.

The world’s major agricultural commodity traders are heavily involved in futures markets. By specifying that their main hedging tool needs to be Fairtrade certified will mean that the actual physical commodity will also need to be Fairtrade certified in order to meet the futures exchange requirements.

Is this wishful thinking? If the main beneficiaries of the commodity trade are serious about sustainability and social considerations, this would be one way of showing it.

Regardless, the onus shouldn’t be skewed to developing countries needing to embrace globalised supply chains. Instead, market structures in developed countries need to enable developing countries to be included in more substantive ways.

*Important disclaimer: As at the time of this post, the author has no direct financial nor personal connection to Shared Interest Society Limited, Triodos Bank, Incofin, Intercontinental Exchange or their related entities. Where details of investment products or schemes are referenced, the author is not making an investment recommendation. Please note the relevant terms and conditions for each organisation, available at these links: Shared Interest, Triodos Bank, Incofin, Intercontinental Exchange.