Warehouse receipts; Commodity finance approach to solve marketing and financial issues of farmers

Inadequate market prices and price fluctuations are observed in Sri Lankan market for storable agricultural products frequently. Specially, low market prices are observed during harvest seasons. In this connection, paddy, onion are prominent.  Poorly organized market channels are frequently criticized by farmers.  Famers have no opportunity to store their products and sell them later at higher prices due to poor storage facilities and short term financial requirements.   Most of the farm products like paddy, spices, onion, cereals are storable products for a significant time. But farmers have to sell them at lower prices after harvest. Moreover, farmers face hardships to find financial sources to purchase inputs for their cultivations. Financial intuitions require collateral and securities for borrowings. Farmers have no such securities. As a result of this, farmers have limited working capital.   The storage facilities and financial opportunities for the short term cash requirements can be provided by introducing commodity finance approach. This approach is being practised successfully in many other countries. This is named as warehouse receipt finance as well.

How commodity finance system works

The commodity finance method has been practiced with many commodities including agricultural products around the world. In this concern, grain warehouse receipts were first used in Mesopotamia in 2400 BC. A warehouse receipt is the document that issued by warehouse operator by the depositor’s name as evidence to the storage of the specified commodity by indicating the quantity and quality and location of the particular warehouse.  This provides the confidence for the depositors   that their commodities will be stored with guaranteed quality and quantity. The depositor of the commodity may be a producer, farmer group, trader, exporter, processor or any individual or corporate body.  These warehouse receipts are negotiable financial instruments. They can be traded, sold, exchanged, and used as collateral to support for short term financing requirements of the farmers.

The warehouse    keeps the stores of commodity in a way of safe custody.  Implying that warehouse is legally liable to value lost through theft, pest, moisture or damage by fire and other catastrophes. However, in case of liquidation of the warehouse operator, warehouse operator’s creditors will not be able to seek right to the commodities stored since, legal title remains with the depositor or holder of the receipt. The   warehouse operator is eligible to cost for covering storage costs.  If the depositor requires financing, financing can be obtained as an advance loan from a bank using the warehoused crop as collateral by presenting the receipts. The depositor (borrower) is required that payment for the commodity is channelled through the financing bank. The bank in turn deducts the loan advanced and interests or other charges before crediting the account of the depositor the balance. The depositor has to pay storage and where applicable collateral management fees for the storage.

Why commodity finance system is needed and its benefits

Agricultural production and trade is dealt with low margins and high uncertainties. In this regard, finding credit for agricultural inputs is an issue for many Sri Lankan farmers. This risky nature keeps financiers and investors away from farmers. Physical collateral like land and machinery is rarely used in agriculture finance due to the liquidity issues. This method would be beneficial for rural small and medium agricultural enterprises which are often have poor working capital due to lack of sufficient loan collateral. Efficient warehouse receipt finance allows farmers to avoid direct sales soon after harvest at low prices. Commodities are stored by reducing costs and increasing liquidity in the supply chain against price volatilities. Farmers are provided incentives to invest in crop production. That will be a good solution to enrich the local food supply chains. Moreover, the warehouse receipt finance can increase the export earnings from agricultural products. For instance spice supply chains can be strengthened by this method. Spice collectors and producers can store bulks and sell them at higher prices later. Farmer income can be improved. On the other hand, the financial institutions are also benefited by this warehouse receipts. For instant, the financial institutions which provide short term financial requirements by accepting warehouse receipts as collateral are able to reach a higher level of liquidity because stored commodities have clear market prices and gain the right access to claim the collateral before other creditors. The banks will receive a higher level of protection of the collateral enforced both by the good management practices of the licensed warehouse and the supervision of the regulatory agency. Further, commodity finance will help to smooth the domestic prices by providing an instrument to farmers to spread sales throughout the crop year. Forward markets will enhance the price discovery for the stored markets. This kind of finance mechanism can help to reduce the role of government in agricultural commercialization and pricing in the long term.
Warehouses in other countries
This commodity finance scheme has been introduced to farmers in different countries in Africa and Asia. For instance; Tanzania, Kenya, Zambia, India, Indonesia and Philippines etc. The commodity finance has usefully practised for cereals like paddy and corn in particular countries.  A research that has undergone in Zambia, has pointed out that rural borrowers were not attractive to financial institutes, because institutions perceived farmers as high risk borrowers due to poor income and less core lateral.  The particular issue has been successfully addressed by using warehouse receipt financing in Zambia.    This system is highly promoted in African continent. For instance;   Mali, Senegal and Guinea has studied to establish a system that benefited by three countries.  Particular study has found that stakeholder trust is the major factor for the success of warehouse receipt finance.   There for the conclusion was, trust must be supported by an appropriate legal environment.  United States Department of Agriculture (USDA) has facilitated post-harvest Inventory financing with the government guarantees to overcome farmers’ cash-flow constraints as collateral for standard nine-month loan programs and to facilitate marketing   crops. Further as inventory documentation for government owned grain that stored in privately owned warehouses and as a   collateral for crops held in commercial storage ( Ex ; Grain milling companies)

Warehouse receipt finance system in Serbia has implemented because, government subsidies and banking loans have failed to provide sufficient funds to farmers.  In Indonesia, this system was established by government   to overcome the low commodity prices during the harvesting time.   However, it has emphasized that coordination   among the government, other stakeholders are as important to smooth run. Central Asian and Eastern Europe countries have   introduced   the commodity finance system especially after the collapse of the Soviet Union. Countries like Bulgaria, Kazakhstan, Hungary, Slovakia and Lithuania have advanced warehouse receipt financing systems with proper legal frameworks. Nevertheless, warehouse receipts issued by public warehouses play a significant role in commodity-based financing in these countries.  Countries like   Poland, the Russian Federation, Turkey, Ukraine, Romania, Moldova, Serbia and Croatia have moderately developed warehouse receipt financing systems. Most of these countries have adopted   primary legislation to support the warehouse receipt finance systems. In conclusion, many countries have promoted this commodity finance with suitable crops and regulations.

Conditions require for a commodity finance system

The importance of agreement and commitment between government institutions and market participants has been highlighted by studies on the success of commodity finance schemes. Further, the studies have emphasized the political will and understanding of the benefits that the system could bring to its participants are as significantly important factors for the smooth run of the system. Moreover, commodity finance system should develop to cover all aspects including inspection, supervision and performance guarantees. That is extremely important to prevent system failures. In this connection, the creation of ‘Government regulatory Agency’ which is responsible for the licensing, regulatory and inspection procedures of the public warehouses is the most common and accepted system for control of the commodity finance system. For instance; these facts have been emphasized by the Department of Banking Operations and Development (India) when warehouse receipt finance system was implemented in India (2006-07).

Since, private sector participation is important in practice commodity finance, Government should establish a licensing and inspection procedure to maintain standards in both financial assets and physical assets and the quality of the stored products. However, inspection of warehouses, inspection of financial institutions and quality determination, grading and independent verification of stored commodities also can be performed under government licensed local or international companies.

The legal enforcement has been emphasized by many research studies on this system. These legal requirements are basically to ensure the creditability and reduce the risk to the financial institutions. For the success of warehouse receipt finance, the rights, liabilities and duties of each party to a warehouse receipt must be clearly defined. It has found that, the financial institutions, traders and warehouse managers have concerned highly the legal aspects. This emphasizes the requirement of new laws like in other other countries. These laws are required to ensure, the acceptance of warehouse receipts as financial instrument that can be exchanged and traded. In this regard, Warehouse receipts must be freely transferable by delivery and approval; the owner of a warehouse receipt must be first in line to receive the stored goods or their agent on liquidation or non-payment of the warehouse receipt; specified time period that to accept the commodity to storage; The reliability of the warehouse receipt system must be assured by suitable insurance scheme which accepted by the other financial institutions.

Some commodity characteristics and market characteristics required to create sufficient incentives for market participants to use warehouse receipt finance. In this concern, the quality of a commodity as collateral is determined by: storability; the prevailing quality certification methods and grades; market transparency; price volatility; liquidation costs; costs of finance and government policies like importation and price control.

Limitation and challenges

Future price predictions are important in commodity finance. Price risk arises due to the variation in general market price level as reflected in the futures market. Basis price is a function of several factors including storage cost, transportation costs, handling costs and processing margin, quality and local supply and demand. In this concern, areas of surplus commodity will have a lower basis level than areas with a deficit. Moreover, similarly a higher quality or grade cash commodity will have higher basis level than a lesser grade or quality of the same trade. Government price policies and importations also have a severe impact on the success of WHRF finance system. Imports to control the domestic prices would have an impact to the system to set prices that cover the storage cost and profit from stored products. In warehouse receipt finance, the bank holds the credit risk from the borrower to the warehouse that issuing the warehouse receipt. The financial strength of the warehouse operator is crucial for the proper functioning of a warehouse receipt system. Possible frauds and fake ware house receipt are also needed to be concerned since such cases have been reported. For instance; in late 2008, several Hungarian banks found that they had provided finance to warehouse receipts that they thought were issued by public warehouses, but that had really issued by private warehouses .From the policy perspective, such experiences indicate the need of a legal and regulatory framework, including establishing a licensing system for public warehouses to avoid misuses or issuing fake warehouse receipts. Further this indicates the importance of raising the banks’ awareness and trust building activities of stakeholders as necessary conditions.

By Kapila Premarathne, Lecturer, Department of Agricultural Systems, Faculty of Agriculture, Rajarata University of Sri Lanka