Financing the food crisis

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By:
Sudip Roy
Published on:

Feeding the world is the most pressing issue facing society. Billions of dollars of new investment is needed to forestall future crises in both supply and price. Markets and financial institutions can play a crucial role in meeting the challenge. But how can they do so without being seen to exploit the most crucial resource of all? Sudip Roy reports.

More on food finance:

Agricultural funds: Tilling the soil
Rabobank’s farming roots
IFC: from food to farm
Middle East: Land grab raises concerns about food security
Ukraine: Investors out to make dough from Europe’s breadbasket
North America: US farmers discover the price of globalization
Vertical farming: Farms among the skyscrapers
Why farmland is not an easy investment

Editor's letter: The food time bomb ticks on

THE FOOD TIME bomb is ticking. With global food prices nearing a record high, radical action is needed if the kind of shocks witnessed earlier this year and in 2007/08 are not to become disturbingly regular occurrences.

The impact of high and volatile food prices can be immediate and devastating. Since June 2010 an extra 44 million people have fallen into poverty – defined as a daily income of less than $1.25 – thanks to the surge in food prices.

"Uncertain and volatile food prices are the single-greatest threat facing the developing world," said Robert Zoellick, president of the World Bank, ahead of a G20 agricultural ministers meeting earlier this year.

Jeremy Grantham, co-founder of global investment manager GMO, argued in a research note published in April that the world has undergone a paradigm shift, with price pressures now a permanent feature of our lives.

Invoking Thomas Malthus’s famous argument that population growth would eventually outstrip that of the world’s finite resources, Grantham wrote: "The prices of all important commodities except oil declined for 100 years until 2002, by an average of 70%. From 2002 until now, this entire decline was erased by a bigger price surge than occurred during World War II."

Describing the change as perhaps the most important economic event since the Industrial Revolution, Grantham argued that a fast-growing and increasingly wealthy population, declining crop yield growth per acre (from 3.5% in the 1960s to 1.2% today) and limited available productive new land have all led to inexorably higher prices.

Production needs to greatly improve to narrow the demand-supply imbalance – the demand for foodstuffs is growing at 2% a year but supply is only increasing at 1% – with the long-term outlook worrying.

The UN’s Food and Agriculture Organization reckons that by 2050 food production will have to increase by 70% from current levels to meet the demands of a population estimated to have grown to 9.1 billion, up from 6.8 billion today.

That means that agricultural investment needs to increase by about 50%. Or to put it another way: $83 billion of net investment a year needs to be made in primary agriculture and downstream services, such as storage and processing facilities, if there is to be enough food to feed those 9.1 billion people by 2050. And that’s excluding the investment required in roads, ports, large-scale irrigation projects and other necessary infrastructure.

It’s a daunting prospect.

Decisive role

Where will this money come from? Clearly governments and multilateral agencies will need to invest large sums on infrastructure, education, technology and extension systems to create the conditions that will enable sustainable investment in agriculture and agri-related businesses.

But equally there is a limit to how much cash the public sector can deploy – especially at a time when government budgets are under such intense pressure.

Instead the decisive role in addressing the food security challenge – in providing more capital, in trying to increase yield growth, in opening up new land and getting it into production – will be performed by the private sector, from corporates to investors and the global and local banks that intermediate them.

As providers of finance and risk capital, banks have a pivotal part to play in allocating resources, helping mitigate price-risk volatility for both producers and consumers, and in supplying fundraising and advisory services to corporates and sovereigns.

The business potential cuts across the full range of a bank’s product suite – lending, risk management, commodity trading, structured finance, project finance, trade finance, M&A, sovereign advisory, equity and debt capital markets, fund indices, research.

Getting some of these disparate internal groups to pull in the same direction is a big challenge, although worthwhile, especially if it encourages greater cross-selling of products.

While returns from agriculture are small compared with other natural resources, the opportunity could be substantial, especially for those banks that get the structure right and understand the industry’s dynamics.

"When I was interviewed for this job my boss said to me: ‘I’m not really interested in the millions of dollars to be earned in this sector, I’m interested in the billions,’" says one investment banker.

"I thought: ‘Good, you’re ambitious. You understand the opportunity because that’s how big it is’."

Big hurdles

It will not be easy, however. Agriculture is a notoriously challenging sector to invest in. That is why most banks pick their spots carefully.

Almost none has globally connected agriculture teams cutting across different products. There is no agriculture or food equivalent of a global council on climate change or centre for environmental markets as there is at international banks as part of their commitment to green finance.

For the most part, banks’ coverage of agriculture is diffuse and disparate. Dutch lender Rabobank is one notable exception (see Rabo’s farming roots), while others such as Standard Chartered and Standard Bank have regional agriculture businesses. Russian investment bank Renaissance Capital has also built a dedicated agriculture unit.

Some international banks have very little exposure to the sector at all outside of the big food companies, such as Nestlé, Kraft, Mars or Tate & Lyle or the main agriculture commodities, such as wheat, corn or maize.

The biggest problem in the agriculture industry is that farming is very fragmented. In Africa, for example, the agricultural sector is typified by subsistence farming by families still using traditional methods. For the most part these farms fall outside the supply chain, which is one of the reasons why Africa has suffered from chronic food shortages.

Even larger-scale farms can hardly be considered big business. Richard Ferguson, head of global agriculture at Renaissance Capital, says there are probably only about 100 farming groups in the world with more than 100,000 hectares. He reckons that the likely average market capitalization of one of these operators would be only about $400 million, assuming they don’t have other non-farming businesses.

"That’s a speck on the investment landscape, although this is an industry that should be a huge part of our global economy," he says.

"There are very few industrial farms in the world. A globally strategic industry is being run by corner shops. What we need to do is capitalize the sector; it’s very undercapitalized," he adds.

Another problem is uncertainty of supply. Unlike in the oil and gas sector, it’s much harder to predict production levels in agriculture because of issues that are outside analytical control, namely the weather and the whims of government.

In August 2010, for example, the Russian government decided to ban grain exports to guard against food inflation after a severe drought wrecked more than one-third of its grain crop.

The ban, which lasted almost a year, together with grain export quotas imposed by Ukraine, drove wheat prices to their highest level since 2007-08, when the world experienced a global food crisis.

Controversy

There’s a further reason why some banks might be coy about becoming too heavily involved in food finance or at least be seen as getting too heavily involved.

Nothing stirs more controversy than banks making money out of sensitive lines of business and few areas are as open to criticism as profiteering from food.

Consequently many financial players, especially those involved in trading agricultural commodities, seek to keep a low profile.

But banking is all about incentives: if there was no prospect of profit-making the banks would simply walk away, leading to even greater ruptures in the markets.

One commodities trader says banks can be agents for good – while making plenty of money at the same time. "The more capital we can get into the industry the more likely we are to avoid a food crisis. Working with capital providers to invest in long-term agriculture is a real positive for the global economy," he says.

To him the logic is simple. "We need to bring more food production on line [in order] to avoid a future crisis where it’s not the price we’re talking about but actual shortages. Whether it be through the trade finance desk, where we’re trying to facilitate trade in agriculture; or my desk, where we’re trying to provide capital to reduce price volatility; or products that are providing investors with access to agriculture which ultimately send a price signal to the market that say ‘plant more’, we can help."

"It’s about fixing the clients’ problems," says Mark Konijnenberg, head of the commodities group at Citi. "We don’t think we are exacerbating the food problem because we are focusing on clients’ needs. Our clients aren’t speculators. They are food companies and governments that need to manage their exposure to volatile commodity markets. We’re trying to help them tailor their budgetary goals, be it for a producer that wants to guarantee a minimum sales price or a consumer that wants to guarantee a maximum purchasing price."

Debate rages about what effect financial players have on food prices, with everyone from hedge funds to Goldman Sachs and its index-tracker fund blamed for destabilizing food markets.

A recent report by the UN’s Trade and Development division concluded that "since 2004 rising volumes of financial investments in commodity derivatives markets, both at exchanges and OTC... is a serious concern, because the activities of financial participants tend to drive commodity prices away from levels justified by market fundamentals, with negative effects both on producers and consumers."

The report urged the usual panoply of recommendations of greater transparency in OTC markets and exchanges, as well as tighter trading regulations. All this is nothing new. Speculators have long been blamed for volatile food prices. In 1897, for example, the German government banned dealing in grain futures after a price shock wrought by a poor harvest earlier in the decade.

What is different, however, is the sheer number of financial participants – pension funds, hedge funds, index investors and ETFs – and the size of trades taking place in the market. The position limit on maize that any one futures trader could buy in the US 30 years ago was equivalent to 75,000 tonnes. Today it’s 2.8 million tonnes.

These two developments are probably exacerbating price volatility, and stricter position limits could ease short-term pressures.

But, as Grantham argued, the underlying reasons for the surge in food prices lie more with global trends – climate change, water shortage, rising populations, China’s rapidly growing middle class and consequent improvements in its diet, increasing use of corn and sugar for biofuel production. The impact of speculators is more at the margin.

"Speculators can change the price of a commodity intra-day or one day to the next but not over the long term,every market in commodities is ultimately driven by underlying demand and supply imbalances"

Sebastian Barrack, Macquarie

Sebastian Barrack, senior managing director within the FICC group at Macquarie

"Speculators can change the price of a commodity intra-day or one day to the next but not over the long term," says Sebastian Barrack, senior managing director within the FICC group at Macquarie. "Every market in commodities is ultimately driven by underlying demand and supply imbalances."

That’s why, he points out, nickel prices are 60% off their historical highs, while copper is still near its highs. "Both are industrial metals but why is one at more than half of its all-time high? Differences in the supply and demand balances," he says.

"The problem for agriculture is that there has been such under-investment in infrastructure in the key producing regions for such a long time that it will take production 10 to 15 years to catch up to the required increases in production and demand growth.

"The amount of money that is flowing into agriculture commodities will help improve that infrastructure – ports, roads, storage facilities – that will allow the price cycle to flatten out, but that will take time," says Barrack, who adds that also the long-run return on capital invested in agriculture has been comparatively poor so capital has moved less freely into the sector than in metals or energy.

Liquidity in agriculture-related commodities varies. The most liquid are corn, sugar and wheat. All three, however, lag behind oil and gas. The number of total open interest contracts for corn, for example, is 1.26 million compared with nearly 1.5 million for crude oil. But the average daily volume of corn contracts traded is half that of oil. Moreover, the notional value of a total open-interest contract of corn is a little more than a third of oil.

The key determinant of liquidity is how easily exportable a commodity is. "If it hits the water it trades in much larger volumes," says Barrack.

He explains: "For a commodity to be successfully traded as a financial product it has to be exportable in significant size. On top of that you need to have a transparent reference price that correlates highly to the prices that producers and consumers receive and pay. The traders, hedge funds and institutional investors then help increase liquidity by offsetting the risks."

Wheat, corn, sugar and soya beans are more liquid than rice mainly because they have active export markets. Although rice is the most eaten foodstuff in the world, it tends to be produced and consumed in the same countries and regions.

The more tradable a commodity is, the more liquid it is, the better the price-discovery process.

The sheer number of exchanges that a particular crop is traded on further compromises liquidity. Wheat alone is traded on five different global markets – Chicago, Kansas, Minneapolis, Matif in Paris and Sydney. Coffee, cocoa and sugar are all traded in New York and London. Local exchanges are also becoming more prominent. The Dalian Commodity Exchange in China, for example, is the most important market for maize in Asia.

"It’s a large tapestry," says James Nuttall, director of EMEA sales and origination, agricultural commodities at Citi. "That’s part of the challenge of being in agriculture. It’s very dispersed."

The fact that liquidity on futures exchanges can be choppy and that the choice of exchange-traded standardized contracts is limited has increased the attractiveness of more structured OTC products.

One of the big issues facing consumers and producers is basis risk – the risk associated with imperfect hedging using futures.

"It can give producers and consumers a massive headache," says Nuttall. "A client in eastern Europe might have an exposure to a certain commodity which is only 50% correlated to the Chicago exchange and might want a basket that gives it a correlation of 80%." Bridging and managing that basis risk successfully is one of the key ways banks make their money.

Helping clients meet their liquidity needs related to commodity positions is another important service. One of the challenges facing corn, sugar and wheat producers in the US, for example, is that their margin calls have increased nearly three-fold since 2005 as the market value of these commodities going through the supply chain for both domestic and international production has risen from $50 billion to $140 billion on the back of price rises and greater production (see US farmers discover the price of globalization).

A liquidity swap, whereby the bank finances the producer’s short future position and so frees up working capital, is becoming an increasingly popular product.

What all this illustrates is that producers and consumers are becoming more sophisticated. And that presents opportunities for banks.

"The bottom line is that the scope for growth of agricultural products is huge," says Konijnenberg.

Big push

It wasn’t always so. With the odd exception there wasn’t much interest in the sector despite agriculture’s importance to the development of what can be termed modern-day banking. The original banks were merchant banks, which were first established in the Middle Ages by Italian grain merchants.

With food prices relatively stable following the crisis in the early 1970s up to 2007, there was little incentive for most banks to get involved. "One reason why commodities have been getting a lot of attention over the past 10 years is because in prior decades the absolute value of most commodities was so low they didn’t have much impact on corporates or sovereigns balance sheets," says Konijnenberg. "When prices started to hike up, combined with the greater volatility, the effect on budgets changed dramatically."

Sipko Schat, chairman of Rabobank’s international wholesale business

"Until seven or eight years ago the industry was considered to be very conservative. It was seen as boring. That’s changed"

Sipko Schat, Rabobank

Sipko Schat, chairman of Rabobank’s international wholesale business, says: "Until seven or eight years ago the industry was considered to be very conservative. It was seen as boring. That’s changed."

This is most evident in the risk management and trading business. While precious metals and energy continue to dominate most banks’ commodities units, firms have started to push hard in agriculture. "It’s still a distant third," says one commodities trader, "but if you take energy, food and water, those are the big issues that the world will have to grapple with over the next couple of decades and they are all linked. If you’re going to trade energy you have to trade agriculture too."

It was partly this natural evolution that led JPMorgan to focus on developing its agriculture-trading desk in 2008. "We were building our commodities business and looked at areas where there was space for banks to play a role. We already had exposure to agriculture through our investor products and traditional lending businesses but we were not leveraging the franchise to end producers and consumers. Therefore we saw it as a good opportunity and thought the sector was worth building out," says Mike Camacho, head of global sales and structuring, global investor products, and global agricultural commodities at the US bank.

The bank bought broker MF Global’s sugar book and a year later, in 2009, it acquired UBS’s global agricultural markets business. It has also been growing organically.

"We have a pretty complete programme now," says Camacho. "We have a North America team, an EMEA team and an Asia team. We also have people on the ground in different regions – Brazil, South Africa, Korea – therefore we are not just covering clients through hubs like New York, London and Singapore."

In June, JPMorgan teamed up with the International Finance Corporation, the private-sector arm of the World Bank, to launch a new risk-management product to provide up to an initial $4 billion in protection from volatile food prices for farmers, food producers and consumers in developing countries.

The facility will involve the IFC underwriting $200 million in credit risk, which will be matched by JPMorgan. The IFC calculates this will enable the private sector in developing countries to buy up to $4 billion of protection against price volatility.

"It’s one piece of the overall puzzle – the challenge to finance the agricultural supply chain becomes more acute in emerging markets"

Mike Camacho, JPMorgan

Mike Camacho, head of global sales and structuring, global investor products, and global agricultural commodities at JPMorgan

 

"It’s one piece of the overall puzzle – the challenge to finance the agricultural supply chain becomes more acute in emerging markets," says Camacho.

While the use of derivatives is common in the developed world they are used less in emerging markets, either by sovereigns or corporates. Some sovereigns have undertaken transactions – the Financial Times reported that Mexico’s government, for example, bought futures contracts in Chicago earlier this year to hedge against rising corn prices – but not many.

The IFC-JPMorgan scheme is available for the private sector only and the facility itself is straightforward. "The transactions covered by the facility are simple vanilla swaps or forwards," says Camacho. "Often producers in emerging markets have limited access to risk-management solutions. They are limited in trading futures on an exchange because of working capital constraints.

"By participating in something like this, instead of having to post margin to the exchange, they can do a simple swap or a forward sale with us, and take advantage of the larger credit lines this facility provides for unmargined hedging. They can then use their savings to re-invest.

"We’ve started with the premise that trades don’t exceed two years. If this takes off we hope to have other development banks buy into the facility and expand it."

One World Bank group official says the facility can only be used to support hedging purposes. "It has to be with parties that are producing or are buying. It’s not for financial speculation. There are reporting mechanisms built in. We were very cognizant of this fact. We wanted to ensure the facility cannot be a tool for financial speculation."

He adds: "For parties accessing the facility, the World Bank group will review the participants to ensure they meet our environment, social and governance standards. So that’s one control we have."

JPMorgan is not alone in investing heavily in its agriculture trading business in recent years. Citi, UBS and Deutsche Bank are all trying to gain market share through big-name hires.

The German bank also formed an alliance with sugar merchant Czarnikow in 2009 that allows it to trade physical cargoes of the commodity. It was a rare example of an investment bank expanding beyond derivatives trading in the food sector into the physical market, thus competing head on with the big trading houses, such as Bunge, Cargill, Archer Daniel Midlands and Louis Dreyfus.

The attraction of the alliance to Deutsche Bank is that it allows the firm to take title of the underlying commodity as well as giving it greater insight into the flow. However, investments by banks in the physical food market remain few and far between, and not just because of the competition from the traders.

"The operational side of the business and the costs involved can be challenging," says Macquarie’s Barrack. "Agriculture is a lot more operationally intensive than crude oil or natural gas. The logistics and documentation are much more onerous. That’s why banks are barely involved in physical commodities in agriculture. We have a small physical sugar business but that’s it."

Instead Macquarie is concentrating its efforts mostly on synthetic products. Its long-standing commitment gives the Australian bank a clear edge over its bulge-bracket rivals, according to Barrack.

"Macquarie is the longest-standing provider of over-the-counter risk management products in the world. We did our first client deal over 20 years ago and today have more people dedicated to the business than any of our competitors by many multiples," he says.

By having a broader and deeper penetration of the market, Barrack believes Macquarie is able to service clients that other banks cannot – counterparties that are too small to be on their radar.

"A classic trade for us would be offering assistance to a miller or crusher that is looking to expand its production," says Barrack. "We lend or invest money to a client that allows it to grow. Concurrently we help it by hedging its price risks that allow it to lock in margins.

"So we’re helping the underlying industry in terms of growth and capacity and protect ourselves by asking our clients to hedge themselves against adverse movements in prices."

Land purchases

While the global banks are largely concentrating their efforts in beefing up their trading units, other more niche players are building specialist agri-focused businesses in areas such as investment banking.

Last October, Renaissance Capital formed a new division concentrating on the emerging markets agriculture sector. The business covers trading, processing and farming companies with the capability to provide advisory, fundraising and research services.

Renaissance was already a big operator of farmland in Ukraine, where it manages 235,000 hectares.

"What we’ve done is fairly unusual," says Renaissance’s Ferguson, a former Nomura banker, who was hired to spearhead the initiative. The team includes a number of dedicated agriculture investment bankers and research analysts dotted around the world. "There are up to 20 people within RenCap who are involved in agriculture on a full- or part-time basis. A good half of them are spending all their time on it," says Ferguson.

One of the bank’s services is advising governments and sovereign wealth funds on land acquisitions.

Securing food is high on the agenda of import-dependent countries, such as China and the Gulf states. Saudi Arabia, for example, has created a national food security initiative although the government tends to stay in the background when it comes to securing overseas land, instead letting local private companies take the lead.

Securing food through foreign land purchases is a highly sensitive issue and arouses as much controversy and criticism as speculators trading in the financial commodity markets (see Land grab raises concerns about food security).

Perhaps the most notorious incident occurred in 2009 when Madagascar’s president, Marc Ravalomanana, was forced from office after agreeing to lease vast tracts of land to Daewoo. The Korean chaebol sought to produce corn and palm oil on 1.3 million hectares of land but the deal led to widespread protests with accusations of neo-colonialism. Eventually the agreement was cancelled by Ravalomanana’s successor.

For critics of land acquisitions, or land grabs as they see it, this amounted to a triumph of good over evil. But the issue is much more nuanced than that.

It’s often the case that poor countries offer the land to foreigners, be they other governments or private investors, such as private equity, hedge funds or farming groups, in the hope they will be able to make it productive.

Globally, an extra 6 million hectares of land needs to be cultivated every year for the next 30 years to meet 2050 targets. Quite simply, more land needs to be brought under production.

Two years ago, the Republic of Congo’s government gave away more than half a million acres of neglected state farms to South African farmers for that very reason. Almost one-third of Congo’s land is , while overall in Africa only 17% of arable land is being cultivated.

It’s not just land that needs developing. Ferguson knows of one African country, which is richly endowed in resources and is highly urbanized, that is keen to sell 40 of its grain-storage facilities. "The government has all these facilities sitting there doing nothing," he says.

How much activity is there? It’s impossible to get any up-to-date numbers but the International Food Policy Research Institute estimated in 2009 that between 15 million and 20 million hectares of farmland had been purchased in developing countries by foreigners for $20 million to $30 million since 2006. It doesn’t seem much.

What is the value of land?

And there’s a good reason why – owning land is not in itself especially helpful in securing food.

"Land is worth nothing," says Ferguson. "A number of governments will throw away millions of hectares but there’s a reason why few potential investors take them up. You have to plan a highly integrated approach to investing – and that is from ports right through to the processing companies. Unless you do that you don’t attract capital and this will be especially relevant in African agriculture in the years ahead."

It’s a message some government investors are learning the hard way. "There’s a prominent sovereign wealth fund sitting on hundreds of thousands of hectares of land wondering why the strategy is not working," adds Ferguson. "The reason is because there is no integrated approach."

Zhann Meyer, regional head for commodity traders and agriculture for Africa at Standard Chartered, echoes Ferguson’s view. "Leasing agricultural land in much of Africa is still relatively cheap – it costs between $10 and $50 per hectare in certain countries. That’s nothing. The challenge, however, is the social responsibility that goes with acquiring agricultural land and the capital expenditure required to make it productive.

"A lot of investors buying or leasing land don’t appreciate the capital required to turn these projects into a commercial farm. That’s why a lot of investments have stagnated. Skilled project managers and technical farming expertise are essential for success.

"The logistical challenges in Africa make the situation worse. If a combine harvester breaks down, for example, it can take up to six weeks to receive a replacement part, as it is coming from abroad. Ideally it would be best to keep spare parts on hand but the cost for this is prohibitive.

He adds: "Due to rising populations, Asia and the Middle East are showing increased interest in agricultural land in Africa, which potentially contributes to the development of commercial agriculture if managed on a sustainable basis."

Investors are not just focusing on Africa. Eastern Europe is on their radar too (see Investors out to make dough from Europe’s breadbasket).

Wolfgang Putschek, head of the consumer products department at Raiffeisen Investments, says: "We have seen Chinese interest through CIC, the sovereign wealth fund, although to my knowledge nothing has yet closed. We have also been talking to Kuwaitis, Qataris and Emiratis about fundraising for operations."

Interestingly, it’s not just foreign governments showing interest. Private equity funds are also active. "For them the financial return is critical while for the sovereigns food security is key," says Putschek.

A third group of investors in eastern Europe are family offices – in particular established farming families from Germany and Austria seeking to expand. "They go to Romania and Hungary. They lease land plots and typically join forces with the local aristocracy," adds Putschek.

For private investors, agricultural land acts as a hedge against inflation as well as potentially providing a good return. But to maximize their investment, the same criteria apply to them as to governments seeking access to food. "It is important investors have an integrated approach from the port to consumers," says Ferguson.

Capital markets potential

While advising sovereigns is one key element of Renaissance’s activities, another is leading transactions in the equity capital markets. "There’s massive potential for equity capital markets activity," says Ferguson.

Renaissance has already helped agri-related businesses raise more than $1 billion this year, ranging from a $540 million IPO on the London Stock Exchange for Russian fertilizer group Phosagro to a $55 million debut offering on London’s AIM market for African food producer and distributor Zambeef.

There’s a growing investor base too. Funds investing in agriculture are a relatively new feature on the investor landscape but since the food crisis of 2007-08 a number of dedicated investment vehicles have been launched. These include funds by some of the biggest institutional investors such as BlackRock and Baring Asset Management. Their funds trade solely in the shares of companies involved in agriculture, not the underlying commodities.

Ferguson reckons the pipeline for further equity issuance is healthy. "Very much so," he says. "It’s a unique opportunity."

The securitization market could also become a bigger source of finance to the agriculture sector, if it recovers its tarnished reputation, especially in a country such as South Africa where the local market is much more developed than in other emerging countries.

"It’s potentially something we can look at," says Jean Craven, head of group strategy at Export Trading Group (ETG), a commodity supply chain operator based in East and Southern Africa. "However, the issue around securitization in Africa is that the market isn’t that liquid."

The problem for any potential agriculture-related participant in the capital markets – equity or debt – comes back to the two big challenges of uncertainty of supply and scale.

"There is a role for the capital markets to play but it remains to be seen to what extent," says Ashutosh Kumar, global head of corporate cash and trade at Standard Chartered. "A lot of what needs to be financed is too small scale so it may not make sense to tap the capital markets."

Jerome Yazbek, chief executive of FarmSecure, an African agricultural service provider, agrees. "Small-scale farms need to be combined with corporate farms to create critical mass," he says. "If you do that then the capital markets have a huge role to play."

Consolidation then is essential to attracting capital and improving efficiencies. The trouble is most consolidation is taking place at the higher end of the value chain. While investment bankers will be salivating at the prospect of multi-billion dollar M&A deals – Cargill, for example, announced plans last month to buy Provima, a global animal nutrition business, for €1.5 billion while Brasil Foods is poised to merge with its main local competitor, Sadia – these transactions will not transform the structure of the industry where change is needed most: at the farm level.

"If you move down the chain, with the exception of the Americas and Australia, consolidation has not really taken place," says Rabobank’s Schat. "It’s still highly fragmented. It’s a challenge, therefore, for farmers to make money. One idea would be to have more cooperative structures but Africa and Asia are still dominated by small-scale farming."

One example is Afgri, a South African farming cooperative that started in 1925 when a group of farmers came together with the aim of aggregating buying and selling powers. Today Afgri, which listed on the Johannesburg Stock Exchange in 1996, operates across the agriculture value chain, providing farmers with input finance, term finance to buy land and machinery and production finance. It also owns retail stores that sell equipment and fertilizers. Afgri owns 4.3 million tonnes of grain storage facilities too, which equates to just over 40% of the total capacity that South Africa has to offer. It also has extensive food-processing capacity – for example the company slaughters just over 1 million chickens a week.

"Many companies focus on components of the value chain but they are not as integrated as us," says Hercules Bloem, head of Africa strategy at the firm.

Willie du Plessis, director of agricultural banking at Standard Bank

"The new approach towards agricultural financing is becoming more commodity focused. Basle III will accelerate that trend"

Willie Du Plessis, Standard Bank

Can the cooperative model be part of the solution to achieving food security? "We obviously believe our model is the right one and we think other firms will copy us or join forces," says Bloem.

The question is: how quickly? In the meantime, banks, especially in Africa, are focusing on ways to get small farmers to become commercial.

"In South Africa there is a need to get smallholder farming sustainable, which is a challenge," admits Willie du Plessis, director of agricultural banking at Standard Bank. "However, there are ways of doing it. Risk-sharing models including proper mentorship can be considered as an option to meet funding requirements."

Standard Bank has established an Agribusiness Centre at Stellenbosch University dedicated to help in this respect. "The centre is solely responsible for training mentors, who are involved with projects in South Africa. The mentors are linked to specific clusters of producers or smallholder farmers to ensure sustainable production," says du Plessis.

The bank also works with public-sector partners, such as local government, to share the risks in financing small-scale farms. "The model should provide for technical expertise to the farmer. We provide the finance and cashflow management. Success lies in commitment and hard work; therefore the key is to identify with farmers who have the profile to succeed," adds du Plessis. Standard Bank is working on such projects in the sugar cane, livestock and grain industries.

Financing the farmer

Other banks are also turning their attention to make small-scale farming more sustainable. Standard Chartered is one such institution. While the lender is predominantly focused on commercial farming in Africa it is also indirectly helping the development of small-scale farming through the financing of its clients.

One such example is in Tanzania, where the bank provides finance to a leading rice farmer. "This farmer, who cultivates 3,500 hectares of rice, has become an example in engaging small-scale rice outgrowers around a commercial venture," says Meyer.

In addition to financing production costs, Standard Chartered assisted in refurbishing the producer’s rice mill. "Through our facility, the farmer has extended input finance to these outgrowers, shares commercial farming expertise and enables access to the mill to process their harvest," adds Meyer.

"Up to 80 families now enjoy the benefits of agricultural mechanization, value added processing and a reliable and transparent market in which to sell their produce," he says.

In another example, Standard Chartered acted as mandated lead arranger in a $120 million structured soft commodity syndicated loan to ETG, a transaction that showcases how it finances various links within the supply chain.

The loan is being used to finance the trade of soft commodities in India, China and over 30 markets in Africa. For example, in Mozambique ETG’s infrastructure of more than 80 agricultural storage and distribution depots supports 25,000 small-scale farmers with technical expertise, inputs, storage and a market price for their crops. In short, these depots help create a market.

Not only is Standard Chartered providing the funds to pay for necessary inputs, such as fertilizers, it is also financing the stock while it’s in storage and the buyer on the other side of the trade. "That way we can support the supply chain end to end," says Meyer.

The emerging markets specialist has a regional agricultural financing portfolio in Africa valued at just under $3 billion. The bank has adopted an innovative financing model in Africa that other lenders, such as Standard Bank, are also starting to use. Instead of taking the land as security for a loan, traditional asset-based financing, it takes the crop, a more novel production-based financing.

"One of the biggest problems in Africa is to obtain finance," says Yazbek. "The finance world is based predominantly on asset-based finance but in this environment farmers often don’t have sufficient assets. They become the risk."

Under a production-based structure that risk is mitigated. It means that the bank owns the crop and employs the farmer via contract managers. "Farmers are employed to grow a crop on our behalf and what he gets after harvest is used to repay costs, with the remainder of the proceed being his profit," says Meyer.

"The crop belongs to us; it’s not the property of the farmer. It’s a contracting arrangement, not a financing one. It also allows us to work in countries where farmers lease their land. Our model mitigates a lot of the risk given the additional support, technical skills and price-risk management we provide to our farmers."

Meyer says their product supports commercial farmers in South Africa, Tanzania, Zambia and Zimbabwe. "The product is very successful," he adds. "In South Africa we finance for 10% of the country’s annual cereal crop harvest."

Managing the risks is vital, including crop damage. Some estimates put crop damage in Africa as high as 40%. Typically the contract manager would mitigate price risk by hedging on the South African futures exchange or enter into forward sales with approved off-takers on behalf of the farmer.

The bank also takes out insurance to protect against external risks, such as bad weather and crop disease. "To benefit from the insurance cover, farmers need to apply sound farming practices," says Meyer. "All these things are essential in maximizing the positive benefits of our financing model."

It’s a labour and technology intensive model. "We have commodity traders and agriculture teams in 14 countries in Africa," says Meyer.

"Another key differentiator is our dedicated collateral management teams in South Africa and Ghana, who are responsible for managing the regional agri-portfolio. They have the systems, know-how and the relationships with independent collateral managers and consultants to ensure our commodities are in good condition while they’re being cultivated or in storage." A strong relationship with the contract manager is also important to the strategy’s success.

Basle III impact

One of the big advantages of taking title of a crop is that it lessens the capital charge a bank faces because the commodity is treated as a short-term, liquid asset, an important consideration with Basle III looming. "By using the intrinsic value of the crop as collateral, we are able to reduce our capital reserve requirements," says Meyer. "If we used land as security it would be different because there is a different weighting given. It would put more pressure on the balance sheet."

Du Plessis adds: "The new approach towards agricultural financing is becoming more commodity focused. Basle III will accelerate that trend."

But there are other unintended consequences from Basle III that could have a detrimental effect on the agriculture industry.

"One of the biggest challenges we might find is that the cost of capital might have an impact on the pricing of our loans," says du Plessis. "That will obviously have an impact on the profitability of the farmer."

The greater cost of capital could lead to a reduction in long-term lending. "We have extended some of our loans out to 15 years," adds du Plessis. "Under Basle III that is something that needs to be re-looked at."

Further food finance reading:
Food finance: Tilling the soil
Rabo’s farming roots
IFC: from food to farm
Middle East: Land grab raises concerns about food security
Ukraine: Investors out to make dough from Europe’s breadbasket
North America: US farmers discover the price of globalization
Farms among the skyscrapers
Why farmland is not an easy investment
There are consequences for short-term lending too, through the one-year maturity floor regulation. "It means if you are doing a 90-day or 180-day transaction you need to maintain capital as if the transaction was for one year," says Standard Chartered’s Kumar. "However, the Basle Committee does not make this rule mandatory, hence while some local regulators implement it, some other countries don’t, and that leads to inconsistencies."

Trade finance could also suffer. The new rules sharply increase the risk weighting of lending between financial firms – an essential element of trade finance because it involves the importer’s bank lending money to the exporter’s bank, often through letters of credit.

New liquidity ratios being mooted could also have a negative impact. "Trade finance and export credit guarantees, which are normal day-to-day activities, have become clubbed in the same bucket as complex derivatives transactions," says Kumar.

These regulatory issues are another set of obstacles that can be added to an already daunting list that need to be overcome in the race to make agriculture, and thus food production, more sustainable. It’s a race the world cannot afford to lose.