37035 NOTES AGRICULTURAL & RURAL DEVELOPMENT CREDIT ALTERNATIVES IN RURAL FINANCE: FINANCIAL LEASING BY AJAI NAIR AND RENATE KLOEPPINGER-TODD ISSUE 10 MAY 2006 Enterprises use credit to acquire productivity-enhanc- the asset for a token price. The lessee is responsible for ing assets. Rural enterprises in developing economies, maintenance and risk of obsolescence of the asset, and however, often lack access to the credit they need. the leasing contract is usually noncancelable. In con- Key reasons for this lack of access include the low trast, operating leases do not include the option to pur- level and scattered nature of economic activity in rural chase the asset. Maintenance costs and risk of obsoles- areas, the enterprises' lack of collateral, inadequate cence are borne by the lessor, and leases are cancelable. capacity among the country's lenders to lend in rural The lessor recoups the investment through multiple areas, and legal and policy environments that discour- leases and final sale of the asset. Because of the option age lending to rural enterprises. Traditionally, leasing to purchase the asset and the risks transferred to the has served as an alternative to credit for urban enter- lessee, a financial lease is a close substitute for a loan. prises, but generally it has not been a feasible option Nearly all rural leases are financial leases. for rural enterprises. This note argues that rural leas- ing can be viable and highlights the key factors to ADVANTAGES OF LEASING facilitate successful rural leasing. Leasing can be an attractive alternative to loans TYPES OF LEASES: because of the advantages it presents to both FINANCIAL AND OPERATING providers and users. From the provider's perspective, the major advantage is the ownership of the leased To better understand the merits of leasing, it is impor- asset, and the related rights in cases of default. In a tant to first define its two main categories: financial secured-credit transaction, the borrower has owner- leases and operating leases. In a financial lease, lease ship of the financed asset, while the lender has a lien payments amortize the price of the asset (amortization on the asset. If the borrower defaults, the lender often may be run for the full price or for most of the price). has to obtain a court order to collect the collateral. In At the end of the lease period, the lessee can purchase contrast, in a leasing transaction, the lessor owns the leased asset. In case of default of lease payments, the company can repossess the asset after giving the lessee a legal notice. A court intervention is needed only if the lessee obstructs the repossession. Usually, court deci- sions are favorable to the lessor, because lessor rights are stronger than creditor rights. Stronger lessor rights also reduce the incentive for the lessee to default. Two other advantages are generally available to leas- ing: (1) the freedom to set lease interest rates and (2) fewer costs to adhere to regulations. Many countries impose interest rate ceilings on loan interest rates, particularly for small loans and rural loans, but they do not regulate lease rates. Leasing companies often are exempt from prudential regulation1 or are subject to less stringent regulatory requirements than that required by banks. Financial leasing is less risky than operational leasing because maintenance and risks of obsolescence are borne by the lessee. From the client's perspective, the primary advantage of based or nonprofit organizations in rural areas demon- leasing is the potential to acquire assets without any strates the mutual benefits of such arrangements and additional collateral. In addition, leasing is usually avail- encourages sustainable links on a fee, commission, or able to clients with little or no credit history, offers more profit-sharing basis.2 CECAM (Caisses d'Epargne et de flexible payment terms, and has fewer transaction costs. Crédit Agricole Mutuels), a cooperative agricultural Most, but not all, of these advantages are available to financial institution providing credit and leases in lessors and lessees in the rural context. Madagascar, uses solidarity group guarantees to moni- tor the physical status of assets and to decrease incen- ENABLING ENVIRONMENT tives for defaulting on lease payments. For a leasing sector to develop and benefit rural enter- Third, leasing companies benefit from technical assis- prises, the necessary enabling environment needs to be tance such as training, advisory services, and manage- in place. This enabling environment should include two ment support. Technical assistance grants can support key elements: a clear legal basis and minimal regulation. product development or improve service delivery. For A good legal framework for leasing, includes (1) clear example, the Central Asian Leasing Project, supported definitions of a lease contract, leased assets, and respon- by the International Finance Corporation (IFC), provided sibilities and rights of the parties to a lease contract; (2) technical assistance to governments and leasing com- clarity in allocating responsibility for liability of third- panies in the region. party losses arising out of the operation of leased assets; (3) priority of lessor's claim over a leased asset; and (4) a Fourth, nonavailability of medium and long-term financ- framework for easy and fast repossession of leased ing is a limiting constraint for financial institutions in assets. Minimal regulation is appropriate, because pru- many countries. Access to capital can be critical if leas- dential regulation is only required if leasing companies ing companies and other lessors are expected to start or take public deposits, which they rarely do. Furthermore, expand rural operations. To meet this need, donor because these leases are not significantly riskier than organizations are providing capital to rural enterprises. loans, banks should be permitted to provide finance The U.K. Department for International Development leases. Additionally, use of internationally accepted provided capital to Development Finance Company accounting standards and an unbiased tax code Uganda (DFCU) to expand its operations to rural areas. enhances the development of the leasing sector. And, the World Bank's Rural Finance Project in Romania has a Rural Credit and Leasing Facility that provides INSTITUTIONAL SUPPORT financing to private banks and leasing companies to be used exclusively in rural areas. In addition to a strong enabling environment, institution- al support can help develop the rural leasing sector. There LESSONS LEARNED are four such types of institutional-level support: (1) sub- FROM CASE STUDIES sidizing startup costs for commercial leasing operations; (2) funding establishment of links between commercial Three case studies reinforce the need to support the providers and community-based or nonprofit organiza- development of leasing services in rural areas and pro- tions; (3) lending technical support to leasing companies; vide concrete examples of viable areas of support at the and (4) providing equity, loans, or guarantees. institutional level. First, subsidizing startup costs helps organizations offset The first of these three cases, the Network Leasing the higher transaction costs and risks of operating in rural Corporation Limited (NLCL) in Pakistan, focuses on areas. These costs and risks tend to be higher for the initial micro and small entrepreneurs. It pioneered microleasing period in which operations are established. The U.S. in Pakistan in the mid-1990s and is presently one of the Agency for International Development provided startup leading providers. Its lease portfolio in 2004 was capital to Development Finance Company Uganda (DFCU), US$11.6 million, of which around 20 percent is estimat- a leasing company, to help it establish rural branches. ed to be in rural areas. The second case , DFCU Leasing Company Limited in Uganda, is estimated to have a Second, funding the creation of links between commer- market share of nearly 80 percent in Uganda and focus- cial providers operating in urban areas and community- es on small and medium enterprises. The company's 2 lease portfolio in 2004 was US$25.7 million and around · Rural leasing can be profitable, but jump-starting rural 20 percent of this is estimated to be in rural areas. The leasing will require government and donor support. third case, Arrendadora John Deere in Mexico, a sub- All three firms studied benefited from access to gov- sidiary of John Deere Capital Corporation, USA, is the ernment or donor funds, particularly in expanding largest provider of farm machinery leases in Mexico. The their rural operations. company's core clientele includes medium and large farming enterprises. Its lease portfolio in 2004 was · A rural leasing company may not be viable. Because US$74 million, 85 percent of which is invested in farm leasing is a specialized financial activity, economies equipment leases. of scale, cost, and risk factors may require that, in most economies, leasing companies have larger urban These case studies demonstrate that rural leasing can be operations. profitable. In fact, all three companies not only were profitable, but also reported their rural portfolios to be as profitable as their urban portfolios. Portfolio quality was generally good, repossessions were relatively few, and only one firm reported write-offs in the past four years. No legal or regulatory constraints to repossession were reported by these companies. The taxation and regula- tory frameworks in the countries differed. For example, leasing companies are subject to prudential regulation in Pakistan and Mexico but not in Uganda, and only Pakistan has a taxation framework with a positive bias toward leasing. These differences, however, did not appear to critically affect the ability of the leasing com- panies to operate profitably. Access to asset-finance was the most significant benefit for clients. For several clients, their first lease was also their first access to formal finance and they could also obtain subsequent leases. Other benefits cited by clients included the absence of or reduced need for additional collateral, less time for processing, and approachability POTENTIAL WORLD of the provider. BANK SUPPORT Five general lessons were drawn from the case studies World Bank projects can support the development of rural leasing in several ways and a small number of proj- · Rural leasing is a means to acquire productive assets. ects are already doing so. For example, the Rural Finance All rural leases provided by the three leasing compa- Project in Romania has a major component that benefits nies are finance leases and were used to finance the rural leasing. Although the Poverty Alleviation Fund acquisition of assets (in contrast to renting of assets). Project in Pakistan does not specifically target leasing, credit under the project is available to leasing companies · Rural enterprises of different sizes benefit from leas- offering microleases and operating in rural areas. The ing, but a provider may not be able to equally serve all Micro, Small and Medium Enterprise Project in Nigeria enterprises. Providers are limited because of differ- supports the creation of a legal and regulatory frame- ences in skills and capacities required to effectively work for leasing and provides startup grants for financial serve enterprises of varying sizes. institutions, some of which are expected to benefit · Non-farm enterprises account for a significant pro- enterprises operating in rural towns. portion of rural leases. In the case of NLCL and DFCU, leases to non-farm rural enterprises accounted for a The World Bank can build on these experiences to fur- larger proportion than leases to farming enterprises. ther support the development of rural leasing markets. 3 As in the case of all rural finance, an enabling environ- include capital support when access to long-term funds is ment is necessary but not sufficient. Although rural leas- a critical constraint. Capital support combined with tech- ing overcomes some of the key constraints faced by rural nical assistance can help leasing firms develop access to credit, it is still subject to several similar constraints. sustainable sources of capital. Although grants may be These constraints include the low intensity of economic the best means to support technical assistance, soft cred- activity in rural areas, poor infrastructure, the high cost its also can be used to provide technical assistance to gov- of developing financial technologies that can be used in ernments as well as leasing firms. rural areas, poor quality of client information, and covariant income risks of large segments of the popula- Rural finance projects should ensure that its services are tion. All these factors may discourage leasing companies available to not only credit providers but also leasing with successful urban operations from expanding to providers. These projects should also explore partnerships rural areas and justify institutional-level initiatives to or possibilities of working in tandem with international encourage rural leasing. and national institutions that provide long-term project finance for leasing companies. CONCLUSION FURTHER READINGS Leasing is a viable tool to finance rural assets. The nature and capacity of existing financial institutions, the level of Nair, Ajai and Renate Kloeppinger-Todd. 2006. "Buffalo, Bakeries, and Tractors: Cases in Rural Leasing from potential demand for leasing in rural areas, and the level Pakistan, Uganda, and Mexico." World Bank Agricultural of development of the leasing industry should determine and Rural Development Discussion Paper No. 28. World the mechanisms to support increased access to leasing for Bank, Washington, DC. Available at http://www.world- rural enterprises. Policy-level support will be required in bank.org/rural. countries that do not have a clear legal and regulatory Nair, Ajai, Renate Kloeppinger-Todd, and Annabel Mulder. framework for leasing. Such support must be sectorwide 2004. "Leasing: An Underutilized Tool in Rural Finance." and not restricted to rural leasing. World Bank Agricultural and Rural Development Discussion Paper No. 7. World Bank, Washington, DC. Available at Institutional-level support, however, can be more targeted http://www.worldbank.org/rural. to rural leasing. A wide range of organizations­­leasing Westley, G. D. 2003. "Equipment Leasing and Lending: companies, banks, financial cooperatives, microfinance A Guide for Micro-Finance." Sustainable Development organizations, and equipment selling companies­­could Department. Best Practice Series, Inter-American benefit from such support. Institutional-level support can Development Bank, Washington DC. 1Prudential regulation involves enforcing requirements such as a minimum level of capitalization, debt-equity ratios, and liquidity requirements on deposit-taking financial institutions to reduce the risk of failure of such institutions, which would result in deposi- tors losing their deposits and risk bank runs. 2The rural organization could provide one or more of the following services: initial appraisal, referencing, guaranteeing, lease pay- ment collection, and supervision. The leasing firm could complete the final appraisal and negotiate favorable terms with suppliers on asset price, maintenance support, and insurance. This note summarizes the findings of two recent publications on rural leasing. "Leasing: An Underutilized Tool in Rural Finance" pro- vides an overview of leasing, analyzes its relevance for rural finance, and makes policy recommendations to support rural leasing. The 10 lessors surveyed for this paper together provided more than US$125 million in leases to rural enterprises in 2002­03. Seventy-five percent of these leases were for agriculture or agricultural processing equipment. The lessors included three microfi- nance organizations, six private companies, and one state-owned company. "Buffalo, Bakeries, and Tractors: Cases in Rural Leasing from Pakistan, Uganda, and Mexico" presents case studies of three compa- nies from among the 10 lessors surveyed. These are profitable companies serving different market niches. THEWORLDBANK 1818 H Street. NW Washington, DC 20433 www.worldbank.org/rural