- As finance has to cover operational costs of providing loans, it may be difficult for private investors to reduce interest rates beyond a particular level.
- However, some instruments can improve lending terms by leveraging types of investment which would have been otherwise unattainable.
- Innovative credit guarantees can reduce the risk profile of the investment, allowing for reduced interest rates.
1. Performance and revenue guarantees
‘Off-take agreements’ are arrangements where a company commits to certain conditions for buying future produce. These agreements can significantly reduce the risk of investments by minimising risk related to the commercialisation of production. They can take many forms, for example:
A promise to purchase a certain volume of production at a fixed price at a certain date in the future.
Price floor policies, such as the rubber subsidy in Acre.
- Agricultural insurance, which guarantees a minimum income despite extreme weather related losses.
2. Credit guarantees
Credit guarantees are a type of insurance policy that protects the lender against non-payment (default) by a borrower. Therefore credit guarantees are a type of instrument used to reduce the risk of investment.
Traditionally, lenders require borrowers to have collateral to act as credit guarantee. Collateral is property, such as land, machinery or other assets that a borrower offers as a way for the lender to secure a loan. If the borrower stops making the promised loan payments the lender can seize the collateral to recoup losses. In this way collateral reduces risk, and, consequently, reduces interest rates.
However, it is possible that many borrowers may not have collateral in the traditional sense. Taking an innovative approach, it is possible to consider alternatives types of collateral or credit guarantee mechanisms. This may include offering expected cash flow analyses as collateral or, more structurally, build in a portfolio-level credit guarantees such as first-loss guarantee schemes. These may come from an aid agency such as USAID or other third party, which guarantee a proportion of the overall loan.
3. Blending mechanisms
Blending mechanisms are increasingly leveraging large amounts of money for development. These mechanisms combine grant aid finance with public or private loans. This has the overall effect of reducing the cost of capital and therefore cutting interest rates. In some cases, blending can leverage loans for projects which would have been otherwise unable to access this money.
This approach is increasingly supported by large development finance institutions including the European Investment Bank (EIB), the Kreditanstalt fuer Wiederaufbau (KfW) and the Nordic Investment Bank (NIB).
In recent years, the European Union has encouraged blending mechanisms by creating several different facilities, leveraging loans from finance institutions and development banks.