Rediscount Lines and Bond Financing

Second-tier institutions that are devoted exclusively to on-lending government and donor funds to retail financial intermediaries are known as rediscount lines. They have gone out of fashion in recent years but they still are used when weaknesses in financial systems constitute severe obstacles to development of certain sectors or areas of the country. For example, the World Bank has supported a rediscount line for investments outside of the Maputo area in Mozambique, since almost all bank investment was concentrated in that area, and rediscount lines in Honduras and Nicaragua, mostly for agriculture. In Estonia, it agreed to the government's con

114. R. Rosenberg, 'Comment on DevFinance Network May 15, 1996', Internet discussion group [[email protected]].

115. J. D. Von Pischke, 'Comment on DevFinance Net-work, May 14 1996', Internet discussion group [[email protected]].

tinuation of a rediscount line for agriculture during the transition to a market economy, and also in Nicaragua it offered to channel subsidized funding to banks that agreed to establish branches in rural areas (without much success).

Rediscount lines tend to specify a limited number of economic activities for which their funds may be used, e.g. agriculture or housing. Their critics point out that directed credit may go to sub-optimal uses when viewed from an economy-wide standpoint, and that the purposes of directed credit may be subverted by the fungi-bility of funds. For example, loans to a farm family may permit it to construct a house in an urban area, by freeing up some of its own resources. Usually, rediscount lines are subsidized for two reasons: (1) an incentive must be offered to financial intermediaries to induce them to lend for purposes that they would otherwise not lend for, and (2) the target sector or group is often judged to need subsidized funding in order to develop. However, subsidization of the target clientele does not necessarily have to be part of the design of a rediscount line.

While the criticisms of rediscount lines are valid, it is undeniable, as pointed out earlier, that the collapse of public sector agricultural banking has left many medium and small-scale farms in a large financial void. This will not be filled until microfinance institutions mature and grow considerably more and/or new types of rural banks emerge. Neither of those solutions is likely to emerge soon in most developing countries. The need for rediscounted funds is most acute for long-term investments, such as reforestation, private irrigation systems, fruit trees and livestock development. To the extent that commercial banks lend for agriculture, almost all of it goes for short-term working capital. To be effective, a rediscount line should be directed toward supporting production lines that have a clear comparative advantage (often this is not the case), and its terms have to be sufficiently attractive to financial intermediaries.

A major barrier to the effective operation of rediscount lines can be a lack of capacity in the retail financial system to absorb more funds. Often banks are fully lent-up in terms of their capital adequacy ratios, especially in light of the attractive terms offered by government paper, and MFIs do not have significant capacity to expand lending. Thus, the core problem may be the identification of an appropriate financial intermediary. Associations of producers have sometimes tried to play that role, but the guarantees they can offer are usually weak, unless they can purchase a guarantee bond from a bank, but that may be expensive and in some countries, impossible. Thus, while there is a certain inexorable logic to the (transitory) need for rediscount lines to foster the development of key sectors in many developing economies, this need often leads back to the need to strengthen existing financial intermediaries at the retail level.

The bond market is rarely tapped for agricultural development but it can represent a financial resource when the circumstances are appropriate. At the end of the 1990s, El Salvador successfully floated bonds on the international market to support a program of renovating coffee plantations. However, the conditions for the success of this program were very strict. They included the following:

(1) A solid history of domestic loan repayment by most coffee farmers.

(2) A proven technology for raising coffee yields.

(3) A relatively homogeneous client group.

(4) A well-organized national federation of coffee farmers that was able to deliver the technology package for renovation and select the farmers for participation.

(5) An acceptable credit rating by the Government of El Salvador, which guaranteed the bonds, on world financial markets.117

Conditions such as these rarely can be satisfied, but when they can, the international bond market represents an under-utilized financial resource to support agricultural development.

117. Source: conversation with Carlos Fuentes of the Ministry of Agriculture of El Salvador, 2001.

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